Why Flawed Economic Models Still Dominate Policy (Feat. Economist Heiner Flassbeck)

Ever wondered if mainstream economics gets it wrong? Economist Heiner Flassbeck critiques neoclassical flaws: market equilibrium, wages, interest rates. He contrasts its static view with Schumpeter’s dynamic innovation & Keynesian insights ignored by policy. Discover why Flassbeck argues for a relevant, empirical economics addressing real issues like trade imbalances.

Frequently Asked Questions (FAQ)

Léon Walras:
- Significant: Pioneered general equilibrium theory.
- Irrelevant (per Flassbeck): Model is unrealistic, inconsistent, and ignores real-world dynamics/innovation.
Joseph Schumpeter:
- Critique: Criticized Walrasian models as too static; emphasized dynamic innovation & “creative destruction”.
- Ignored: Ideas seen as too complex/unpredictable vs. preferred simplicity of equilibrium models.
Neoclassical Dominance in Germany:
- Reasons: Perceived mathematical elegance, lack of strong alternative, dismissal of Keynes, preference for market-friendly conclusions, wrongly credited post-war boom.
Keynes vs. Neoclassical (Saving/Investment):
- Keynes: Saving doesn’t automatically equal investment; can reduce demand/profits.
- Neoclassical Counter: Interest rates balance them.
- Flassbeck: Counter ignores initial demand drop, making it unlikely.
Labour Market (Not Neoclassical):
- Flaws: Ignores demand effects of wage cuts; firms innovate forward, not backward; assumes unrealistic substitution/adjustment.
- Implication: Wage cuts to boost jobs are ineffective/harmful.
Economic Policy Evolution:
- Shift: From Keynesian demand management (~1945-70s) to Neoclassical/Monetarist focus (~1970s+).
- Flassbeck: Monetarism flawed; neoclassical ideas still dominate policy (esp. Germany) despite issues.
Lucas Critique:
- Critique: “Rational expectations” neutralize policy.
- Impact: Supported market efficiency, revived neoclassical models.
- Flassbeck: “Nonsense”; based on unrealistic assumptions about people understanding flawed models; acceptance is ideological.
German Surpluses & Trade Imbalances (Flassbeck’s View):
- Criticism: Germany’s huge surpluses (from wage suppression) are unsustainable, rule-breaking, and ignored due to a “cartel of silence.” Trump’s critique of imbalances was fundamentally correct.
- Solutions: Require cooperation (surplus nations must adjust policies), open Eurozone reform (revisit rules/debt), and internal rebalancing—not splitting the Eurozone or resorting to trade wars.

What is the problem?

Based on the interview with Heiner Flassbeck, the fundamental problem is the continued dominance of neoclassical economics despite its flawed assumptions and irrelevance to the real world. Flassbeck argues that this leads to a misunderstanding of how the economy actually functions and results in misguided economic policies.

Here are the key aspects of this problem as outlined in the interview:

Irrealistic Assumptions: Neoclassical economics relies on unrealistic assumptions such as perfect information, no risk, and the absence of profits. While proponents argue these simplifications help identify the core of economic principles, Flassbeck believes they define away the very factors that make markets necessary and drive economic activity.
Flawed Equilibrium Theory: The neoclassical focus on general equilibrium, exemplified by Walras’ work, posits that all markets tend towards a stable equilibrium through price adjustments. Flassbeck argues this is fundamentally flawed because crucial elements like the real wage and real interest rate cannot be determined within such a system. Furthermore, he contends that the economy is constantly being disrupted by innovation and entrepreneurial activity, making the idea of a stable equilibrium irrelevant.
Ignoring Economic Movement and Innovation: Neoclassical models fail to adequately account for economic dynamism and the role of entrepreneurs who drive change by introducing new products and processes. Schumpeter, according to Flassbeck, was a pioneer in understanding this, but his ideas have been largely misunderstood and ignored by mainstream economics.
Misunderstanding of Saving and Investment: The neoclassical view that saving automatically leads to investment via the capital market and interest rate adjustments is incorrect, according to Flassbeck. He, drawing on Keynes and Kalecki, argues that increased saving initially leads to a reduction in corporate profits and potentially lower investment.
Flawed Labour Market Model: The neoclassical model assumes that labour and capital are easily substitutable and that wage decreases lead to increased employment. Flassbeck argues this is unrealistic, citing the example of Greece where wage cuts led to decreased demand and higher unemployment. He emphasizes that entrepreneurs are driven by forward-looking innovation, not by simply reversing production methods in response to wage changes.
Persistence Despite Empirical Evidence: Despite the theoretical inconsistencies and empirical contradictions, neoclassical ideas, often in modified forms like stochastic equilibrium models, continue to underpin the models used by central banks and international institutions.
Influence on Policy and Lack of Debate: The dominance of neoclassical thinking has shaped economic policy, such as the focus on monetary policy and the neglect of fiscal policy in Germany. It has also stifled critical debate on important issues like trade imbalances within the Eurozone. Flassbeck points to a “cartel of silence” in Germany that discourages criticism of its export-driven economic model.
Problematic Theories in Practice: Examples like the failure of monetarism and the reliance on questionable concepts like the “natural rate of interest” (r-star) highlight the practical shortcomings of theories derived from neoclassical foundations. The enduring belief in the neoclassical labour market model, even after the Eurozone crisis, is another example of this persistent problem.

