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A typical textbook exposition starts with a bank customer depositing cash in a bank, and the bank being required to keep a fraction (1/m) of this deposit as Reserves, while it lends out the rest:

Now let us suppose that on January 2, 2008, an eccentric widower comes into Bank-a-Mythica and deposits $100,000 in cash in his checking account. The bank now has $100,000 more in cash reserves and $100,000 more in checking deposits. Because deposits are up by $100,000, required reserves rise by only $20,000, leaving $80,000 in excess reserves…

Bank-a-Mythica… will lend out the extra $80,000—let us say to Hard-Pressed Construction Company… There is now $100,000 in checking deposits and $80,000 of cash in circulation, making a total of $180,000—whereas prior to the original deposit there was only the $100,000 in cash. The money-creation process has begun…

OVERSIMPLIFIED MONEY MULTIPLIER FORMULA

If the required reserve ratio is some fraction, m, the banking system as a whole can convert each $1 of reserves into $1/m in new money. That is, the so-called money multiplier is given by: Change in money supply = (1/m) x Change in reserves… {Baumol, 2011 #6257`, pp. 636-40}

This model implies that, for banks to create money, Reserves must be created first. It asserts that the amount of money in existence is therefore controlled by the Central Bank, which both creates Reserves, and sets the “Required Reserve Ratio” as well. It is clearly believed by policymakers like Bernanke, since his justification for Quantitative Easing during the GFC was in part the belief that banks would lend out excess reserves and thus stimulate the economy:

Large increases in bank reserves brought about through central bank loans or purchases of securities are a characteristic feature of the unconventional policy approach known as quantitative easing. The idea behind quantitative easing is to provide banks with substantial excess liquidity in the hope that they will choose to use some part of that liquidity to make loans or buy other assets. {Bernanke, 2009 #6625`, p. 5. Emphasis added}

Double-entry bookkeeping shows that this model only works if all loans are in cash.65F67F^[1]

The model starts with a saver depositing cash into his bank account, which creates excess reserves for the bank—as shown in the first row of Figure 18. Lending those reserves out clearly requires a negative entry in the Reserves column, as shown in the second row. But what is the second entry?

Figure 19: The first two stages in the fractional reserve banking model, with the second phase incomplete

If we show this as an increase in the deposit account of the saver, then we make an accounting error—as shown in Figure 19.

Figure 20: Reducing Reserves and increasing Deposits violates double-entry bookkeeping

We can show Reserves falling and Loans increasing at the same time, as shown in Figure 20. But that has a problem: the borrower has accepted a liability—the debt—but as yet has no asset to show for it.

Figure 21: Lend from Reserves works if Reserves fall and Loans rise

The only way to square this circle is that the loan must be in cash. Then the borrower leaves the bank with an increased liability—the bank loan—and an equivalent sum in cash, as shown in Figure 21. Reserves must also be in cash, for the transfer from Reserves as an Asset for the Bank to Cash as an Asset for the borrower to work.

Figure 22: The Money Multiplier model only creates money if all loans are in cash

Cash loans, and cash-based Reserves, may have been commonplace in the 19^th century Wild West, but today? Almost all loans are made by crediting a borrower’s bank account. This model cannot describe modern electronic banking—and yet it is taught by and believed by Neoclassical economists.

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‘All the creditors must appear in the Ledger at the right-hand side, and all the debtors at the left. All entries made in the Ledger have to be double entries—that is, if you make one creditor, you must make someone debtor.’ {Gleeson-White, 2011 #4185`, p. 93}

Knowing which entries to record as Debits (DR) and which to record as Credits (CR is challenging. I developed a far simpler means to achieve the same ends. For each transaction:

• Record an increase in an account balance as a positive entry;

• Record a decrease in an account balance as a negative entry; and

• Ensure that the equation Assets minus Liabilities equals Equity is obeyed

“Equity” here means the net worth of the entity being considered. If your Assets exceed your Liabilities, than your net worth is positive; if your Liabilities exceed your Assets, then your net worth is negative.

