Modern Economy, 2011, 2, 25-30
doi:10.4236/me.2011.21004 Published Online February 2011 (http://www.SciRP.org/journal/me)
Flaws of Modern Economic Theory: The Origins of the
Contemporary Financial - Economic Crisis
Ezra Davar
Independent Researcher, Former – Ben-Gurion University of the Negev, Yehuda Hanasi, Netanya, Israel
Received January 7, 2011; revised January 18, 2011; accepted January 21, 2011
Abstract
The Paper shows how fundamental flaws in the modern economic theory are a central part in the formation
of financial bubbles: 1) The Keynesian multiplayer is based on the substitution of the cause (the national in-
come) for the effect (investment); which yields inadequate results. 2) Modern general equilibrium theory is
based on the following assumptions: a) modern version of free goods conception; b) “Walras’ Law”; This is
realistically absurd, as according to these assumptions, the equilibrium price of some goods and services
might be equal zero. 3) Modern money theory assumes that fiat money is the only type of money, which is
erroneous.
Keywords: Flaws of Modern Economic Theory, Keynes’s Multiplier, Modern General Equilibrium Theory,
Modern Money Theory, Smith, Walras, Keynes
1. Introduction
Financial bubbles are a major issue when discussing the
current global financial - economic crisis. Yet, their ori-
gin in economic theory has been not adequately dis-
cussed. This paper discusses crucial flaws in the modern
economic theory and shows that these flaws are the ori-
gins of the financial bubbles and consequently of the
contemporary financial - economic crisis.
P. Krugman (Nobel Prize Winner in Economic Sci-
ences) concluded his recent paper stating that, “So here’s
what I think economists have to do. First, they have to
face up to the inconvenient reality that financial markets
fall far short of perfection that they are subject to ex-
traordinar y delusion s and the madn ess of crowd s. Second,
they have admit and this will be very hard for the people
who giggled and whispered over Keynes that Keynesian
economics remains the best framework we have for
making sense of recessions and depressions. Third,
they’ll have to do their best to incorporate to realities of
finance into macroeconomics” [1].
Classic economists (Smith, Marx) and Walras attest to
the complexities of real economics and used abstractions
to research specific issues. However, they emphasized
that mathematical models must closely represent reality,
but these models never quite reproduce reality. For ex-
ample, Marx and Walras stated that in reality general
economic equilibrium can never be achieved. Walras’s
theory illustrates how equilibrium might be established
for hypothetical economics. A model, such as Walras’s
would have to be considered in the framework of the
reality to be recommended or applied .
While modern authors have not merely assumed that
theory may diverge from reality, they extended this pre-
mise to an extreme, “the more significant the theory, the
more unrealistic assumptions”. For example: 1) the
Keynesian multiplayer is based on the subs titution of the
cause (the national income) for the effect (investment);
which yields an inadequate results. 2) Modern general
equilibrium theory is based on the following assumption s:
a) modern version of free goods conception; and b)
“Walras’ Law”; which assu me that with an excess supply
of a commodity, its price has to be zero; which is realis-
tically absurd [2]. (There are three Nobel laureates Ar-
row, Debreu and Hicks on the GET; and two others, who
earned their Nobel on the topics involving the GET: Sa-
muelson and Allias). 3) Modern money theory assumes
that fiat money is the only type of money, which is erro-
neous.
Classics considered money theory as a central and
non-separate from economic theory and have discussed
their reciprocal influence. Smith discussed his monetary
theory, not only in the Book II, but also throughout the
Wealth of Nation s. Marx did not focus his money theory

E. DAVAR
26
only once, but his significant ideas on money appear
throughout th e four volumes of his Capital. One of Wal-
ras’s major and unique contributions is his integration of
his money theory into his general equilibrium theory
which enabled him to consider real economic and the
financial sector as one integrated system. Yet, Walras
considered two types of money: money as a medium of
exchange, a measure of value and store of value (the
money commodity - numéraire) and money for circula-
tion (the money commodity - numéraire or fiat money);
thus there are two different prices for the money com-
modity: a) when money commodity is used as a measure
of value its price equal to one; b) when money commod-
ity is used in circulation its price equal to the rate of in-
terest. In contrast, in the works of most modern econo-
mists, these sectors are separated and there is only one
type of money - fiat money. Moreover in the modern
general equilibrium theory, money either disappeared
(Arrow-Debreu Model), or considered in very simplified
form and with unrealistic assumptions (see Applicable
(Computable) General Equilibrium, Input-Output Analy-
sis, and Dynamic Stochastic General Equil ibrium Theory).