In essence, Flassbeck’s argument is that neoclassical economics provides a fundamentally incorrect framework for understanding the economy, leading to poor policy choices and hindering effective solutions to economic challenges. He advocates for a shift towards an economics that focuses on the movement and dynamics of the system, drawing on the insights of thinkers like Keynes and Schumpeter.

What is the solution?

Drawing on the interview with Heiner Flassbeck, the solution to the problems caused by the dominance of neoclassical economics involves a fundamental shift in economic thinking and policymaking. Here are the key elements of this proposed solution:

Embrace a dynamic view of the economy: Instead of focusing on equilibrium models, economics should prioritise understanding the movement and dynamics of the economic system. This involves recognising that markets are constantly being disrupted and are rarely, if ever, in equilibrium.
Recognise the crucial role of entrepreneurs and innovation: The theories of Schumpeter, who understood the importance of innovation and the disruptive nature of entrepreneurial activity, should be central to economic analysis. This means moving away from static models that ignore the forces driving economic change.
Understand the actual relationship between saving and investment: The flawed neoclassical assumption that saving automatically translates into investment needs to be discarded. Instead, the insights of Keynes and Kalecki, who demonstrated that increased saving can initially lead to a reduction in profits and potentially lower investment, should be acknowledged.
Reject the neoclassical labour market model: The idea that labour and capital are easily substitutable and that wage cuts automatically increase employment is incorrect. Real-world examples, like Greece, show that wage reductions can lead to decreased demand and higher unemployment. The forward-looking nature of entrepreneurial investment, not simply reacting to wage levels, needs to be understood.
Adopt a pragmatic approach to economic policy: Policymaking should be based on a realistic understanding of how the economy functions, not on rigid and unrealistic theoretical models. This includes recognising that monetary policy is a pragmatic art requiring experienced individuals with sound judgment, not just the application of flawed models like the monetarist approach or the calculation of theoretical interest rates like r-star.
Recognise the importance of fiscal policy: Over-reliance on monetary policy and neglect of fiscal policy, as seen in Germany, needs to be rectified. Fiscal policy has a crucial role to play in managing demand and stabilising the economy.
Foster open and critical debate: The “cartel of silence” that stifles criticism of dominant economic thinking and policies, such as Germany’s export-driven model and Eurozone imbalances, needs to be broken. Serious and open discussion based on sound economic principles is essential for effective policymaking.
Seek cooperative solutions for trade imbalances: The mercantilist idea that export surpluses are inherently good needs to be abandoned. Cooperative solutions aimed at reducing large and persistent trade imbalances are necessary for global economic stability. This requires negotiation and a willingness by surplus countries like Germany and the Eurozone to adjust their policies.
Understand and address the debt question: The role and necessity of public debt need to be properly understood. Rigid rules like the debt brake in Germany need to be reconsidered in light of economic realities and the need for public investment.
Promote a more open and flexible approach within the Eurozone: The foundational principles of the Eurozone, including the Maastricht Treaty, need to be critically discussed. A more open discussion about the roles of fiscal and monetary policy, potentially drawing lessons from the US system where monetary policy considers both employment and price stability, is needed. The issue of diverging wage and competitiveness within the Eurozone also needs to be addressed through cooperation.
Empower competent and knowledgeable policymakers: Individuals with practical experience and a deep understanding of economic realities, rather than those solely relying on flawed theoretical models, should be at the forefront of economic policymaking.