I have implemented these rules in the simulation and data analysis program Ravel, in what I call Godley Tables. Figure 10 shows a blank Godley Table. An entity’s Assets are shown on the left, as Pacioli recommended, and its Liabilities are shown on the right. The gap between them is the net worth or Equity of the entity, and the final “A-L-E” column checks whether the transaction is entered properly. If it is, each row will sum to zero. If it is not, the sum of the row will not be zero, which shows that an accounting error has been made.

Figure 11: A blank Godley Table with its A-L-E=0 check to ensure transactions are properly recorded

It takes two or more Godley Tables to show a transaction fully: one shows the perspective of one party in a transaction—say the seller; the other shows the perspective of the other party in a transaction—say the buyer. A simple transaction of buying a product from a shop requires three tables: the Buyer’s, the Seller’s, and the Bank’s.64F^[1]

Figure 12: Showing a simple sale using Godley Tables

This simple framework destroys the models that economists use to describe banking, but I’ll first use it to describe real world banking.

1. Loans Create Deposits

The fundamentals of how bank loans create money are extremely simple. When a bank and a borrower agree to and execute a loan contract, the bank adds the specified amount of the loan to the borrower’s deposit account at that bank, and records the identical sum as the borrower’s debt to that bank. The increase in debt and the increase in the borrower’s deposit account are identical to the penny, as Figure 12 illustrates numerically.

Figure 13: An arithmetic example of loans creating deposits

There are of course numerous banks, and a complex machinery of interbank settlement. But at the level of an entire national economy, the aggregate effect of many banks making many new loans, and many debtors repaying old ones, is the same as this numerical example. Net new lending—which is normally positive, but can be negative, if borrowers are in the aggregate repaying debt—adds Credit dollars per year to Loans, and the same to Deposits. In this sense, though people who understand this normally say “Loans create Deposits”, the correct statement is that “Credit increases both Loans and Deposits”.

Figure 14: Credit creates both Loans and Deposits

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Instead, one of the peculiarities of Neoclassical economics is that it assumes that money doesn’t matter, apart from the impact of money growth on the rate of inflation. The real level of output—the volume of goods and services created by the production system—is assumed to be unaffected by the money supply, the banking system, or the level of private debt. Consequently, Neoclassical macroeconomic models completely omit the banking system: neither banks, nor private debt, nor money, figure in mainstream “Dynamic Stochastic General Equilibrium” (DSGE) models.61F^[1]

The models of money and banking that Neoclassical economists do have—the “Money Multiplier/Fractional Reserve Banking” model of money creation, and the “Loanable Funds” model of bank behaviour, are not serious models of money and banking, but excuses to not include banks, money, and private debt in their models of the macroeconomy. Though Neoclassicals will never admit it, their models fall apart with the least inspection of what they imply in double-entry bookkeeping form (brace yourself: some accounting logic is coming).

On the other side stands a rival tradition dating back over a century, which argues that banks, debt and money play critical roles in a capitalist economy. Neoclassical economists have, of course, ignored this tradition—even when one of their own, Irving Fisher, ultimately contributed to it, with his explanation for The Great Depression.

In “The Debt-Deflation Theory of Great Depressions” {Fisher, 1933 #152} Irving Fisher asserted that the Great Depression was caused by a combination of too much private debt,62F^[2] and too low a rate of inflation:

I venture the opinion, subject to correction on submission of future evidence, that, in the great booms and depressions, each of the above-named factors has played a subordinate role as compared with two dominant factors, namely over-indebtedness to start with and deflation following soon after… {Fisher, 1933 #152`, pp. 340-41}

Fisher dubbed the ensuing process a “debt-deflation”. Starting from a position of generalised over-indebtedness, debtors attempt to attract business to themselves, rather than their rivals, by dropping their prices. But because virtually everyone is doing it, the price level drops, and the ratio of private debt to GDP actually increases:

In that case, the liquidation defeats itself. While it diminishes the number of dollars owed, it may not do so as fast as it increases the value of each dollar owed. Then, the very effort of individuals to lessen their burden of debts increases it, because of the mass effect of the stampede to liquidate in swelling each dollar owed. Then we have the great paradox which, I submit, is the chief secret of most, if not all, great depressions: The more the debtors pay, the more they owe. {Fisher, 1933 #152`, p. 334}

The empirical data supports Fisher’s contention. According to US Census data, the nominal level of private debt peaked in 1930, but the ratio of private debt to GDP peaked 2-3 years later, because nominal GDP fell faster than nominal debt: see Figure 9. The burden of private debt was rising between 1930 and 1933, even though the level of debt was actually falling—see Figure 10.

