On 18 March 2013, the German Friedrich Ebert Foundation organized a conference in Berlin on ‘How to tame the monster’ (of financial markets). At this conference, Klaus Regling, Managing Director of the European Stability Mechanism (ESM), mocked economic textbooks, in particular ‘American’ textbooks where, he said, ‘you never shall find any hint that wages might fall’. His mockery reveals one of the great errors of classical economic theory, that is, the notion that an economy in crisis will return to equilibrium if only wages fall enough. The fallacy lies in reasoning from the movement of a single wage to the movement of the wage level. If all wages fall, the wage level decreases and so does the price level. This well-known process of deflation increases the real burden of debts. It is an illusion to believe a government might reduce its debt burden by organizing a deflationary process. This does not only hold in the ‘special case’ of Greece, which has been conceded by Regling; it is a general principle.

To understand this principle we have to clarify the so-called ‘stock-flow-problem’ in monetary economics, that is the relation of monetary flows (income flows) and monetary stocks (assets and liabilities) in an economy. For that purpose a Keynesian perspective is needed.

This chapter draws on an early, tentative analysis of John Maynard Keynes, his famous Economic Consequences of the Peace of 1920.