Has the Fed got a grasp on economic reality?

History shows us that the U.S. Federal Reserve's grasp on economic reality hasn't been anywhere near as strong as you might hope or expect, so maybe it's time it used a new economic model.

Back in 2011, CNBC's Karen Tso asked me how I could be so critical of Yellen's predecessor, Ben Bernanke, an acknowledged academic expert on the Great Depression. My answer was that Bernanke, his predecessor, Alan Greenspan, and many others in the economic establishment are associated with a single strand of economic thinking, neo-classical (and more specifically, monetarist) economics.

Although this approach is being increasingly discredited, in practice it remains despite its utter failure to anticipate the global financial crisis (GFC) — or indeed just about any other significant financial crisis- the dominant school of economic thinking.

Professor Steve Keen, my advisory board colleague of economics think tank IDEA Economics, has stridently criticized the group-think of Bernanke including Larry Summers, Ken Rogoff, Paul Krugman and the IMF's Olivier Blanchard, who all studied the same courses taught by Stanley Fischer at the Massachusetts Institute of Technology.

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The group's views aren't entirely uniform; but are informed by a uniform economic framework. Differences in opinion tend to be about details rather than fundamentals. Hence selective mass blindness prevents the economics profession answering the question posed by Queen Elizabeth II to the London School of Economics "Why did nobody notice it (the GFC)?"

U.S. Federal Reserve
Brendan Smialowski | Bloomberg | Getty Images
U.S. Federal Reserve

The answer is that quotations by leading economists about the apparently rude health of the US and global economies in 2007-08 would fill volumes. They tend to range from Bernanke waxing lyrical about "the Great Moderation" to Blanchard telling us, as late as August 2008, "The state of macro is good".

Tempting as it may be, I'm not poking fun at high-profile individuals' shortcomings, so much as diagnosing widespread institutional failure.

While the GFC has been put behind us, the lack of any better understanding of its causes among most influential mainstream economists and policymakers remains a cause for concern.

They tend to believe debt is merely a liquidity preference; one wealthy retiree's deposits fund, via bank intermediation, is another borrower's home or business loan. This ignores the fact that in the USA or the U.K. over 95 percent of 'money' is simply created by bank lending.

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Economists who don't understand where the vast majority of 'money' comes from (Paul Krugman has admitted that he can't recognize this ) are like heart surgeons who have only ever attended dental school.

They didn't spot the onset of the GFC because they didn't even know where to look for warning signs: The role of private debt in creating booms and busts is still ignored while an expanded money supply is being asked to do the heavy lifting of stimulating economic activity (for which it is totally unequal to the task) while the risk of creating asset bubbles goes largely ignored (once again);

These economists tend to be unaware that stability can be destabilizing; if a disease like appendicitis is ignored it becomes life-threatening. By treating the symptoms with ever-increasing dosages of painkillers the patient might feel he's getting better. In fact he's getting worse until eventually his appendix bursts with catastrophic results. They see the economy as a linear system. However, as anyone in business knows in reality the economy is non-linear.

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The economists I've talked about here seem to regard human responses to situations as both homogeneous and rational; that everyone reacts in the same way, that everyone always has perfect information and makes the best long term choices. But the history of capital markets is of irrationality and imperfect information and of panics and crises which policymakers and their models failed to anticipate.

Are there any alternatives?

For many years Steve Keen has been developing a dynamic, non-linear double entry book-keeping economic model that, unlike the Fed's model, produces recessions and downturns rather than being able to be manipulated to produce never-ending economic expansion.

It accurately foretold the nature and extent of the Global Financial Crisis. That said, it's not yet complete. In other words, the model has uniquely been able to tell us what and why the consequences of policy will be but not exactly when or where.

Recently Professor Keen indicated he may be close to major breakthroughs that will at some point address this. I sincerely hope so.

Paul Gambles is Co-Founder of MBMG Group and an advisory board member of IDEA Economics.