Economics and politics - comment and analysis
4. September 2023 I Heiner Flassbeck I Economic Policy, Economic Theory, Europe

The German and Global Malaise – from the Perspective of the Neoclassical Theory

Suddenly they are all complaining. With an enormous delay, even the professional optimists in the German media have realised that something is fundamentally wrong. Germany is once again the sick man of Europe, the British Economist notes again, pointing to the decline in GDP this year.  I am surprised, however, that liberal economists, who would call themselves neoclassical, do not participate much more actively in the debate and at least contribute important aspects to a theory of the crisis. But the neoclassical authors are always immediately on the wrong track because they do not want to admit the macroeconomic implications of their own theory and consequently blame the governments for the malaise. After all, markets cannot be wrong in principle and, if they are allowed to work, always lead quickly back to equilibrium.

Last week, no fewer than eleven authors tried their hand at diagnosing the seriously ill patient in a cover story in Der Spiegel and produced a smorgasbord of causes and therapies that is unparalleled in terms of intellectual confusion. The “explanations” for an economic weakness range from a supposed lack of skilled workers to weak digitalisation, hectic climate protection to overbearing bureaucracy, although if you look at it soberly, the weakness is about one year old.

In addition, although some estimates put Germany at the bottom of the list this year, there can be no doubt that the economic slowdown has now spread to the whole of Europe. Indeed, it is a global phenomenon. As overpowering as the German bureaucracy may be, it has not yet had any influence on the development of China, Germany’s most important trading partner.

It should irritate the amateur economists even more that the significant global slowdown coincides with a phenomenon commonly referred to as inflation. The German finance minister, at any rate, is rock-solidly convinced that “inflation” is an accurate description of the current state of the German and European economies (in a recent interview). This is surprising, however, because inflation usually arises in phases marked by economic strength. After the pandemic, there was practically no talk of strength anywhere in the world.

But if “inflation” is not the result of a booming economy at all, but the consequence of price increases in the wake of supply shocks and speculation in certain commodities and energy sources, the neoclassical economists would immediately have to unpack their analytical tools and apply them consistently. First of all, they would have to state that supply shocks can never trigger a weakness in demand, because price increases triggered by supply shocks immediately mean increased yields for the producers of the substances that have become scarce. This leads to a redistribution, but by no means to a global demand shortfall. The real incomes that are destroyed here by high energy prices are, after all, rising real incomes for the suppliers of raw materials and energy.

What does neoclassicism teach us about the supply shock?

The neoclassicist is on the safe side with this. His theory has a clear answer for all the problems that could still arise now – and it is one that does completely without state intervention. If the actors favoured by the supply shock do not buy exactly the same goods that would have been bought by the now disadvantaged consumers, this means structural change, which must be accepted by the governments, because it can only be managed by private companies largely without friction.

Should it be the case that energy producers buy fewer goods in the short term than the energy-consuming consumers would have done, this too is not a problem for a neoclassical expert. We would then observe rising current account surpluses of energy producers and falling ones of energy consumers (which is indeed the case), but the “capital” not needed by energy producers would quickly flow back to the consumer countries (recycling of the oil billions was what they called it in the 1970s) and be used there for investments.

If the beneficiaries of the price increases have a higher savings rate than the disadvantaged, then in neoclassical terms this means an opportunity for the world as a whole, because it opens the possibility to invest more with the increased savings. The only question that remains is how this happens in the neoclassical imagination. What is the transmission mechanism that needs to be relied upon for this opportunity to be seized by the highly efficient capital markets?

There is no doubt about this question for neoclassical economists either: higher savings lead to an increasing supply of capital in the world’s capital markets. This forces interest rates to fall and these stimulate companies to invest more. Therefore, there can never be a demand shock, even if a redistribution in favour of wealthy actors with higher savings rates was at the beginning of a supply shock.

Falling interest rates?

One “little thing”, the attentive reader will have noticed, has unfortunately gone wrong if one compares the course expected by the neoclassical theory with reality. Interest rates have not fallen at all but have risen significantly worldwide. As in the 1970s, the central bankers, above all those responsible at the ECB, have reinterpreted the temporary price increases triggered by the supply shock as dangerous “inflation” and have pushed through exactly the opposite of what is compelling for neoclassical theory as a market outcome.

However, if you expected the neoclassical economists to go on the barricades and massively criticise the European central bank, which is forcing the opposite of what they believe to be “right” because it is market-driven, you were disappointed. No renowned neoclassicist has taken monetary policy to task for this insane attack on neoclassical reason. They are all lambasted and congratulate the central bankers for their consistency in “fighting inflation”.

What to do about rising interest rates?

What is crazy, however – there is no other way to put it – is that the neoclassical economists, even if they do not dare to criticise monetary policy, do not want to take note of the fact that in the case of a demand gap (worldwide, but especially in the “damaged” consumer countries) triggered by rising savings (of the suppliers of raw materials and energy), an interest rate hike makes everything much worse and cannot be corrected by any other economic policy means in the world except precisely by stopping this nonsensical means of raising interest rates as quickly as possible.

Neoliberal economists who are asked by politicians or the media what can be done about the malaise would have to answer that nothing will help as long as the absurd constellation of higher savings and simultaneously increased interest rates is not overcome. Instead of taking such a theoretically acceptable standpoint, the neoclassical economists ponder subsidised electricity, better depreciation rules, general tax cuts or even bureaucracy reduction as suitable therapies in this situation. One can only laugh heartily at such naivety, which reveals that they do not understand the macroeconomic dimension of their own theory. Using bureaucracy reduction against the constellation described above is like putting a drawing pin on the road to stop a tank.

It gets bad, however, when not only the academic neoliberals but also the political neoliberals who call the shots at central banks don’t know what is happening and what they should do. At the central bank meeting in Jackson Hole last month, Christine Lagarde made a statement about investment in Europe that exposed her cluelessness:

“At the same time, our higher exposure to these shocks can trigger policy responses which also move the economy. Most importantly, we are likely to see a phase of frontloaded investment that is largely insensitive to the business cycle – both because the investment needs we face are pressing, and because the public sector will be central in bringing them about.”

With a global demand gap and sharply rising interest rates, for which it is itself responsible in Europe, it expects “frontloaded investment” from the private sector and the state, because the “need for investment” is oppressively high. And these investments are supposed to be insensitive to the business cycle.

Indeed, the “need” is high all over the world, but that means nothing. When the central banks raise interest rates, they destroy the concrete demand for investment goods, and when in Europe the states have to comply with nonsensical debt rules, the hope for the public sector is also a foregone conclusion. What the president of the ECB is saying is not only naïve, but also dangerous, because it gives the impression that politicians only have to wait until the “need” asserts itself. One wonders why there is no supervisory body at the ECB to prevent anyone from writing such nonsense into the manuscript of its president.