Preface

When First Principles Fail

Economists continuously pursue new ideas and have achieved considerable success. Yet few pause to ask whether the foundations beneath them are truly solid. In my view, they are not.

Demand has two well-known dimensions: willingness to buy and ability to pay. Willingness without ability is mere desire, and it is boundless. The substance of demand, therefore, lies entirely in the ability to pay.

The ability to pay, then, does not lie in money itself. Money is a claim on goods and services. It is those goods and services that constitute the ability to pay.

Money is merely a medium of exchange. It is a veil over what is fundamentally goods and services trading for goods and services. Your capacity to demand what others produce is ultimately proportional to what you produce yourself.

All goods and services must be produced, via investment. Demand, therefore, is ultimately a supply-side phenomenon. In aggregate, demand always equals supply because they are identical forces, differing only in the angle from which they are viewed.

Mainstream economics justifies insufficient effective demand by two laws: diminishing marginal propensity to consume and diminishing returns on investment. But they are insufficient to support the conclusion. Both are tools of partial equilibrium analysis, valid only when all other factors are held constant. In the real world, nothing is held constant, so the conclusion does not follow directly. Take consumption as the first example: a shift in its structure is enough to break the pattern of diminishing marginal propensity to consume. Capital is no different. Diminishing returns arise only because labor is assumed to lag behind capital. Stop assuming capital as one undifferentiated mass, split it into Capital A and Capital B, and the logic unravels: if Capital A expands rapidly through, say, advances in intelligent machinery, there is no reason the return on Capital B must fall.

Since demand and supply are essentially identical at the aggregate level, the aggregate supply and demand model (AS-AD) does not hold. And if the model itself does not hold, what becomes of the analyses built upon it?

Mainstream macroeconomics measures GDP with considerable sophistication. Yet it regrettably omits a concept without which the measurement is fundamentally misleading: pseudo-GDP. Misguided investment destroys wealth, and it cannot, by any honest accounting, be counted as GDP. But without the concept of pseudo-GDP, much of these misguided investment count toward GDP. The consequences are serious. In theory, the framework ties itself in knots. In practice, erroneous capacity is misdiagnosed as excess capacity or insufficient demand, and stimulus is applied where loss-cutting is needed. The concept of pseudo-GDP reveals that what mainstream economics defines as insufficient effective demand is something else entirely.

The identity GDP = C + I + G + NX tells you nothing more than how to measure GDP, especially not about GDP creation. Measurement is an act of categorization and summation; it says nothing about cause and effect. Thus, it cannot be used to conclude that if C and I fall, raising G will compensate to sustain the identity. This category error invalidates macroeconomic policies built upon it, and the entire "three-horse carriage" theory, which inherits this error—and collapses with it.

Money exists because it reduces transaction costs, facilitates trade, and deepens the division of labor. Yet it becomes the mainstream to tune monetary policy into a lever for achieving multiple goals, such as economic growth, full employment, and balance-of-payments equilibrium. Whether monetary policy can even achieve these goals is a separate question; the more fundamental problem is that the entire approach has the cart before the horse. The same confusion runs through the mainstream endorsement of mild inflation as economically beneficial: where exactly is the threshold between mild and non-mild? And more importantly, inflation is a seigniorage tax—a covert erosion of property rights. That undermining property rights could be good for the economy is a claim mainstream economics asserts but never seriously defends. These are not minor oversights: they are foundational failures.

If monetary policy were confined to a single objective, the conundrums outlined above would dissolve, and constructs such as the Mundell-Fleming Trilemma would cease to exist. This single objective is to maintain the monetary stability. This book takes precisely that approach. I make no claim that it is the only path to a sound theory, but a theory built on this foundation is demonstrably more concise and logically consistent than what mainstream economics currently offers. It is a direction that deserves serious attention.

Exchange rates offer another illustration. Since prices in microeconomics are determined by supply and demand, beyond anyone's control, artificial intervention can only substitute non-monetary prices for monetary ones, never eliminate the adjustment itself. This reduces the entire debate between fixed and floating exchange rate regimes to a single practical question: which adjustment mechanism is more effective? Floating regimes move the nominal rate directly; fixed regimes achieve the same end indirectly, through shifts in wages and prices.

The Triffin Dilemma also remains highly contestable. The expanding U.S. trade deficit is fundamentally a byproduct of heightened global demand for the dollar; given this premise, it is paradoxical to suggest that a surge in market demand would inherently destabilise the asset's value. Empirical data over recent decades reinforces this skepticism: while the U.S. trade deficit has consistently widened, the U.S. Dollar Index has merely fluctuated within a stable range of 71 to 121. Even now, with the trade deficit hovering near historic highs, the index remains resilient at approximately 99.45—a level far from indicative of a weak currency. This enduring divergence demonstrates that when a sovereign currency functions as the global reserve currency, the issuing nation faces no structural dilemma between supplying international liquidity and preserving currency stability.

Or so it appears. The book goes further, and so can the reader.

This book addresses the fundamentals of macroeconomics, and fundamentals are where everything begins. When first principles fail, no structure holds, however sophisticated the edifice built upon them. I cannot claim that every argument in this book is correct, but I am confident that the questions it raises and the insights it offers are genuinely illuminating. My hope is that readers come away with one lasting conviction: that the foundations of economics must be able to withstand the scrutiny of both theoretical logic and empirical experience. At present, they do not.

I owe a debt of gratitude to Mr. Zhou Mingjun, Mr. Wang Guohai, and Mr. Chen Jin for their generous support throughout the publication and translation of this book. My deepest thanks go to all the students in my masterclass. It was your probing questions, your refusal to accept easy answers, and our countless hours of tireless discussion that drove home a truth I now hold firmly. Foundational problems cannot be resolved by memorizing answers; they must be hammered out through meticulous, painstaking work. In every class, the roles quietly reversed. Rather than me instructing you, it was you who compelled me to re-examine every inference I had thought settled. The most valuable insights in this book were forged in precisely those moments when your challenges stopped me mid-thought and sent me back to think it over again.

A special word of thanks is due to Mr. Chen. This translation has been four years in the making, and without his tireless dedication, this book would never have found its way to English-speaking readers.

Zuoshi Xie

Tuesday, May 12, 2026