Further Debunking Economics: Interview with Economist Steve Keen
While many economists have argued that no one could have foreseen the 2008 financial crash, some economists were sounding the alarm well before the bubble burst. One of them was Steve Keen, a Professor of Economics & Finance at the University of Western Sydney, and author of the book “Debunking Economics: The Naked Emperor of the Social Sciences” (Zed Books UK, 2011). Keen is credited with predicting the 2008 financial crisis in December 2005. He has argued that his foresight on the crisis is due to a little-known secret: that many widely believed economic models have been shown to be wrong, which many economists — particularly those in government policy positions — will not admit.
Keen argues that economic theory is particularly wrong when it comes to the “Efficient Markets Hypothesis,” which still dominates academic thinking about finance, even after the Global Financial Crisis. Since 1995, Steve’s main research focus has been the development of an alternative, empirically grounded theory based on Hyman Minsky’s “Financial Instability Hypothesis,” which argues that finance markets are not self-equilibrating but inherently unstable. Keen’s forthcoming book on the topic, “Finance and Economic Breakdown,” will be published in 2012. He also writes the blog Debtwatch.
Keen talked to Left Eye on Book‘s Christine Shearer about “Debunking Economics,” the problems with many economic ideas and neoclassical thinking, and his own work toward a new model — and theory — of economic systems.
Christine Shearer: You begin “Debunking Economics” with a critique of the fundamental principles of [classical] microeconomics: supply and demand. You argue that the equations around demand are flawed because they assume one consumer that is then aggregated to the level of the market, which you say does not hold up empirically or mathematically. Conversely, for supply, economists argue that firms exercising their profit-maximizing behavior will supply goods at a level in which it is not profitable to produce beyond that level – where marginal cost equals price – but its defining equations only hold up under demonstrably false assumptions?
Steve Keen: It’s more than just demonstrably false. The equation, first of all, with demand what they do is have a distilled explanation of an individual’s behavior. And that is deriving individual demand from a set of preferences, and then they say after you determine these preferences you can say what an individual’s demand will be, and they then jump straight from that point to talking about the market. And if any textbooks actually talk about that transition process then they simply say there can be conflict. What they’re leaving out at the very start of the exercise is assuming that you can change the prices without changing the distribution of income or level of income. Well, if you change the price of bananas, it won’t affect individual income all that much. But when you have an entire society involved, any change in prices necessarily changes not just income but the entire distribution of income as well. Some neoclassical economists have done this work, to get the foundations, and they’ve concluded that if you get consumers with different tastes and different prices, and different goods – some luxuries, some necessities – you can derive any demand curve; just a squiggly line across a sheet of paper without taking your hand off the page. Now of course they don’t teach that in the introductory courses because, as soon as you do that, good bye demand and supply. Because if you just draw like a sine wave, there’d be absolutely no reason why that could not be a legitimate demand curve in a market.
That’s the first stage. The second, on supply, they argue that firms face rising costs of production and they therefore will, as volume rises, the increase in volume will push up the level of price for them, at a stage where the firm will say, ‘Well, I’m not going to produce any more – any more than this and I’ll produce at a loss.’ Well, if you actually empirically ask what sort of cost structures that they face – well, Alan Blinder, who was once vice-president of the Federal Reserve and a very influential neoclassical economist, went out and did precisely that in a book called “Asking About Prices.” And here’s a very rough conclusion of what he said: he said that 89% of firms for which he was reporting had constant or falling marginal costs, which is the opposite of the situation that is taught in the textbooks. So they are wrong about firms facing a rising point in terms of cut-off costs. But he said OK, let’s pretend that they are right even though we know that they are wrong, but let’s just look at the mathematical argument: the position that they find is profit-maximizing does not maximize the profits of the individual firm, the levels of output does.
So neoclassical economists are wrong about the shape of the demand curve, they’re wrong about there only being one possible shape being logical given what the shape can be, and they’re wrong about the point of profit-maximization. So the whole thing is a shambles, but it’s taught without those nuances in textbooks. So students have this would-be perfect vision if everything else is correct in the belief — and it’s not the students’ fault that they go this way — in the belief that everything else is in fact correct. But good neoclassical economics have proven that the demand curve does not look like what the textbook says it does, and I myself and other colleagues have argued that the supply function is completely different as well. So it’s a total shambles, but with that perfect picture the students go off believing the rest of that ideology: you know, that markets are perfect, markets choose the best possible point — when the theory, properly worked out, shows that markets cannot identify what the best point is anyway.
