Why the Old Economics Got It Wrong
A New Look at Money, Debt, and Macroeconomics with reference to Professor Steve Keen's ‘modern economics’.
We at eaarthnet have written this mainly for those without any economic training and also students starting a career in economics being trained in the neo-classical bubble.
Economics, the study of how societies manage resources, money, and production, has failed in its most important task: explaining the real economy we live in today. For decades, policymakers and economists have relied on the neo-classical approach — a framework developed over a century ago — to justify decisions about interest rates, government spending, and financial regulation. But this model is deeply flawed, mathematically incorrect, and increasingly irrelevant to the crises and realities of the 21st century.
Let me explain why this matters. To understand macroeconomics — which examines the economy as a whole — we must move beyond equations based on unrealistic assumptions and instead adopt a new economics grounded in the actual nature of money and the significant role of debt. It is time for politicians and the public to grasp these concepts so we can build a better, more resilient economy.
The Flawed Foundation of Neo-Classical Economics
Neo-classical economics is built on a few core assumptions that sound logical in theory but break down in practice:
• Rational agents: People always make decisions to maximise their utility or profit.
• Equilibrium: Markets naturally find a stable balance where supply equals demand.
• Perfect information: Everyone knows everything they need to make decisions.
• Money as a neutral veil: Money is just a medium of exchange with no intrinsic impact on production or growth.
These assumptions lead to elegant mathematical models, but they do not describe how our economy behaves. In reality, people often act irrationally or with incomplete knowledge. Markets experience booms and busts, not just smooth equilibria. Crucially, money is not neutral — it matters fundamentally because it is a social institution that affects real economic outcomes.
The Mathematical Contradiction: Aggregate Demand Cannot Equal Supply
One of the most critical errors in neo-classical macroeconomics is the treatment of aggregate demand (total spending) and aggregate supply (total output). The theory states that over time these must balance out; otherwise, the economy would be in constant chaos. This leads to the assumption that recessions are temporary deviations that will naturally correct as markets adjust.
However, from a mathematical and accounting perspective, this is impossible. For the entire economy to spend less than it produces indefinitely is illogical because one person’s spending is another’s income. Without sufficient aggregate demand driven by spending, output falls, which reduces income further — creating a vicious cycle.
What neo-classical economics misses is the feedback loops created by money creation and destruction, especially through debt. When banks lend money, they create new money that fuels spending. When debts are repaid or defaulted on, money is destroyed, reducing spending power. This dynamic directly influences aggregate demand, making it variable and potentially unstable.
Money Is Not Neutral; It’s a Tool and a Weapon
In modern economies, money is created primarily through debt by private banks. When a person or a business takes out a loan, banks simultaneously create a deposit — new money — that increases the total money supply. Repayment destroys that money. This means debt is not just an obligation; it is the source of the money circulating in the economy.
Ignoring this mechanism leads neo-classical economists to misunderstand how recessions, inflation, and financial crises happen. They see debt as a burden on growth, advocating austerity policies that reduce borrowing and government spending in downturns, worsening recessions.
But debt also powers economic growth and spending. When managed prudently, borrowing supports investment, jobs, and consumption. The challenge is the financial cycle — the build-up and collapse of debt — which naturally causes instability.
Why Debt Drives the Economy More Than Wealth
Traditional economics focuses on wealth or real assets (houses, factories, goods) as the foundation of economic health. But in reality, debt levels have grown far faster than wealth in recent decades. A huge part of economic activity is driven by borrowing, fueled by confidence that future income will repay these debts.
This relationship means the economy is vulnerable to debt crashes. When borrowers cannot repay loans or refuse to borrow more, overall spending collapses, causing a recession or worse. Policy ignoring debt dynamics is like sailing a ship ignoring the weather — disaster is almost certain.
The New Economics: Endogenous Money and Financial Instability
The alternative framework, often called post-Keynesian or complexity economics, recognises these realities:
• Money supply is endogenous — created by the lending decisions of banks responding to demand, not fixed by central banks.
• Debt dynamics must be central to macroeconomic models.
• The economy is inherently unstable due to financial cycles.
• Policymakers must actively manage debt and money flows, not just interest rates or tax rates.
Steve Keen’s models, for example, incorporate the Minsky Financial Instability Hypothesis: economies cycle between stability and crisis due to debt build-up and deleveraging. His simulations show how excessive private debt causes economic collapses and why austerity prolongs recessions.
How Politicians and Policymakers Should Respond
The failure to understand the true nature of money and debt has led to misguided policies globally:
• Recession victims punished by austerity cuts.
• Financial crises are ignored until too late.
• Misplaced faith in central bank tools like interest rate tweaks.
Instead, the new economics suggests:
• Governments should view deficits not as evils but as necessary money injections when private sector debt contracts.
• Public investment and full employment policies should be embraced to maintain aggregate demand.
• Financial regulations should limit unsustainable credit expansions.
• Debt jubilees or restructuring must be considered regular tools in downturns.
Understanding money as a social institution and debt as a macroeconomic driver means policymakers can transcend the outdated neo-classical dogma and manage economies more like the complex systems they are.
Key Examples of How Money and Debt Shape the Economy
• Example 1: The 2008 Financial Crisis
The crisis was precipitated by several decades of rising private debt in the U.S. housing market. Banks loaned money recklessly, creating enormous new deposits, inflating house prices. When borrowers defaulted, banks had to write off debt, destroying money supply, causing a massive contraction of spending and a severe recession. Neo-classical models ignored this dynamic, leading to policy mistakes like austerity instead of financial system reform.
• Example 2: Government Deficits and Prosperity
Contrary to popular belief, government deficits don’t necessarily harm the economy; they inject net spending into it. When the private sector repays debt and reduces spending, government borrowing can fill the gap to keep incomes stable. Failing to recognise this leads to damaging austerity policies that reduce growth and increase unemployment, as seen in many countries post-2010.
• Example 3: The Illusion of ‘Neutral Money’
Neo-classical economics treats money as neutral—just a unit or medium that doesn’t affect output. But in reality, changes in money supply alter spending decisions immediately. For example, during inflation, if central banks tighten money to curb prices by raising interest rates, lending contracts, reducing spending and causing recessions. This shows that money changes economic activity directly.
• Example 4: The Role of Debt in Growth
Economies that have rapidly grown in recent decades, such as China, have done so with massive credit expansion fueling investment and consumption. Without recognising this, policymakers might misinterpret growth as purely supply-side driven, neglecting financial risks. Excessive private debt, however, can eventually choke growth by forcing households and businesses to divert income from spending to debt repayment.
• Example 5: The Danger of Austerity
When governments cut spending or raise taxes to reduce deficits during a downturn, aggregate demand falls further. This causes unemployment and lowers incomes, ironically increasing debt burdens relative to incomes, and deepening recessions. This was evident in Europe after the global financial crisis, where austerity policies prolonged economic pain without helping to reduce debt in real terms.
Conclusion: Rejecting the Old and Embracing the Real
Economics is not just an academic exercise. It shapes the lives of millions worldwide. The neo-classical model, despite decades of dominance, is mathematically flawed and practically disconnected from reality. Politicians and citizens alike must reject outdated paradigms and equip themselves with a true understanding of money and debt.
This knowledge empowers us to build economies that are stable, fair, and prosperous — designed to serve people, not abstract equations. It is time to embrace a new economics that reflects the real world and the true drivers of growth and prosperity.
Love this! So clear and easy to read and understand. A great tool. Thanks for sharing