Figure 10: The private debt ratio rose from 1930 to 1932 (right hand axis), even as nominal debt was falling (left hand axis)

A critical part of Fisher’s analysis was that repaying bank debt destroyed money:63F^[3] “when a debt to a commercial bank is paid by check out of a deposit balance, that amount of deposit currency simply disappears”. Fisher clearly stated that this was a consequence of bank lending, not of “peer-to-peer” lending: “A man-to-man debt may be paid without affecting the volume of outstanding currency, for whatever currency is paid by one, whether it be legal tender or deposit currency transferred by check, is received by the other, and is still outstanding”.

Speaking as a representative of Neoclassical economists, Ben Bernanke explained that they ignored Fisher’s arguments… because of the characteristics of peer-to-peer lending:

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Instead, one of the peculiarities of Neoclassical economics is that it assumes that money doesn’t matter, apart from the impact of money growth on the rate of inflation. The real level of output—the volume of goods and services created by the production system—is assumed to be unaffected by the money supply, the banking system, or the level of private debt. Consequently, Neoclassical macroeconomic models completely omit the banking system: neither banks, nor private debt, nor money, figure in mainstream “Dynamic Stochastic General Equilibrium” (DSGE) models.61F^[1]

The models of money and banking that Neoclassical economists do have—the “Money Multiplier/Fractional Reserve Banking” model of money creation, and the “Loanable Funds” model of bank behaviour, are not serious models of money and banking, but excuses to not include banks, money, and private debt in their models of the macroeconomy. Though Neoclassicals will never admit it, their models fall apart with the least inspection of what they imply in double-entry bookkeeping form (brace yourself: some accounting logic is coming).

On the other side stands a rival tradition dating back over a century, which argues that banks, debt and money play critical roles in a capitalist economy. Neoclassical economists have, of course, ignored this tradition—even when one of their own, Irving Fisher, ultimately contributed to it, with his explanation for The Great Depression.

In “The Debt-Deflation Theory of Great Depressions” {Fisher, 1933 #152} Irving Fisher asserted that the Great Depression was caused by a combination of too much private debt,62F^[2] and too low a rate of inflation:

I venture the opinion, subject to correction on submission of future evidence, that, in the great booms and depressions, each of the above-named factors has played a subordinate role as compared with two dominant factors, namely over-indebtedness to start with and deflation following soon after… {Fisher, 1933 #152`, pp. 340-41}

Fisher dubbed the ensuing process a “debt-deflation”. Starting from a position of generalised over-indebtedness, debtors attempt to attract business to themselves, rather than their rivals, by dropping their prices. But because virtually everyone is doing it, the price level drops, and the ratio of private debt to GDP actually increases:

In that case, the liquidation defeats itself. While it diminishes the number of dollars owed, it may not do so as fast as it increases the value of each dollar owed. Then, the very effort of individuals to lessen their burden of debts increases it, because of the mass effect of the stampede to liquidate in swelling each dollar owed. Then we have the great paradox which, I submit, is the chief secret of most, if not all, great depressions: The more the debtors pay, the more they owe. {Fisher, 1933 #152`, p. 334}

The empirical data supports Fisher’s contention. According to US Census data, the nominal level of private debt peaked in 1932, but the ratio of private debt to GDP peaked 2-3 years later, because nominal GDP fell faster than nominal debt: see Figure 9. The burden of private debt was rising between 1930 and 1933, even though the level of debt was actually falling—see Figure 9.

