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Economics in practice. It’s a mess.

It’s already quite a while I studied Mathematical Economics. I also never put my study into practice so don’t see me as a final authority on this, but watching the world as it turns I sometimes wonder about how we deal with economic issues. When it comes to our daily lives and in the planning our politicians and bankers do.

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A synthesis of Keynesian and classical theory

Basic classical economics tells you that you should keep your books balanced. Never spend more than you have, but also spend what you have. Keynesian economics seemed the opposite. Never keep your books balanced. Stimulate the economy when it operates under it’s potential output, dampen it when it’s well over it’s potential output. Both theories had their merits (I don’t want to go into detail, this is not a lecture on basic economics), but the odd thing I noticed was that neither theory was ever applied.

During my studies in the eighties Reagan and Thatcher were in power. And while being both ultra conservative they did not follow the rules of classical economics. Especially Reagan was a big spender who kept borrowing money to finance the arms race with Russia (which he eventually won). Other republican presidents did more or less the same. Were they Keynesians by heart then?

Nope, they did not follow the rules of Keynesian theory either for they did not increase taxes when the economy seemed overheating and it looked like everything was going well. Instead the US debt climbed to the enormous height it is today. Now faced with a recession the government of the US should actually spend money to stimulate the economy. However it has no space to do it. On the other hand the US should increase taxes to combat the debt. Also impossible. In a situation like this it would make matters worse. So we can be assured that the US debt will stay more or less where it is.

The EU is more or less in the same kind of dilemma. Faced with actual deflation economies should be stimulated by actually spending government money. However this is not happening because of the debts that were incurred in the banking crisis. Austerity is the motto of many governments. It’s a call for many to return the paradigm of classical economics (which seems safe). We have to balance our books! So a Keynesian stimulus is right out of the window. For Finland that is odd stance to take. The economy is clearly in a situation of underspending, yet the new government wants to cut. It sounds nice! It sounds macho! But it will not be the positive stimulus that Finland clearly needs.

Enter the European Central Bank (ECB). One of the problems in any economic crisis is that the money circulation slows down. The money circulation can be stimulated by lowering interest rates, but in the current situation these rates are already almost zero. That means that the ECB has lost an instrument to control the amount of money in economy. So they have now resorted to the one thing they can do. It is called Quantitative Easing (QE) and it is simply a way to bring more money into economy on a massive scale. If everything goes well it should be enough to cause some inflation. Enough to get the economy going without additional help of our governments.

This program was initiated some months ago. It’s a gamble. I hope it works out well, because if does not we are in deep trouble. And when this over I hope that politicians realize that they can’t ignore basic economics unpunished. There are limitations to growth. Limitations to the strain you can put on the environment. And limitations on the ability for markets to regulate themselves. A bit more modesty, a bit more prudence and a bit more realism on all sides will profitable to us all.