Power of economics and economics of power

Aug 6, 2018 by

Markets in equilibrium or the so called “market clearing condition” is one of the most fundamental assumptions in conventional economics. According to Richard A. Werner, professor and chair for international banking at the University of Southampton, 99 % of economics books assume market clearing and hence, conventional economics ignores the role of power in their representation of the economy. This was one of the issues that led Professor Werner to propose a new theory of disequilibrium. In equilibrium models, price (P) and quantity (Q) are defined at the point of intersection between the supply and demand curves. However, according to Professor Werner, we cannot expect equilibrium to take place in any market, let alone all markets at the same time as it is usually assumed in conventional economic models of general equilibrium. The reason is that the assumptions needed to guarantee equilibrium simply do not reflect reality. These assumption are: no transaction costs, perfectly distributed full information, fully flexible prices, infinite lives (no time constraints), perfect competition, profit maximization of rational agents, no influence among agents, and complete markets.

Professor Werner argues that on the contrary to conventional economic paradigms, the reality shows that all markets are out of equilibrium and rationed. If markets are rationed, then quantity, and not the prices, determines the market outcome. In this case the short side dominates, i.e. the lowest in quantity between demand and supply determines the allocation of resources. According to Professor Werner, once the reality of non-equilibrium markets is recognized, power in the economy enters economics.

The issue of rationed markets is particularly important in the market for money. Professor Werner claims that the definition of money in conventional economics, ranging from most narrow definition M0 to the broadest M25, is flawed as it ignores the use of money in the economy. He argues that money can be used either for asset investments (i.e. financial transactions) or for investments in the real economy. The former drives to asset price inflation, whereas the latter leads to economic growth (measured as GDP growth). Professor Werner further proposes a new approach to money that recognizes the role of banks as creators of money in terms of credit creation through balance sheet operations. In fact, 97 % of all money are created in this way.

As other markets, the credit (money) market is rationed, i.e. at the given interest rate level, the demand for credit exceed the supply. According to Professor Werner, this means that banks – all private banks – have the power to decide on the amount and the allocation of money in the economy, i.e. banks determine the quantity by limiting the credit supply. As a result, the banks’ decisions on credit creation strongly affect the economy. On one hand, if banks provide credit for financial transactions, they induce inflation and asset price bubbles. If banks, on the other hand, supply credit for real investment, the created money and the following increase in purchasing power leads to real economic growth.

In today’s globalized and deregulated banking system, the society, policy makers and regulators have lost the control of the credit creation and allocation, Professor Werner argues. This results in the continuously occurring price bubbles in e.g. asset and real estate markets, as well as low growth rates. He proposes two alternatives to remediate this situation: 1) formal or informal regulation of credit growth rates and credit allocation (e.g. credit control or window guidance), or 2) ensuring accountability of banks decisions towards the community. In his opinion, the latter presents a better solution, by not only avoiding concentration of power in financial regulators but also by responding to sustainable development issues. Local and cooperative banks, he argues, are good examples to follow. Local banks are more affected by the wishes of the local community than large multinational bank, simply because they invest locally and rely on the deposits of members in the local community. Only with a decentralized, local banking system, the power over banks, the credit supply and growth, is shifted back towards the community.

Written by: Fabricio Bonilla Pacheco and Emilie Soysal

Based on the lectures held by: Richard Werner (“The flaws of traditional economics and the use of scientific methods to analyse money and banking” and “Key issues for sustainable monetary reform”)