Research and Insights

Macroeconomics is a sub-discipline of economics that deals with how an economy is controlled. Traditional goals are full employment and price stability, complemented in the 21st century by the overarching goal of sustainable management of natural resources and fighting climate change.

The previous use of economic policy instruments such as fiscal policy (cuts in government spending, tax cuts for higher incomes and businesses), monetary policy (ECB interest rate hikes), and trade policy has led to problems that have accompanied us for decades and are particularly urgent today: growing inequality, mass unemployment, climate change, excessive resource consumption. To solve these problems, we must use our economic policy instruments differently. Only then can we hope to initiate the associated societal transformation.

Private and public companies produce what we buy. Companies only produce if they believe they can sell their production – no sales, no profit. Companies must make financial investments because they usually need to acquire their production means before they can sell their products – production takes time. Many companies therefore borrow money to be able to produce at all. For these loans, they must pay interest, which is why profits are necessary for the permanent operation of private companies. If companies cannot generate permanent profit, they disappear from the market. This is how goods and services for society's consumption are provided.

The state can also produce goods and services. It can either produce them itself or acquire them from private companies that would not otherwise produce them. Adam Smith advocated the provision of education services by the state since not all citizens could afford private school attendance for their children. Schools are therefore organized by the state, with the state having the public purpose in mind and not striving for profit maximization. Therefore, attending a public school in Germany is free.

Government spending and money creation

In addition to the two mentioned modes of production, there is also production in households, which is care work. However, since this work is unpaid, it is neither considered in the consumer price index nor counted as employment. In an industrialized society of the 21st century, there are essentially two ways to produce goods and services on the market: either through private companies or the state.

The state creates its own money through the central bank, the Deutsche Bundesbank. The central bank is responsible for money creation in the Eurosystem, as confirmed by Christine Lagarde. This system consists of the European Central Bank (ECB) and the national central banks (NCBs). The currency is digitally produced, which is why the monetary system works like a scoreboard on a computer. Just like the letters that make up this text, the account balances at our banks are also generated by a computer. They are entries in digital account systems managed by banks and central banks.

A central insight is that, unlike private households and companies, the federal government can make payments without having "money" in advance. It is created by the Bundesbank when issued and correspondingly destroyed when taxes are paid by the non-government sector. The notion that taxpayers finance the state is thus incorrect. All payments by the federal government are executed by creating new digital money in the form of bank balances at the central bank. Therefore, the state, with its spending, is a very important factor because it changes the demand for goods and thus production and employment.

What kind of economic governance do we need?

Experiences from the Great Depression of the 1930s and the Great Financial Crisis of 2008/09 have clearly shown that the state must steer the economy through its spending. There are no tendencies leading to "self-regulation" of the economy. An economy achieves neither full employment nor price stability on its own. Sustainable resource management (raw materials, energy, water, etc.) can only be achieved through state intervention.

If the economy does not achieve goals such as full employment, price stability, and sustainable management on its own, what should economic policy instruments look like and how should they be used? Currently, there is a consensus among  policymakers that the central bank is entrusted with the responsibility for the inflation rate, and the state, with its fiscal policy (government spending and tax system), plays a passive role. The ECB has a fixed inflation target of two percent and uses some self-determined interest rates as instruments. These form the basis of the interest rates for banks that are made available to households and businesses.

The current consensus is that higher ECB interest rates would lead to private investments being less profitable. This would result in a reduction in demand for goods and services and for labor. As a consequence, the pressure on prices and wages would decrease, and the inflation rate would fall.

However, this would also lead to an undesirable increase in unemployment, with a part of society being sent into unemployment due to the pursuit of price stability. The US economist Larry Summers proposed exactly these measures to the current US government in June 2022, assuming that excessive spending was driving the increased inflation rates.

However, the government has been banking on "Bidenomics," an alternative economic policy paradigm. Unlike Summers, the Biden administration's economists, like many of their colleagues, identify increased energy prices as the true reason for the higher inflation rates. Accordingly, interest rate hikes in the US and elsewhere have been largely ineffective. Although, according to the current consensus, they should lead to higher unemployment, the current result is record employment. A possible crash in the US real estate market would not be an economic policy success but would create significant new problems. Presumably, energy prices would have fallen even without interest rate hikes, as Japan's example shows, where the central bank did not raise interest rates. The policy rate there has remained at zero.

At the same time, the Biden administration abandoned the idea of "trickle-down growth," the notion that tax cuts for the rich lead to more investments and, consequently, more employment, higher productivity, and more production. However, these results have not occurred in the US or in Germany, where the tax cuts of the red-green federal government at the turn of the millennium did not yield the expected results. Instead, the Biden administration uses government spending for green investments that also create unionized jobs and aim to achieve full employment. It relies on "crowding-in" because when the state increases its spending, private companies must invest to compete for government contracts.

Economic theory for the 21st century

Currently, we observe in the US a new economic policy that uses government spending to achieve sustainability, price stability, and full employment. Through green investments, such as in high-speed trains, electric cars, and solar panels, the US government supports private companies in converting their production. Although the programs are not yet large enough, this is an important step forward. The limit for additional government spending lies in the restriction of resources and labor. On the one hand, the state, through its spending, deprives the private sector of these resources, which is likely to reduce the production of consumer goods. On the other hand, the state can only buy what its companies and citizens sell, and that is limited.

Implementing US economic policy in the Eurozone would currently be difficult as national governments are subject to tight deficit limits, which have only been suspended until the end of this year. If government spending exceeds three percent of GDP after deducting tax revenues, a deficit procedure must be initiated according to the rules of the Stability and Growth Pact, leading to cuts in government spending. Existing institutions stand in the way of modern economic policy, especially regarding green public investments. Even the employer-financed Institute of Economics (IW) argues against the national debt brake, which prevents these necessary public investments.

A forward-looking economic policy should be oriented in such a way that the principle of sustainability has the highest priority and takes precedence over other goals such as full employment or price stability, without pitting them against each other. The goal of full employment should be pursued through fiscal policy, i.e., through variations in government spending.

However, price stability must always be considered. If the state needs scarce resources, even small increases in government spending might have a strong inflationary effect. As Isabella Weber emphasizes, the state should intervene in price formation where market results are not acceptable. Such economic policy is much better suited to achieving the goals of full employment, price stability, and sustainable resource management than a further focus on largely ineffective central bank interest rates while neglecting fiscal policy.


Disclaimer: This article is a translated version of the intervention that was originally published in German language as part of the Economists For Future Debate Series in the online magazine Makronom. Hence, some of the linked references are in German.

About the author:

Dirk Ehnts is the spokesperson of the Samuel Pufendorf Society for Political Economy. In his research, he focuses on monetary theory, macroeconomics, pluralistic economics, and financial markets. He is a member of the committee on the history of economic though at the German Economists sAsociation. He has worked as a research assistant in the German Parliament and held many academic positions, among them Free University Berlin (visiting professor) and the Berlin School of Economics and Law (visiting lecturer). His book “Modern Money Theory: A Simple Guide to the Monetary System” has been published in New York by Springer in April 2024 and can be accessed here.