Figure 10: The private debt ratio rose from 1930 to 1932 (right hand axis), even as nominal debt was falling (left hand axis)

A critical part of Fisher’s analysis was that repaying bank debt destroyed money:63F^[3] “when a debt to a commercial bank is paid by check out of a deposit balance, that amount of deposit currency simply disappears”. Fisher clearly stated that this was a consequence of bank lending, not of “peer-to-peer” lending: “A man-to-man debt may be paid without affecting the volume of outstanding currency, for whatever currency is paid by one, whether it be legal tender or deposit currency transferred by check, is received by the other, and is still outstanding”.

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Speaking as a representative of Neoclassical economists, Ben Bernanke explained that they ignored Fisher’s arguments… because of the characteristics of peer-to-peer lending:

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The amount of energy that the leading machine of a given age can process has risen exponentially over time. Steam-engine powered locomotives based on James Watt’s initial design generated about 200 horsepower, and consumed about 30 tons of coal per day. The comparable machine of our day is the Falcon 9—in terms of a leading-edge device used for transportation—which consumes 2.5 tons of fuel per second. The comparison is crude, but indicative: the Falcon 9 consumes over 7,000 times as much as the first steam engines.

Human consumption levels have also risen dramatically, while the amount we can devote to production has remained a constant. The average unskilled worker sustains about 75 watts over an 8-hour working day. When that average unskilled worker was a slave, most of the energy they received as inputs went into work. The average unskilled worker in Europe or America puts in no more than a slave once did, but receives a huge amount of energy for consumption purposes: electric light, heating, cooling, petrol for commuting. That higher energy consumption is where our increase in living standards has come from.

These facts are evident from statistical data, which can be seen in a plot of global energy consumption against global GDP—known as GWP or “Gross World Product”. Both rise lock step, as the first chart in Figure 7 shows, and the change in GWP and the change in energy are both very tightly correlated, and of the same order: a 6% increase in energy correlates with roughly a 6% increase in GWP, and vice versa. There has been a gradual increase in GDP per unit of energy over the period from 1971 to 2023—the 4^th chart in Figure 7—which probably reflects the growing share of “services” in GWP as the world has become more financialized. But this ratio has less than doubled over half a century: there is no way that GDP is “decoupling” from energy, because, in a fundamental sense, GWP is energy converted into useful work. You can’t “decouple” from what you are.

Figure 7: Energy and GWP^[2]

All of this should be reflected in economic models of production. But in fact, none of it is.

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Economists model the physical aspect of the economy—the physical system by which goods are produced—using what they call “production functions”. These are mathematical functions that link inputs, as hypothesised by economists, to outputs. Both the Neoclassical and Post-Keynesian schools of thought use production functions in which there is no explicit acknowledgement of the need for energy, or other inputs from the biosphere, in order to produce the physical goods and services which we describe as “Gross Domestic Product”.

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In this video, I discuss how economists came to ignore the role of energy in production, and how they therefore blindside us to the dangers of global warming. The high pollution, high stress environment in which we live further damages our physiology as well as our economy.

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I can think of no better aphorism for Neoclassical economics. Its solutions are well-known, its models are neat, its explanations are plausible, but its arguments are wrong. But to understand this, you have to go well beyond a textbook-level of knowledge of economics, because economic textbooks present a sanitised version of the theory, shorn of the fallacies which infest it.

Normally, this is because the textbook writers are themselves unaware of the problems with the theory. But on occasions, textbook writers who themselves uncovered fallacies in the theory ignore their own discoveries, and teach the theory as if their own work had never happened.

The most significant instances of this phenomenon—a leading economist finding a flaw in the theory, and then publishing a textbook which ignores both the flaw and his own research into it—concern the two fundamental constructs in economics, the demand curve and the supply curve. The textbook writers in question were prominent and highly influential economists: one, Paul Samuelson, was the main architect of post-WWII mainstream economics; the other, Alan Blinder, was Vice-Chairman of the Federal Reserve, and Vice-President of the American Economic Association.