Christine Shearer: So supply and demand is the basis of free market economics because it assumes equilibrium – i.e. the government could only disrupt this natural balance? It is the equations behind the philosophy of economic liberalism?
Steve Keen: Yeah, and that’s the whole idea, that there is an actual balance out there. And that’s a very seductive thing for a student. I know I was seduced by it when I first learned it in high school and becoming a University student, and it’s a very seductive vision because what it actually communicates is that you can have an economic system that distributes to society resources without having any power – and you don’t have any power because the model argues in favor of competition rather than collusion. You have firms not colluding with each other, workers not forming unions, and you have the government keeping out of the way, and that would lead to the perfect situation rather than leading to political anarchy, etc., etc. So it’s a very seductive vision of an anarchist society that works well. And, strangely enough, I think most neoclassical economists without knowing it are effectively anarchists because they are arguing in favor of no government, and that is an argument that a lot of humans have had over time and the trouble is both left and right anarchy failed, in that anarchy when it did manifest on the left became centralized power in the socialist system – it had a lot to do with the economic failure of that society. And when you try to create society built on this model, that doesn’t work either because the actual ideas behind them are totally unsound as well, and you get the sort of canards we see now in financial markets, but it’s an essential part of why economists are so anti-government: they have a vision of society that doesn’t need government.
Christine Shearer: Yet the Great Depression of the 1930s arguably created an opening for new theories of the economy to be considered, such as John Maynard Keynes’s argument that government spending could bolster employment and thus demand, helping jolt economies out of a slump. Such economic theories were applied to the macro level to create models for numerical simulations of the economy, and were often linear and assumed equilibrium. The Investment-Saving/Liquidity preference model (IS-LM), for example, was informed by the work of Keynes, but took out his consideration of uncertainty and complexity (yet is still called neo-Keynesianism). But it did consider that government may have a role to play in stabilizing economies?
Steve Keen: Yeah, the whole way that Keynes was undermined by neoclassical themselves is remarkable, it’s one of the reasons that I am so aggressive about the case I make today because I am not going to let that happen to my arguments and the arguments that New Keynesianism and Complexity Theory also make. What was called Keynes’s theory, which was the IS-LM model, which was developed by John Hicks, and Hicks later in life, in fact 1979, 1980, or 1981, I think, wrote a paper for the “Journal of Post-Keynesian Economics,” said when looking back at the history of how he derived the model, he first developed that model in 1934 and, this is pretty much a quote: “Before I had written even the first of my papers on Keynes, and it was a general equilibrium model, it was a neoclassical model of economics.” But because he wrote it up in what was called a review of Keynes, economists accepted it as Keynesian, and there were ways in which you could see several of Keynes’s ideas in the general theory, I don’t think Hicks was entirely wrong to argue that, but it left out fundamental issues like uncertainty, money, expectations, ideas about the future affecting what you do today – all that from Keynes disappeared, it was a totally simplified vision.
Now if you take all that into account, which is what I have been doing and people in the post-Keynesian tradition have been trying to do, you get models that are inherently unstable and in some cases government spending can counteract that in the same way that a room that is subject to extremes of heat and cold from the climate, an air conditioning system can change the temperature inside by moving in an opposite direction from what is happening with the weather, like a stabilizer. So it is possible for the government to have that role.
Christine Shearer: But eventually the “monetarist” dynamic stochastic general equilibrium (DSGE) model took out the role of government policy altogether, beyond managing the money supply, on the premise that anything the government does will be counteracted and neutralized by the behavior of the economy — essentially creating a model of macroeconomics informed primarily by the microeconomic “laws” that you critique?