Krugman states that “that Keynesian economics re-
mains the best framework we have for making sense of
recessions and depressions”, because, by his opinion,
“It’s important to understand that Keynes did much more
than bold assertions. The General Theory is a book of
profound deep analysis that persuaded the best young
economists of the day” [3]. Meanwhile, the Keynes’s
crucial suggestion for “active government intervention -
printing more money”, is based on his Multiplier concep t,
which is incorrect (vide infra).
Yet, Keynes’s second central issue, Involuntary Un-
employment is still controversial: a) there is no existing
conventional determination of involuntary unemploy-
ment; b) there is no measuring metho d for it; c) the link-
age between involuntary unemployment with voluntary
and full employment is not considered. Unfortunately,
Keynes’s definitions of full employment, voluntary un-
employment and involuntary unemployment are ex-
tremely vague and incomplete [4]. These definitions only
became murkier as Keynes’s followers tried to explain
them. For example, post-Keynes’s economists have been
discussing whether “involuntary unemployment” is equi-
librium or a disequilibrium phenomenon. There are two
opposite claims, those that claim it is a disequilibrium
phenomenon [4 ,5] and those that claim that it is an equi-
librium phenomenon [6,7]. Therefore, the economics
literature to date either ignored the co-existence of these
two kinds of unemployment or claimed they were both
the same [8-11]. Moreover, there is Macroeconomics text
books of which make no mention of it at all. Meanwhile,
it might be demonstrated the following main characteris-
tics of a general definition of involun tary unemployment:
1) It is an equilibrium phenomenon; 2) It may or may not
exist, and, if it does, then equilibrium employment is less
than the available quantity of the primary factor; 3) It
may co-exist with voluntary unemployment.
The mon ey theory is an anchor of Keynes’s economic
theory and his main contribution; and the source of Key-
nesian Revolution. However, Keynes was not the first
who suggested government intervention. Walras stated
that in real economics where distorted equilibrium con-
ditions persist, the State should intervene by regulating
wages, prices and the quantity of money [12]. But
Keynes was the first, with no theoretical foundations, to
call for ‘printing more money’.
Meanwhile, Keynes’s money theory is incomplete and
even incorrect. First, Keynes merged the transaction -
motive, which already represents a combination of the
income - motive and the business - motive, with precau-
tionary - motive. This eliminates the difference between
two types of money: money as a medium of exchange, a
measure of value and a store of value (the money com-
modity - numeraire) and money for circulation (the money
commodity - numeraire, or fiat money), and therefore,
consequently, the difference between two various prices
for money commodity are also eliminated. This is the
main reason that in modern economics only fiat money is
used.
Second, Keynes asserted that L1 liquidity function of
the amount of cash to satisfy the transactions and precau-
tionary motives (M1) depends mainly on the level of in-
come [M1 = L1(Y)]. Here, Keynes assumed that the li-
quidity function is the inverse function of the income
function. Keynes used this approach very frequently, for
example for the employment function, which is deter-
mined as the inverse function of the aggregate supply
function [13], Hicks also used this approach in his fa-
mous IS -LM model). However, the inverse function exist
only for the function of one variable with specific prop-
erties, namely, the function must be either strictly in-
creasing or strictly decreasing function. Yet, the income
function is the function for many variables (prices and
available quantities for all categories - goods, factors of
production (labour. fixed capital and money) and so on).
Therefore, the assumption that the income function as the
function of one variable, ones of money, ones of avail-
able quantities of either labour or fixed capital, is incor-
rect. What means that the liquidity function for the
transactions-and precautionary - motives [M1 = L1(Y)] as
the inverse function of th e income function is not exist.
2. The First Flaw: Keynesian Multipliers
The multiplier, one of the central issues of The General
Theory, is a major tool developed by Keynes for estab-
lishing a relationship between income, investment, con-

E. DAVAR
27
sumption and employment. Majority of economists have
been stating that the Keynesian multiplier is a new para-
digm in economic theory and asserting that ‘without the
multiplier there would have been no General Theory no
Keynesian macroeconomics’ [14]. Furthermore, Keynes,
himself, stated that ‘The theory of the multiplier. … half
the book is really about it’ [15]. However, there were
economists who expressed doubts regarding the multi-
plier [16,17].
Keynes stated that “Let us call k the investment multi-
plier. It tells us that, when there is an increment of ag-
gregate investment, income will increase by an amount
which is k times the increment of investment” [13]. This
must mean that an increment of the investment a certain
time period would yield increasing income by the multi-
ple it of k (multiplier) in the future (forthcoming time
periods). In other words, the source of income’s increase
must be the additional fixed capital which is a transfor-
mation of the new investment.