Together, their findings destroy the iconic foundations of Neoclassical economics, the supply and demand diagram. Explaining why this is so will take us on a substantial diversion from the specific topic of the economics of climate change, and it will take several chapters to show just how unsound Neoclassical economics is. But it is necessary to know this background in order to be able to understand how the laughably bad work of climate change economists came to be published in the first place.

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Samuelson and America as the One Big Happy Family

Paul Samuelson and John Hicks developed the methods by which economists derive an individual’s demand curve {Samuelson, 1938 #291;Samuelson, 1947 #5848;Samuelson, 1948 #6947;Hicks, 1934 #4984;Hicks, 1934 #4985}. Their methods showed that an individual’s demand curve necessarily sloped downwards: that the individual’s demand for a commodity necessarily declined as its price rose. ^[1] In his textbook Economics—now maintained by William Nordhaus—Samuelson told students that the “law of downward-sloping demand” also applied to the market demand curve:

Market Demand
Our discussion of demand has so far referred to “the” demand curve. But whose demand is it? Mine? Yours? Everybody’s? The fundamental building block for demand is individual preferences. However, in this chapter we will always focus on the market demand, which represents the sum total of all individual demands. The market demand is what is observable in the real world.

The market demand curve is found by adding together the quantities demanded by all individuals at each price. Does the market demand curve obey the law of downward-sloping demand? It certainly does. {Samuelson, 2010 #6096`, p. 48}

“Certainly”? Half a century earlier, Samuelson reached a very different result.

In Neoclassical theory, individual demand curves are derived by combining an individual’s tastes—represented by what are called “indifference curves”—with the individual’s income and relative prices. For the market demand curve to have the same properties as an individual demand curve, it must be conceptually possible to represent an entire economy by “social indifference curves”. Samuelson commenced his 1956 paper “Social Indifference Curves” {Samuelson, 1956 #1495} with the concession that this was only possible in extremely limited and clearly unrealistic cases:

What defense do we make when challenged on the use of community indifference curves for a country or group of individuals? I suppose one of the following:

(a) We may claim that our country is inhabited by Robinson Crusoe alone and claim only to show how trade between such single person countries is determined. This is admittedly not very realistic.

(b) In order to give the appearance of being more realistic, we may claim that our country is inhabited by a number of identical individuals with identical tastes; they must also have identical initial endowments of goods if this artifice of examining what happens to the representative individual’s indifference curves is to give us a true description of the resulting market equilibrium. This case, too, is not very realistic, though it may seem a slight improvement over Robinson Crusoe.

(c) We may claim to be depicting trade of a totalitarian nation. One dictator determines demand within his country and his consistent indifference curves provide us with the community indifference curves for that country. Some might regard this as Robinson Crusoe brought painfully up to date.

(d) None of the previous explanations meets the case of two (or more) dissimilar individuals within each country. {Samuelson, 1956 #1495`, p. 3. Emphasis added}

He then proved that community indifference curves were impossible, with the sole exception being “where tastes are identical, not only for all men, but also for all men when they are rich or poor” {Samuelson, 1956 #1495`, p. 5}. This proof showed that a market demand curve derived by adding up multiple individual downward-sloping demand curves could have any shape at all—it did not have to slope down.^[2] As later rediscoverers of this conundrum concluded, “The utility hypothesis tells us nothing about market demand” {Shafer, 1993 #349}.^[3]

This should have been “a Pythagorean moment” for economics. Pythagoras believed that all numbers could be expressed as the ratio of two integers: we call such numbers “rational” today. But one of his followers discovered that there were “irrational numbers”: numbers that were not the ratio of two integers. This follower was purportedly drowned for his troubles,^[4] but the result was ultimately accepted. The dogma that all numbers were rational was abandoned, and mathematics advanced dramatically as a result.

This has not happened with economics, because the economists who proved this result {Gorman, 1953 #1491;Samuelson, 1956 #1495;Sonnenschein, 1972 #1484;Sonnenschein, 1973 #1483;Sonnenschein, 1973 #1486;Sonnenschein, 1974 #1482;Kihlstrom, 1976 #1485;Shafer, 1982 #6082;Shafer, 1993 #349} were too wedded to their dogma—the teleological belief that a free market economy maximizes social welfare—to accept this conundrum that they had discovered.