Steve Keen: Yes, and this is one thing I’ve done in the second version of “Debunking Economics” going through the history of using economic theory of what was the driving force of macroeconomics over time. It had nothing to do with making the models more accurate and everything to do with trying to create a model derived from microeconomic foundations. So they derived a model of one consumer using one product, who knows the future, and is rational about allocation of time and effort between labor and collusion and so on, has technology that functions perfectly, etc. etc., and as Robert Stoller, a staunch neoclassical economist said, how can anyone expect a sensible, short- to medium- term macroeconomic model to come out of that set-up? That’s what they’ve done. And of course it completely ignores the existence of money and the existence of banks. I mean, the financial crisis was considered an exogenous shock. But it’s only an exogenous shock because their idiotic models completely ignore the financial sector. That’s a sign of the total disarray neoclassical economics was in when the 2008 crisis hit because their models argued that there could be no crisis and then they had the gaul to say that, ‘Well, our models worked during the good times.’ It’s just bizarre.
Christine Shearer: So this is the model behind neo-liberalism, grounded in faith of neo-classical economics?
Steve Keen: Yeah. Neoliberalism is a political ideology that has been adopted in the last forty years because it seemed to be working with the growth of the financial sector and the power of recovery from the 1970s, 1980s, the 1990s crisis and so on, and it became dominant on both sides of the fence. I really try to distinguish my arguments from the political realm because I really don’t care if you are on the left or the right – if your economics are bad, you are still going to be wrong. And this is what has actually happened: we have adopted an economics that appeared to be correct because it was practiced at a time when there was an enormous debt bubble driving economic performance. And the debt bubble gave a huge growth to the financial sector and for a short term stabilized unemployment and inflation, with a little bit of help from China on the inflation front obviously, while at the same time driving debt to unsustainable levels. So we have both left and right throughout the world espousing neoliberalism and the elephant in the room behind it that drove the whole thing – the level of debt – has finally exploded the room, and we have really a barren political philosophy on both the left and right which is why, you know, there is such disarray in Europe right now. So, if you’re going to have left or right politics, you need to have a realistic model of economics, and because both often sustain unrealistic models, that is why we’re in a financial crisis right now and why politicians are paralyzed right now and why rather than neoliberalism – and I’m emphasizing the liberal part – we’re more likely to see a rise in neo-fascism, and neither left nor right nor the middle can afford to have that happen, but have set up the conditions by swallowing this theory.
Christine Shearer: Neoclassical economics assumes that, first, bank deposits are made, and then individual banks and financial institutions issue loans based on those deposits – the “Money Multiplier” model. But you and other economists argue that, in reality, loans are often issued first. Is that one of the main factors leading to debt bubbles?
Steve Keen: Yeah. And if people want to draw a mental picture in their head, I just worked this out for a conference presentation I’ll be giving in April, discussing why, for example, [Paul] Krugman‘s model of bank lending is so transparently wrong, because of how he thinks banks operate. So neoclassical economics, it’s not just that they leave money out, it’s that they leave banks out completely. So if you don’t have banks and you want to borrow, you’d have to knock on your neighbor’s door and say, ‘Can I have some money please? And I’ll include the rate of interest as well.’ Well, if your neighbor did that his stock of money would fall and your stock of money would rise and there would be no macroeconomic impact. The reality is you walk straight past your neighbor’s house and go to the bank and say, ‘I have this great idea, can you lend me a million dollars?’ And the bank says, ‘Yeah, it’s a good idea, here’s a million dollars and, by the way, you owe us a million dollars’ and, by attaching that condition, that bank increases spending power without changing the spending power of existing actors in the economy. So you have a boost in demand coming out of the loan, and this is the essential reason that the crisis occurred and that neoclassical didn’t see it coming, because they are still arguing that the level of debt doesn’t matter macroeconomically. Krugman has been arguing this in recent economic posts quite vociferously, saying debt is just money we owe to ourselves and therefore it has no overall impact. That’s the “borrow from your neighbor” model, not “borrow from your bank.”
So they are ignorant about the nature of banking, and when you take it into account, you find that loans are created and the creation of loans simultaneously creates deposits, and reserves generated or supplied by the Federal Reserve are necessary for banks, otherwise they would face credit crunches on a daily basis. And the money multiplier model is a mirror of what actually happens: rather than a reserve being created for a purpose by companies taking money from the economy and giving banks excess reserves and banks lend that way, or depositors going to a bank and giving banks excess reserves and loans are created out of excess reserves, loans and deposits are being created at pretty much the same instant, and reserves are generated by the repayment of loans. So it’s a bit like the solar system – we talk about sunrise and sunset, but we know what is really going on is the earth is spinning on its axis. So it’s not that the earth is sitting still, it’s the other way around. And we talk about that vision but know better. But economists talk about the money multiplier vision and they don’t know better.