Here, Keynes made two incorrect suppositions. First,
income and investment have been substituted; invest-
ment now becomes the cause and income the effect.
Moreover, here investment is determinant, which is op-
posite to Keynes’s another statement that “Saving and
Investment are determinates”. However, the theory of
causality teaches that such a substitution is generally
incorrect.
Second, Keynes’s “multiplier” is only a psychological
phenom enon, while the basic component - product i on - is
omitted.
Hence, we can conclude that k cannot be the multi-
plier.
Careful analysis shows that Keynes’s “multiplier” is
the inverse of the marginal propensity to invest (save).
This means that the rate of the multiplier depends on the
marginal propensity to inv est and the lower the latter, the
higher the multiplier. For example, if the marginal pro-
pensity to invest is 0.1 then the rate of multiplier is 10,
and if the first is 0.05, than the latter is 20. Consequently,
to increase income is it better to consume than to save.
So individuals were encouraged to spend on consump-
tion and not save. Ther efor e, for the las t twenty ye ars th e
average propensity to invest in USA was decreased and
reached 0.04 which means that the multiplier rate must
be 25. This is madness (!).
To decode this puzzle it is enough to remind that by
definition the inverse of the marginal propensity to invest
(save) indicates the required quantities of income for a
unit of investment when the marginal (average) propen-
sity of both does not change. Therefore, the real meaning
of Keynes’s multiplier is a requirement, and not a multi-
plication. Hence, the requirement indicates the amount of
national income required to realize one unit of invest-
ment (saving) in the same time period, when the mar-
ginal (average) propensity to consume is constant, since
“when investment changes, income must necessarily
change in just that degree which is necessary to make the
change in saving equal to the change in investment”
[13,18]. This means that the increment of the income is
not derived from the increment of the investment, but the
derivation must come from the existing unemployed
primary factors (fixed capital and labour).
By this definition, again using Keynes’s example
where the marginal (average) propensity to invest equal
to 0.1, to increase the investment by one, at the same
time the income must increase by 10, where 9 units are
intended to increase consumption. It must be stressed
that the corresponding increase of income might not be
possible at all, because it depends on the magnitude of
the available unemployed factors: labor, fixed capital,
scarce raw materials, etc. [19]. In the latter case, the rela-
tionship between national income and investment is in-
versely, whereas in the previous case, the relationship is
direct.
Concurrently, it must be emphasized that Keynes also
used similar interpretation of “multiplier” not only in
General Theory (see the quotation above on this page,
and [13], but also another publication. Keynes wrote:
‘According to the multiplier theory, there is an arith-
metical relation between the level of consumption and
the level of net investment, so that, other things being
equal (i.e. nothing occurred to ch ange the value of multi-
plier) consumption and net investment rise and fall in the
same proportion’ [15]. The comments are needless!
Moreover, Harrod and Hicks, mainly used the second
interpretation of “multiplier”. It is amazing that authors
such as Keynes, Harrod, and Hicks termed as a ‘multi-
plier’, which has to be source o f multiplication, but actu-
ally meaning requirement!
Keynes’s followers have been trying to vindicate the
‘multiplier’ and therefore, have been considered succes-
sive-period (lagged or dynamic) multiplier according to
Kahn [20] in parallel with his instantaneous (static) ver-
sion. However, there are two crucial differences between
them. First, Keynes discussed closed economy where the
source of the investment is the national income, while
Kahn considered open economy where the borrowing is
the source of the investment increment. Second, in the
latter case, to calculate net multiplier it is necessary to
reduce the amount of repayment for borrowing from
yielding increasing income.
Finally, in the consequence of Keynes’s multiplier, his
followers created three additional multipliers: govern-
ment spending, taxes, and money. However, sometimes
their utilization is contrary to economic theory. For ex-
ample, it has been claimed that on the one hand, an in-
crease in government purchases will raise the income,

E. DAVAR
28
while on the other hand, an increase in tax will decrease
the income, or alternatively, a decrease in tax will in-
crease the income [21]. But this claim is erroneous, be-
cause it is generally conventional that in the close eco-
nomics taxes are main source of the government revenue
(spending). Meanwhile, R. J. Shiller [22], in his recent
paper, suggests a tax increase to stimulate ‘our ailing
economy’.