This led to behaviour by these economists which, in a purely psychological sense, can be characterised as insane. The desire to show that a free-market system maximizes social welfare was so strong that they devised “solutions” to this conundrum which literally contradicted the foundations of Neoclassical thought.

Samuelson’s solution was to invoke altruism.

Classical scholars will remember Virgil’s famous warning in The Aeneid to “Be wary of Greeks bearing gifts”.^[5] The same warning applies to Neoclassical economists wielding the concept of “altruism”. A theory based entirely on the concept of maximizing self-interest appealing to altruism to overcome a logical conundrum, is as trustworthy as a Wooden Horse at the gates of Troy.

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I can think of no better aphorism for Neoclassical economics. Its solutions are well-known, its models are neat, its explanations are plausible, but its arguments are wrong. But to know this, you have to go well beyond a textbook-level of knowledge of economics, because economic textbooks present a sanitised version of the theory, shorn of the fallacies which infest it.

Normally, this is because the textbook writers are themselves unaware of the problems with the theory. But on occasions, textbook writers who themselves uncovered fallacies in the theory ignore their own discoveries, and teach the theory as if their own work had never happened.

The most significant instances of this phenomenon—a leading economist finding a flaw in the theory, and then publishing a textbook which ignores both the flaw and his own research into it—concern the two fundamental constructs in economics, the demand curve and the supply curve. The textbook writers in question were prominent and highly influential economists: one, Paul Samuelson, was the main architect of post-WWII mainstream economics; the other, Alan Blinder, was Vice-Chairman of the Federal Reserve, and Vice-President of the American Economic Association.

Together, their findings destroy the iconic foundations of Neoclassical economics, the supply and demand diagram. Explaining why this is so will take us on a substantial diversion from the specific topic of the economics of climate change, and it will take several chapters to show just how unsound Neoclassical economics is. But it is necessary to explain how the laughably bad work of climate change economists came to be published in the first place.

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1. Samuelson and America as the One Big Happy Family

Paul Samuelson and John Hicks developed the methods by which economists derive an individual’s demand curve {Samuelson, 1938 #291;Samuelson, 1947 #5848;Samuelson, 1948 #6947;Hicks, 1934 #4984;Hicks, 1934 #4985}. Their methods showed that an individual’s demand curve necessarily sloped downwards: that the individual’s demand for a commodity necessarily declined as its price rose. ^[1] In his textbook Economics—now maintained by William Nordhaus—Samuelson told students that the “law of downward-sloping demand” also applied to the market demand curve:

Market Demand
Our discussion of demand has so far referred to “the” demand curve. But whose demand is it? Mine? Yours? Everybody’s? The fundamental building block for demand is individual preferences. However, in this chapter we will always focus on the market demand, which represents the sum total of all individual demands. The market demand is what is observable in the real world.

The market demand curve is found by adding together the quantities demanded by all individuals at each price. Does the market demand curve obey the law of downward-sloping demand? It certainly does. {Samuelson, 2010 #6096, p. 48}

“Certainly”? Half a century earlier, Samuelson reached a very different result.

In Neoclassical theory, individual demand curves are derived by combining an individual’s tastes—represented by what are called “indifference curves”—with the individual’s income and relative prices. For the market demand curve to have the same properties as an individual demand curve, it must be conceptually possible to represent an entire economy by “community indifference curves”. Samuelson commenced his 1956 paper “Social Indifference Curves” {Samuelson, 1956 #1495} with the concession that this was only possible in extremely limited and clearly unrealistic cases:

What defense do we make when challenged on the use of community indifference curves for a country or group of individuals? I suppose one of the following:

(a) We may claim that our country is inhabited by Robinson Crusoe alone and claim only to show how trade between such single person countries is determined. This is admittedly not very realistic.

(b) In order to give the appearance of being more realistic, we may claim that our country is inhabited by a number of identical individuals with identical tastes; they must also have identical initial endowments of goods if this artifice of examining what happens to the representative individual’s indifference curves is to give us a true description of the resulting market equilibrium. This case, too, is not very realistic, though it may seem a slight improvement over Robinson Crusoe.

