January 25th, 2012
in Op Ed
by Dirk Ehnts
Editor's note: This is the second in a series of essays where Dr. Ehnts is discussing aspects of Karl Popper's epic “The Open Society and Its Enemies” (1945) in a series of essays. Previously we posted the Introduction followed by the first essay Sociological Laws and the ECB as a single article.
In the previous post we have followed Popper’s argument that the understanding of sociological laws can help us build institutions for the better. If the sociological laws are not understood, institutions can be damaging, if the erroneous assumptions are not corrected. I invoked the European Central Bank as an example.
As many institutions, it was well-meant, but nevertheless its design has been flawed. The subject of norms and natural laws stands at the center of debate a little later. The Ancient Greeks were confusing norms with natural laws, thus arguing that some things were ‘natural’ when in fact they were not. Popper summarizes the discussion of this section (p. 75):
Looking back at this brief survey, we may perhaps discern two main tendencies which stand in the way of adopting a critical dualism. The first is a general tendency towards monism, that is to say, towards the reduction of norms to facts. The second lies deeper, and it possibly forms the background of the first. It is based upon our fear of admitting to ourselves that the responsibility for our ethical decisions is entirely ours and cannot be shifted to anybody else; neither to god, nor to nature, nor to society, nor to history. All these ethical theories attempt to find somebody, or perhaps some argument, to take the burden from us. But we cannot shirk this responsibility. Whatever authority we may accept, it is we who accept it. We only deceive ourselves if we do not realize this simple point.
Let me start with the first tendency: monism. The Merriam-Webster dictionary offers three definitions of monism, the last one being “a viewpoint or theory that reduces all phenomena to one principle“. Since many theories in monetary economics are abstractions of reality they might be called theories of monism. This does not mean that these kinds of models are without value. It’s just that these models might mistake norms for facts, and that they therefore might be wrong. The interest rate should serve as an example.
The traditional (neo-classical) view of the interest rate is that it coordinates debt over time. In an economy, some households have more money than they need to buy what they want to consume today. They are willing to make loans to households with funds that are lower than their planned consumption. Given that the debtors are able to repay, it makes sense for surplus households to lend money to deficit households. Given that deficit households are trying to find the lowest interest rate demanded, and surplus the highest interest rate offered, we have established some kind of equilibrium. This theory of loanable funds explains that the interest rate depends on the aggregated wishes of households to borrow and lend. If more households want to become deficit households, the interest rate goes up, and if more households want to become surplus households vice versa. Arbitrage and profit-maximization are the two principles that establish this equilibrium. The institution of debt, which is nothing else but borrowing and lending, is no longer a norm, but a fact. Nothing else is needed to explain the interest rate but optimizing agents in free markets.
The opposite view is that of the (Keynesian) liquidity preference. Here, the surplus households demand a compensation to part with their liquid funds. This compensation takes the form of an interest rate. The relative shares of potential deficit and surplus households influences the interest rate, but there is another scenario possible in which the mechanism breaks down. If there are expectations of falling prices, then lenders might not be willing to lend at any rate of interest. They know that the deficit households will somehow invest the money, but if all prices are predicted to fall, then there will be no lenders at any interest rate. The market for debt freezes, it has effectively broken down. Here, the norm of debt is not reduced to fact. Instead, uncertainty is introduced in the picture. While the interest rate at times is governed by supply and demand of funds, we don’t know exactly over which periods this will be the case. We do know that sometimes the interest rate doesn’t work, that no additional debt is created. We are aware of the norm of debt contracts and understand that the interest rate is not a fact but the outcome of a norm.
Only those that share the view of the interest rate as a liquidity preference are able to adopt a critical dualism. They understand that norms – or better, institutions – might have failed and that this might have produced a situation in which nothing is lend and nothing is borrowed. Those of the loanable funds theory can only explain this situation by stating that no household wants to be a deficit or creditor household and that therefore all households are in a position that cannot be improved. In the euro zone, we can be quite sure that when lending to some governments stopped this was not the case. Instead, it is an institutional problem that has caused some private credit markets to freeze. Some of these institutional problems lie inside the countries that are not able to borrow anymore, some lie outside those countries. A part of these problems lies with the design of the euro. Which leads us to the second concept that stands in the way of a critical dualism: the burden of responsibility.
Fear can drive us to shirk responsibility, and shift it to something or somebody else. Very often, institutions are created in order to shift responsibility from people to this institution. There are many examples, like courts and judges, or the central bank. The job of today’s central banks is inflation fighting. According to contemporary monetary theory, accelerating inflation is fought by creating less demand for factors of production, including labor. This means that when the central bank decides that inflation is too high the interest rate is increased. This should lead to less demand for investment and as a by-product, subsequently, to higher unemployment. Perhaps many people are not aware of this mechanism, but this is nevertheless what happens. As Popper has argued, whatever authority we accept, finally it is us who accept it.
Therefore, the European Central Bank as an institution overseeing a euro zone with unemployment rates in some nations in the double digits, negative growth rates and unsustainable debt burdens is not the responsible. It is the people of Europe who have to take responsibility with the social condition of the continent. They accepted the ECB as an institution that should oversee the monetary system, hence they are accountable for the outcome. Analyzing the faults and errors, a critical dualism is necessary in order to understand correctly the way things work and, when that is established, to improve European institutions by modifying existing and creating new ones. Europe, after all, can only advance when the lessons of recent history have been learned, and responsibility is shifted not to one country or another, but back where it belongs: to the voters that have accepted the design of the ECB and its fellow institutions, like the Stability and Growth Pact.
About the Author
Dr. Dirk Ehnts is a research assistant at the Carl-von-Ossietzky University of Oldenburg (Germany). His focus is on economic integration and economic geography, covering trade, macro and development. He is working at the chair for international economics since 2006 and has recently co-authored a book on Innovation and International Economic Relations (in German). Ehnts has written at his own blog since 2007: Econblog 101. Curriculum Vitae.