The money multiplier shows that an increase in the
monetary base increases the money supply by the multi-
ple of the money multiplier. Thus, the money supply
depends on the rate of money multiplier; a high money
multiplier considerably increases the money supply. The
money multiplier is inversely dependant on the reserve-
deposit ratio and the currency - deposit ratio; the lower
these factors, the higher the money multiplier. Conse-
quently, if the government prints more money, as Keynes
advised and spending on consumption and banks de-
crease the reserve-deposit ratio and the currency-deposit
ratio then the money supply might be considerably in-
creased. This is a central cause of financial bubbles!
3. The Second Flaw: Modern General
Equilibrium Theory
The modern general equilibrium theory (MGET) is con-
sidered a major achievement in the abstract science of
economic theory and regarded “as the kernel of econom-
ics or even social science” [23]. The importance of the
MGET is that it provides proof of the existence of gen-
eral equilibrium ‘The proof of general equilibrium is the
crowning achievement of mathematical economics’
[24,26]. It might be that the proof of its existence is a
mathematical achievement, but the question is whether
this proof is harmonious with the economic situation in
reality.
However, the above statement requires compatibility
between the MGET and real economics. Yet, when they
are incompatible, the MGET violates the underlying as-
sumption of classical economic methodology; the recip-
rocity between theory and reality, which renders MGET
irrelevant. Unemployment (voluntary and involuntary) of
primary factors (included labor) is a clear example,
which cannot be satisfactorily solved by modern theory.
Unemployment is primarily a structural problem and,
therefore, the only possible solutions are within the gen-
eral equilibrium framework. However, the MGET cannot
be used, since the MGET does not apply to real econom-
ics. Not only is the MGET based on the Walras’s as-
sumptions [25] (free competition, uniformity of prices,
and no taxation, public sectors and intern ation al trad e ar e
omitted), but the MGET also ignores some of Walras’s
realistic achievements. Furthermore, the MGET is based
on several unrealistic additional assumptions [27]: First,
the free goods conception, as formulated by post-Walras
economists (in contrast to the classical free goods con-
cept); Second, “Walras’ law”; Third, the excess demand
(supply) for goods and services is determined as a dif-
ference between the final endowment and the initial
(available) endowment; which providing crucial role in
the proof for the existence of equilibrium [26]. Accord-
ing to these assumptions, the equilibrium price of some
goods and services, specifically when these are in excess
supply, might be equal zero, or even negative (a rather
absurd assumption, which does not warrant our atten tion).
For example, in an equilibrium situation, with high un-
employment, wages have to be equal zero: ‘In a purely
neoclassical version, permanent unemployment would
require a zero wage [28]. However, such wages contra-
dict reality economics. Therefore, the main achievement
of modern general equilibrium theo ry (MGET), the proof
of equilibrium existence basing on these unrealistic as-
sumptions, becomes completely meaningless.
Yet, according to the MGET, prices are exclusively
determined by the model; namely, by the internal condi-
tions of the model, but these are not options in the given
framework of changing of prices (demand and supply
function). Therefore, the equilibrium prices of the MGET
might not be represented by positive values. Moreover,
the measurement of prices depends, if money is also in-
cluded, on the measurement of utility functions, which
may vary for different individuals.
Consequently, there is an additional distortion. When
price of the primary factors is particularly strongly posi-
tive and price of a certain goods is equ al to zero, then the
value of the factors used in the production of these goods
is distributed between other goods and thus, “falsifies”
their prices.
Finally and perhaps most importantly, the “Walras’
Law”, formulated by post-Walras economists, is one of
the crucial assumptions of the MGET and differs essen-
tially from Walras’s original laws. Moreover, it is an
intermediate stage of Walras’s own laws. Moreover,
Clower used it “to demonstrate” Keynes’s contribution to
economic theory in his influential paper [5] and Mor-
ishima alleged that Walras’s General Equilibrium Theory
does not recognize “Walras’ Law” [29 ]. Yet, with regard
to the conception of free goods, which is crucial in pro-
viding the proof of existence of equilibrium, Walker
states that ‘His (Walras’s) assertion have been erroneous
because he neglected to consider free goods, which are
used in positive amounts but have zero pri c es’ [30].
The “Walras’ Law”, unfortunately, has replaced Wal-
ras’s original laws, not only in the textbooks, but also in
professional literature. Subsequently, the original laws
have become relatively unknown and abandoned, a sig-
nificant loss to economic science. The thought of an “al-
ternate” to Newton’s laws coexisting with the original is

E. DAVAR
29
ludicrous, yet in economics such anomalies are common
place.