(c) We may claim to be depicting trade of a totalitarian nation. One dictator determines demand within his country and his consistent indifference curves provide us with the community indifference curves for that country. Some might regard this as Robinson Crusoe brought painfully up to date.

(d) None of the previous explanations meets the case of two (or more) dissimilar individuals within each country. {Samuelson, 1956 #1495, p. 3. Emphasis added}

He then proved that community indifference curves were impossible, with the sole exception being “where tastes are identical, not only for all men, but also for all men when they are rich or poor” {Samuelson, 1956 #1495, p. 5}. With this proof, in general a market demand curve derived by adding up multiple individual downward-sloping demand curves could have any shape at all—it did not have to slope down.^[2] As later rediscoverers of this conundrum concluded, “The utility hypothesis tells us nothing about market demand” {Shafer, 1993 #349}.^[3]

This should have been “a Pythagorean moment” for economics. Pythagoras believed that all numbers could be expressed as the ratio of two integers: we call such numbers “rational” today. But one of his followers discovered that there were “irrational numbers”: numbers that were not the ratio of two integers. This follower was purportedly drowned for his troubles,^[4] but the result was ultimately accepted. The dogma that all numbers were rational was abandoned, and mathematics advanced dramatically as a result.

This has not happened with economics, because the economists who proved this result {Gorman, 1953 #1491;Samuelson, 1956 #1495;Sonnenschein, 1972 #1484;Sonnenschein, 1973 #1483;Sonnenschein, 1973 #1486;Sonnenschein, 1974 #1482;Kihlstrom, 1976 #1485;Shafer, 1982 #6082;Shafer, 1993 #349} were too wedded to their dogma—the teleological belief that a free market economy maximizes social welfare—to accept this conundrum that they had discovered.

This led to behaviour by these economists which, in a purely psychological sense, can be characterised as insane. The desire to show that a free-market system maximizes social welfare was so strong that they devised “solutions” to this conundrum which literally contradicted the foundations of Neoclassical thought.

Samuelson’s solution was to invoke altruism.

Classical scholars will remember Virgil’s famous warning in The Aeneid to “Be wary of Greeks bearing gifts”.^[5] The same warning applies to Neoclassical economists wielding the concept of “altruism”. A theory based entirely on the concept of maximizing self-interest appealing to altruism to overcome a logical conundrum, is as trustworthy as a Wooden Horse at the gates of Troy.

Samuelson’s Trojan Horse was the assertion that individual demand is really family demand, because altruism applies within the family, so that the family functions as an individual:

Where the family is concerned the phenomenon of altruism inevitably raises its head: if we can speak at all of the indifference curves of any one member, we must admit that his tastes and marginal rates of substitution are contaminated by the goods that other members consume. {Samuelson, 1956 #1495, pp. 9-10. Emphasis added}

The rule to enable a family indifference curve to be derived, given altruistic behaviour within the family, was that “Income must always be reallocated among the members of our family society so as to keep the “marginal social significance of every dollar” equal” {Samuelson, 1956 #1495, p. 11}.

He then leapt, without even drawing breath, from the assumption that income is altruistically reallocated within a family, so that a family indifference map can be constructed, to the assumption that the same altruistic behaviour happens at the level of the nation:

5. Since most “individual” demand is really “family” demand, the argument can be made that such family demands have been shown to have none of the nice properties of modern consumption theory. However, if within the family there can be assumed to take place an optimal reallocation of income so as to keep each member’s dollar expenditure of equal ethical worth, then there can be derived for the whole family a set of well-behaved indifference contours relating the totals of what it consumes: the family can be said to act as if it maximizes such a group preference function.