In essence, Flassbeck argues for a move towards a more empirically grounded and dynamic economics that learns from past mistakes and is willing to challenge long-held but flawed neoclassical assumptions. This shift is crucial for developing effective policies to address the real economic challenges facing the world.

In short

Shortened Problem:

The core problem, according to Flassbeck, is the dominance of flawed neoclassical economics. Its unrealistic assumptions (like perfect equilibrium and information) and neglect of real-world dynamics (like innovation and Schumpeter’s insights) make it irrelevant. This flawed framework misrepresents key concepts like saving/investment and the labour market, yet persists in academia and policy. This leads to misguided economic policies, ignores empirical evidence, stifles critical debate (e.g., on German trade surpluses), and hinders solutions to real economic challenges.

Shortened Solution:

Flassbeck’s proposed solution requires a shift away from neoclassical dogma towards a dynamic, empirical, and pragmatic approach. This involves:

Adopting a dynamic view: Prioritise understanding economic movement and innovation (Schumpeter) over static equilibrium.
Using realistic models: Embrace accurate understandings of saving/investment (Keynes) and the labour market, rejecting flawed neoclassical versions.
Implementing pragmatic policies: Base fiscal and monetary policy on real-world understanding and sound judgment, not rigid, flawed theories.
Fostering open debate & cooperation: Encourage critical discussion (breaking the “cartel of silence”) and seek cooperative solutions for global issues like trade imbalances and Eurozone reform.
Rethinking core assumptions: Address fundamental issues like public debt realistically.

Essentially, the solution is to build and apply an economics relevant to how the world actually works.

Summarized

The Problem: Dominance of Flawed Neoclassical Economics

According to Flassbeck, the core issue is that neoclassical economics dominates despite being flawed and irrelevant to the real world.

Why it’s flawed:
- Relies on unrealistic assumptions (e.g., perfect equilibrium, perfect information, no risk).
- Ignores real-world dynamics like innovation, disruption, and the role of entrepreneurs (Schumpeter).
- Misrepresents key concepts like the true relationship between saving and investment (Keynes), and how the labour market actually functions.
Consequences of its dominance:
- It persists in academia and policy despite its flaws and contradictory evidence.
- Leads to misguided economic policies based on incorrect models.
- Stifles critical debate on important issues (like Germany’s trade surpluses and Eurozone imbalances).
- Hinders effective solutions to real economic challenges.

The Solution: Shift to Dynamic, Empirical, Pragmatic Economics

Flassbeck advocates for a fundamental shift away from neoclassical dogma. The key elements are:

Prioritize a dynamic view: Focus on understanding economic movement, innovation, and disruption (Schumpeter) rather than static equilibrium.
Use realistic models:
- Adopt accurate understandings of saving/investment (Keynes/Kalecki).
- Recognize the real complexities of the labour market.
- Reject flawed neoclassical assumptions.
Implement pragmatic policies:
- Base fiscal and monetary decisions on real-world evidence and sound judgment, not rigid, flawed theories.
- Recognize monetary policy as a pragmatic art.
Foster open debate & cooperation:
- Encourage critical discussion (breaking the “cartel of silence”).
- Seek cooperative solutions for global issues like trade imbalances and Eurozone reform.
Rethink core assumptions: Address fundamental concepts like the role and necessity of public debt realistically.

Overall Goal: Build and apply an economics that is relevant to how the economy actually functions.

Long form

Who was Léon Walras and why is he considered so significant, yet simultaneously irrelevant, in the history of economics according to the interview?

Significant: Walras (1870s) pioneered general equilibrium theory, a foundational neoclassical concept where all markets supposedly reach equilibrium via price adjustments.
Irrelevant (Flassbeck’s View): His model relies on unrealistic assumptions (no profit/risk, perfect info) and is internally inconsistent (can’t determine real wages/interest rates needed for adjustment). Crucially, it ignores the real-world dynamics of innovation, change, and constant disequilibrium, making it a flawed guide.

What were Joseph Schumpeter’s main criticisms of Walrasian economics, and why did his alternative ideas not gain widespread acceptance in mainstream economics education?