So, modern general equilibrium theory diverged from
representing the current financial sector, greatly simpli-
fying the problem of money loosing any ability to dis-
cuss the money quantity regulation problems. This is
additional cause for the financial bubbles.
4. The Third Flaw: Modern Money Theory
From the seventies, the majority of countries of the
world used a fiat money as standard money; fiat money
replaced the mon ey commodity and h ad to fulfill all four
functions of money. But this is opposite with the princi-
pal statement of classical money theory, that only mo-
ney commodity have to serve as a measure of value, and
fiat money has to be used for circulation. Moreover, the
quantity of fiat money must be regularized by the quan-
tity of the money commodity. Smith has stated repeat-
edly, “The whole paper money of every kind which can
easily circulate in any country never can exceed the val-
ue of the gold and silver, of which it supplies the place,
or which (the commerce being supposed the same)
would circulate there, if there was no paper money” [31].
Theoretical and practical backgrounds for that process,
unfortunately, were not properly discussed. Friedman,
the guru of monetarism and Nobel Prize laureate and
Schwartz wrote “Unfortunately, there are currently legal
obstacles to any developments that would enable gold to
be used not only as a store of value or part of an asset
portfolio but as a unit of account or a medium of circula-
tion. Hence, the current situation provid es little evidence
on what would occur if those obstacles were removed”
[32]. To the best of our knowledge, unfortunately, they
did not reveal here or an ywhere else, what kind of “legal
obstacles” - because they do not ex ist. So, modern econo m-
ics is “governed” by fiat money, namely by American dollar.
The replacement of the money commodity by the fiat
money has yielded several phenomena, predecessors of
the financial bubbles. First, because the fiat money has
no objective value, economics (markets) is managed
without valuating of goods and services; Moreover, the
fiat money has subjective value, as Woodford states “We
now live instead in a world of pure “fiat” units of ac-
count, where the value of each depends solely upon the
policies of the particular central bank with responsibility
for it” [33]. Second, because there is only one type of
money, namely fiat money, there is only one price - the
rate of interest and the price of the money commodity is
absent. Therefore, this is another reason why fiat money
cannot be served as a measure of value. Third, there are
neither obstacles nor limits to pr inting paper mon ey (one
of the central causes for financial bubbles).
Modern theory of money is generally concentrated on
the macroeconomic level [15]; despite that, it is conven-
ient that the modern microeconomic theory has been
compatible with reality rather than with macroeconomic
theory. However, since Walras, unfortunately, micro-
economics theory has not developed from the point of
view of money theory [34-36]. First, fiat money is only
served as money. Second, fiat money is valueless and
useless; therefore, it has no direct utility and cannot ap-
pear in the utility function. Third, Walras manipulated
the demand and supply of all categories, later obtaining
the final endowment by their means. Hicks, Lange, Pat-
inkin, and Clower use initial and final endowment, which
allows calculating demand and supply. Finally, th e utility
function includes all goods simultaneously while Walras
considered utility function for each good separately.
On the other hand, the modern theory formally deter-
mines the rate of interest similar to the classical approach;
namely, according to modern theory the rate of interest is
determined by the relationship between aggregate de-
mand and aggregate supply of money. However, there
are essential differences between them, since the modern
theory of interest is based on the Keynes’s approach
(vide supra). Moreover, the differences are deepened.
For example, the supply of money depends not only on
the quantity of printed money as well as Keynes’s ap-
proach but also on the rate of the money multiplier (see
above p. 27). Yet, the modern theory of money continues
determining the demand function for money as an in-
verse function of income according to Keynes, the exis-
tence of which is doubtful (see above p. 25).
5. Conclusions
Financial bubbles are the practical implications of flaws
in economic theory. The paper considered flaws in the
modern economic theory in three central topics: 1) the
Keynesian multipliers; 2) Modern general equilibrium
theory; and 3) Modern money theory showing them dis-
tant from reality and even erroneous.
Remedying these flaws is necessary, but still insuffi-
cient for prev enting and resolving fin ancial bubbles. Just
as Keynes failed (because his theory is both incomplete
and incorrect) to build a bridge between Classical Eco-
nomic Theory and his era’s economic reality, Krugman’s
suggestion to re-embrace Keynes must not and cannot
not be the solution. Urgent rethinking and reconsidera-
tion of modern economic theory in the spirit of Classical
Economic Theory (Smith, Marx) and Walras to be more
compatible and closer to the contemporary economics
must be the first step for curing the sick state of our cur-
rent economics.

E. DAVAR
30
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