6. The same argument will apply to all of society if optimal reallocations of income can be assumed to keep the ethical worth of each person’s marginal dollar equal. By means of Hicks’s composite commodity theorem and by other considerations, a rigorous proof is given that the newly defined social or community indifference contours have the regularity properties of ordinary individual preference contours (nonintersection, convexity to the origin, etc.). {Samuelson, 1956 #1495, p. 21. Boldface emphasis added}

This is doubly insane. Not only does Samuelson defend a theory based on self-interest by appealing to altruism, he also acts as if—to use a favourite Neoclassical phrase—the mere act of assuming something causes it to happen.

Unfortunately for Neoclassical economists, the mere fact that you can assume a mechanism does not create that mechanism. Assuming that Mars has a breathable atmosphere does not create a breathable atmosphere on Mars, and assuming an ethical redistribution of wealth does not create an ethical redistribution of wealth. And yet Samuelson acts as if making a ridiculous assumption is sufficient to overcome the problem that his ridiculous mechanism would solve.

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This video deserves more views than it’s currently getting. If you watch it, and especially if you share it with your contacts, YouTube will promote the video more strongly, and the analysis will get seen by more people.

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In the video, I work towards the outcome shown in the screenshot below, which shows the basic accounting for government deficits and bond sales.

I start with what taxation does, which is obvious to most people: it takes money out of private sector deposit accounts. Therefore, taxation reduces the financial net worth of the private sector (Households and Firms):

That’s seeing the process from the point of view of Households and Firms. At the Banking system level, it looks like this, before we put in the second entry to balance the transation.

That second entry is that Reserves--which are the Banks’ assets and the Central Banks liabilities--fall by the amount of the tax, because, at the level of the Central Bank, the tax revenue is transferred to the Treasury’s accounts there, generally called the “Consolidated Revenue Fund”:

At the Treasury, this means that tax revenue increases its financial net worth.

All the above should be clear, to everybody from Austrians to MMTers. Everyone can understand that taxation reduces the money supply (which is essentially the sum of Deposit accounts), thus reducing their financial net worth, and increasing that of the government.

Now the part that should be obvious, but isn’t, because bad economics and ideology get in the way: government spending has the exact opposite effect, so that government spending increases the money supply, thus increasing the financial net worth of households and firms, and decreasing that of the government.

This already is the exact opposite of what economics textbooks teach. They assert that a government deficit reduces the amount of money the private sector has--which they call “Loanable Funds”:

They never specify what these precisely are, but they have to be the sum of deposit accounts (or some variable fraction of them). The accounting shows the opposite to what the textbooks claim: a deficit increases the funds in household and corporate deposit accounts. Rather than “crowding out” the private sector, a deficit increases the amount in private bank accounts.

This hasn’t shown bond sales yet. Do they reduce the supply of money?

Not if they’re bought by the banks. The revenue from bond auctions is equal to the deficit--the excess of government spending over taxation--plus interest on existing bonds. That interest, like the deficit itself, is financed by the Treasury going into negative net worth.

If you object to the government being in negative financial worth, you’re objecting to money itself. The reason that a shop in, let’s say Clacton, accepts UK£0.99 in payment for buying a 99 Flake, is that it’s a liability of the relevant government. Try giving the shopkeeper the equivalent in Thai Baht and you’ll walk would with nothing.

In this sense, creating liabilities on itself is one of the major functions of a government. Where its liabilities are accepted as money in payment for goods and services defines a country’s borders just as much as the existence of border guards and customs officials does. And if these financial liabilities are also used to create public infrastructure--rather than, say, bombing another country--then we get nonfinancial assets (roads, schools, hospitals, etc.) as a side effect of government net financial negative equity.

Bond sales to banks do not affect the money supply at all. Instead, they let banks swap a non-tradeable, low-income-earning asset--Reserves--for a tradeable, higher-income-earning asset: Treasury Bonds.

When you simulate this system, you see that government deficits have the opposite effect to that alleged by economics textbooks. Rather than deficits reducing economic activity, they increase them. The “Holy Grail” of government surpluses, pushed by almost all other pundits (outside myself, Richard Murphy, and MMT advocates), actually reduce the money supply and reduce economic growth.

I explain all this relatively slowly in this new video. Please watch it, and share it around. We are paying a huge price for the ignorance that the conventional wisdom promulgates about government deficits.

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