Christine Shearer: If neoclassical economics assumes that, as you put it, “debt merely involves the transfer of spending power from the saver to the borrower,” then does that make its models unable to account for financialization?
Steve Keen: Yeah, exactly, because as far as they are concerned there is nothing really significant about a growth in the financial sector. It’s just that there is specialization going on – they don’t distinguish between industrial capitalism and financial capitalism, whereas I think it is extremely important to do that, because it’s industrial capitalism that ultimately gives you productivity, growth, technological progress, and so on. Financial capitalism is like the grist in some ways – it provides the cash flow necessary so that new ideas can be put into place, the Schumpeterian approach to what money should do, in which it does play a useful role, but anything above a certain scale is funding a Ponzi scam, which is what financialization was, and neoclassical economics – some neoclassical books still specifically argue assuming no Ponzi behavior, and we have just lived through the biggest Ponzi scheme in history, so assuming that is assuming that we live on a different planet.
Christine Shearer: You say that economist Paul Krugman argues that many macroeconomic models did not forecast the 2008 crash because they did not factor in the role of private debt. Yet you argue that the problems with the models are more fundamental and grounded in their assumptions — primarily that markets left to their own devices inherently strive for equilibrium. You therefore created a model (based partly on Hyman Minsky‘s financial instability hypothesis and others) with a particular focus on the ratio of private debt-to-GDP — and did forecast a crash? In other words, your model assumes the economy has a type of life cycle, not just stasis?
Steve Keen: Yeah, this is the bizarre thing about economists, they think they are doing really cool, hot-shot stuff, with models of what Krugman still calls “comparative statics0″ that start at a point of equilibrium and make a change and see how the “equilibrating variables” change in a given situation over a time path between the two. That is so primitive, it is so nineteenth century, because in the twentieth century in particular the real sciences continue using dynamic tools to model what they are talking about. Dynamic models are the rule in every other discipline, and there are computer software that let you do this quickly in prototype in dynamic modeling software, you don’t even have to build the thing. So economics is doing nineteenth century math and thinking it is hot shot. So all I’ve done is say, ‘Let’s look at how this is done in the genuine sciences like engineering, physics, biology, and so on’ and then adapted those dynamic modeling techniques for economics. And when I do it’s a life cycle – things change over time. And this is the importance of Minsky – his verbal vision of how that happens was pretty accurate. And that is that you have a debt-driven economy where entrepreneurs have to borrow money to do their investing or their Ponzi behavior, and banks supply the money most of the time, and you have a boom-bust cycle coming out of it, and once you put yourself in, for example, a “hysterical” time, banks make loans and most of those loans succeed, and they say ‘Hey, we should lend out more money, we have been too conservative,’ and you get a cycle out of it, a series of ratcheting up over time, and then a breakdown when the bubble bursts, and it is possible to model that relatively easily using dynamic tools. You can’t even see it if you are using comparative statics.
Christine Shearer: How does economic globalization factor into your work – i.e. the increasing ability of investors to move funds across borders at ever-increasing speeds?
Steve Keen: I’m still modeling because it takes a while to build complicated, dynamic models, I’m still building an aggregated banking sector and an aggregated economy and I’m not looking at the national, but the intention is to take that model and then split it to look at national economies and banks and so on. And I’m sure that once I do that I’ll show that globalization makes things worse because you have extra volatility, like when you have one country offering a high interest rate, people in other countries will sell their currency and buy yours and take advantage of higher returns, and when they do that not only do they get a higher return they also drive up the value of your dollar because they’re bidding it up in global markets. That then causes your own manufacturing to become uncompetitive over time, your economy will go into a crash and then you’ll start to lower interest rates, those same dollars flee out of your currency to avoid capital loss that comes with the currency falling and goes back to their own society, it’s then a destructive process. Add that to what’s happening at the global level when you ignore those international fluctuations, it simply makes things worse. So we’ve gone down a completely disastrous path of letting finance become an international plaything. One of the things that Keynes argued many decades ago that was forgotten was that, after the experience of the 1920s and 1930s, he said, “And above all else, let finance be national.”
