“Economics is extremely useful as a form of employment for economists.“
John Kenneth Galbraith

Since the financial crisis erupted in 2007-08, plunging the world into one of the worst recessions in living memory, economists, policy makers and central bankers have trotted out a now-familiar line: that the bursting of the sub-prime bubble that sparked the crisis was a one-in-a-million event that could not be predicted or anticipated.

But what if the economic models they were using – and continue to use – are completely flawed? As the Swedish documentary posted below reveals, the neo-classical model that has formed the basis of economic “science” (a term I use in the loosest possible sense) over the last 30 or so years has ignored one essential – some might say the essential – ingredient of any modern economy: debt.

According to neoclassical economists, debt is a zero-sum game. In other words, banks create credit, or debt, by drawing on its deposit base. As such, debt is seen as neither good nor bad and is considered to play a benign role in the economy.

The way macroeconomists have traditionally thought about banks is as intermediaries, says IMF economist and former banking executive Michael Kumhof, one of a growing number of “fringe” economists who are calling for a new economic model that more accurately reflects the complex nature and role of the global financial sector.

According to Kumhof, most neoclassical and Keynesian economists labour under the delusion that banks just sit there and wait for deposits to arrive. Once they have enough deposits, they lend them out to businesses or individual customers. But what happens in reality is the exact opposite: When they are feeling bullish about the economic outlook, banks don’t need to wait for any deposits because when they create a loan, they create a deposit. In other words, they “create money out of thin air.”

Even central banks, the institutions that now exert the most influence over national economies, often use models that completely ignore the impact of bank lending. This may explain why so few of them have been able to ward off the effects of the financial crisis.

Steve Keen, one of a select few economists to have warned of the risks posed by the subprime bubble, argues that subscribing to an economic model which excludes banks, money and debt is “insane” and is the reason why the vast majority of economists had no idea the crisis was coming.

What’s more, most of the models used by economists and central bankers today do not reflect the increasing complexity and interconnectedness of the global financial industry.

As research by Stefano Battiston has shown, around 80 percent of the entire global corporate world is controlled by just 100 companies. And the vast majority of these companies are banks and financial institutions that have become so highly interconnected that a seemingly isolated problem in one institution can quickly spread to infect the whole system.

And given the scale of leverage in the financial sector, with some banks leveraged as much as 60 or 70 to one, as well as the huge risks associated with many bank investments, in particular derivatives products, the chances of a systemically vital institution experiencing its own “Lehman moment” is far greater than most regulators and central bankers are currently letting on.

Economic Suicide

By ignoring the central role of financial deviancy and complexity in the current economic crisis, mainstream economists are effectively giving an out-of-control banking sector carte blanche to continue sucking the life blood out of the productive economy.

In the words of Keen, “as each country slips into the debt trap, we have to create more money at the central bank level, ‘give’ it to these countries and then tell them to pay the banks back.”

To draw an analogy, it is as though neoclassical economists and central bankers were physicians treating a patient with a gangrenous leg. But instead of amputating the infected limb – that is, the bankrupt financial sector – and stopping the rot, what they are actually doing is protecting and nurturing the gangrene, helping it to spread throughout the patient’s body – that is, the productive economy. Eventually the infection destroys the host, and with it, itself.

Across the West, countries that are already bucking under the weight of too much debt are being forced to take on even more in order to service the debt that’s already been created. Add to that the central banks’ increasing use of impressive-sounding money-printing measures such as the Fed’s quantitative easing and the ECB’s Long Term Refinancing Operation (LTRO) – measures which, as George Soros noted in 2009, provide “artificial life support to the banks at considerable expense to the taxpayer” – and it’s perhaps no surprise that many countries are cracking under the strain of excessive debt.

To continue “servicing” their debt, the same countries are pressured to embrace austerity by the same mainstream economists whose blind devotion to flawed macroeconomic models prevented them from seeing the risks of a housing bubble in the first place.

If the recent experience of countries such as Spain, Greece and Portugal is anything to go by, self-imposed economic austerity is far from a panacea. On the contrary, all austerity actually achieves is to accelerate economic deleveraging as the rate of economic activity all but grinds to a halt. And the more the economy slows, the more loans it needs to sustain its debt dependence.

The consequence of such misguided economic policies is potentially very dire indeed, warns Keen: “So long as this austerity is forced on the public, they’re the ones that are going to feel the pain. And they’re being told by the elites who actually benefitted from the bubble in the first place that they need to suffer to overcome the mistakes the elite made. This is a recipe for demagogy.”

When the British historian Thomas Carlyle coined the term “dismal science” to describe the economics discipline in 1849, little could he have known how bad things would actually get. A poor man’s science with very little, if any, predictive capacity, economics has metamorphosed over the last few decades into a dogma, a creed, a sect. What’s more, as the film Inside Job revealed, many of its core tenets have been used to excuse and enable the worst excesses of a rogue financial sector.

Like the flatearthers in the 15th and 16th centuries, neo-classical economists are never wrong; when their models and reality do not meet, it is reality that’s at fault. Economists like Keen and members of the Austrian School who challenge these failed dogmas are few and far between, but their numbers are on the rise. And if the economics discipline is to retain any credibility in the years to come, it would do well to listen to what they have to say.