Schumpeter’s Critique: He argued Walrasian equilibrium was too static. Real economies are driven by dynamic forces: entrepreneurs, innovation, and “creative destruction,” which constantly cause disequilibrium and generate profits/losses.
Why Ignored: Schumpeter’s ideas introduced complexity and unpredictability. Mainstream economics preferred the perceived mathematical elegance and determinism of equilibrium models. The establishment was likely resistant to his paradigm-challenging, “chaotic” view.

How did neoclassical economics come to dominate economic thinking in Germany, especially considering the earlier prominence of the historical school of national economy? Neoclassical economics dominated in Germany because:

The earlier Historical School lacked a strong macroeconomic framework.
Neoclassical models offered perceived mathematical elegance and comprehensiveness.
Keynesian ideas were initially dismissed as only relevant for crises.
The post-WWII boom was wrongly credited to market-oriented “Ordnungspolitik” (Flassbeck attributes it to Keynes’s Bretton Woods system).
German economists preferred the theory’s perceived order and market-friendly conclusions.

What was the Keynesian Revolution, and how did neoclassical economics subsequently incorporate or counteract its key insights, particularly concerning saving and investment?

Keynesian Revolution: Keynes (and Kalecki) argued saving doesn’t automatically equal investment. Increased saving can reduce demand and profits, potentially causing stagnation if no one borrows and spends the saved funds.
Neoclassical Counter: Claimed interest rates adjust in the capital market to balance saving and investment.
Flassbeck’s Rebuttal: This ignores the initial negative impact of saving on demand and business revenue, making the smooth interest rate adjustment unlikely.

Why does the interviewee argue that the labour market is not a market in the way neoclassical economics describes it, and what are the implications of this different perspective? Flassbeck rejects the neoclassical labour market model (lower wages = more jobs) because:

It ignores the demand effect: Wage cuts reduce spending and overall demand (e.g., Greece), hurting businesses and employment.
Businesses innovate forward, not backward; they don’t dismantle capital or adopt less productive methods just because wages fall.
It assumes unrealistic instantaneous adjustments.
Labour and capital aren’t easily substitutable in the way theory suggests.
Implication: Policies like wage cuts to boost employment are likely ineffective or harmful.

How has the thinking in economics and economic policy evolved from the Keynesian era of the mid-20th century to the present, particularly concerning the role of government and monetary policy?

Keynesian Era (~1945-70s): Active government management of demand (fiscal/monetary policy).
Neoclassical Resurgence (~1970s+): Shift driven by stagflation fears, leading to Monetarism (controlling money supply) and favouring market-oriented policies (strong in Germany).
Flassbeck’s View: Monetarism was empirically flawed. Germany clung to rigid rules over pragmatic policy.
Today: While pure Monetarism is discredited, neoclassical ideas (market efficiency, rational expectations) still heavily influence policy institutions (e.g., EU Commission), with Germany particularly resistant to change.

What is the “Lucas Critique,” and how did it contribute to the resurgence of neoclassical economics, particularly in labour market theory?

The Critique: Argued people have “rational expectations” – they anticipate policy effects and adjust behaviour, often neutralizing the policy.
Impact: Supported ideas of market efficiency and non-intervention; helped revive neoclassical models.
Flassbeck’s View: Calls it “grandiose nonsense,” arguing it unrealistically assumes people understand and act perfectly based on flawed economic models. Sees its acceptance as ideological bias favouring markets over evidence.

What are the interviewee’s views on Germany’s persistent current account surpluses, the lack of debate surrounding them, and potential solutions to global trade imbalances?

Flassbeck’s Criticism: Germany’s huge surpluses (from wage suppression) violate rules and are unsustainable. Criticizes the “cartel of silence” preventing debate in Germany. Believes Trump’s core critique of imbalances was correct.
Proposed Solutions:
- Cooperative action: Surplus countries (Germany/Eurozone) must adjust policies via negotiation (WTO).
- Open Eurozone discussion: Re-evaluate rules (Maastricht), understand debt properly, allow policy flexibility.
- Avoid protectionism: Cooperation is better than trade wars.
- Reject splitting Eurozone: Focus on internal rebalancing.

Resources & Further Watching

Watch the original interview (German): ‘Das hat mit Wissenschaft nichts zu tun! | Heiner Flassbeck zerstört die Neoklassik im Interview’ by Agitator der sozialen Marktwirtschaft
Watch Next (Playlist): Economics

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