Christine Shearer: Do you think economic globalization played a role in the “debt crisis” affecting Europe today and what happened to Latin America in the 1980s?
Steve Keen: Yeah, for sure. Latin America is a classic case of the banks finding that they could not lend to European or American borrowers anymore at the scale that wanted to, so they lent to the Third World, and you have the Third World debt crisis coming out of that and it was papered over until the next debt crisis and there was a whole series of debt crises until finally you can’t just keep on juggling it and it comes down and crushes the economies.
In terms of the European situation, for example, that’s another classic one where – not just globalization – but the attempt to expand the national economy to continental-scale itself set off crisis because, before the Euro, you had separate countries which could all use separate monetary policy, fiscal policy, and exchange-rate policy if they needed to, and those three variables could adjust if there were imbalances between one nation and another. Then when they formed the Euro, first they ruled out exchange-rate policy because it is one currency across the whole continent, and then they ruled out fiscal policy because they were told they could not have a deficit over three percent of GDP, and finally it ruled out monetary policy because rules were set by the European central bank. So, essentially, it said to countries like Greece, ‘We’re going to tie your legs to the Germans and you’ve got to keep up with them and you cannot use any other means to modify your performance. See how you go.’ And of course they failed. And of course we have the crashes coming out of that. So Europe going down this road of globalization being a good thing without thinking through the consequences has actually made the situation far worse than it would have been without the forming of the European Union.
Christine Shearer: Why are banks foreclosing on homes in the US rather than helping homeowners renegotiate terms to meet payments – is there a financial gain for them to foreclose?
Steve Keen: That’s a really good question. I think the best answer is that banks have systems set up that treat a fall as an episodic thing, not a systemic thing. So on an episode-by-episode basis, it is not in the interest of banks to reduce returns because if they do it for the few borrowers that got into trouble, the many borrowers that didn’t would say, ‘What about us?’ and there would be a clamor and they wouldn’t be able to do it. So the easiest thing for them to do is, when somebody can’t pay their debts, foreclose and swallow the losses, and keep the vast majority of your loans that are still solvent. What happens when it suddenly becomes a systemic crisis and 25 to 40 percent of your borrowers are effectively insolvent? Well, you’re still continuing a practice that worked when it was an episodic crisis that is now a systemic one, and they would actually be better off if they would change their behavior to what you are talking about and renegotiate terms because at least they’d still be getting a cash flow. So in fact banks, by using a non-crisis model of what you do when somebody becomes insolvent, are actually making the crises worse, not just for the overall society, but even for themselves.
Christine Shearer: The 99% movement has highlighted the role of the increasing gap between the very wealthy and everyone else. While the movement has largely portrayed this as an issue of equality and fairness, I am wondering if you see the disparity more in terms of your models: as symptomatic of continuing economic decline, particular the level of private debt?
Steve Keen: Yeah, it’s something that’s driven by the rise in the level of financial wealth and therefore debt reduction backs it up. Because capitalism is always going to have inequality, and there is no social system that has not had inequality, and even one that claimed to bring equality like the Fidel Castro distribution of income where you might not have much money but you live in a palace, and everybody else does not have much money and they do not live in a palace – it is still inequality and is an essential aspect of the society and you cannot quite get away from it.
But you get an exaggerated level of inequality in a capitalist system when you allow financial bubbles to occur because the Ponzi speculators make a fortune out of it when it is going up and when it starts going down they run away with the money they made already and it’s really the growth of financial debt that matters.
One thing I found when I did my PhD in the early 1990s was I built a model based on Minsky’s financial instability hypothesis that just had three elements to it: workers’ share of income, employment rate, and the ratio of debt-to-GDP. Now, when I worked out the equilibrium of the model, and I worked out how the equilibrium would change with various shifts — and it was not an equilibrium model but a dynamic one, of course — but in equilibrium there were three economic variables: employment rate, the debt-to-GDP ratio, and not the workers’ share, it was the capitalists’s share of income that affected equilibrium. Workers’ share of income depended on the level of debt, so that if the level of debt rose, the workers’ share of income fell, and this is ironic because in the model itself I simply had capitalists doing the borrowing, workers didn’t do any borrowing at all, but it turned out that the essential group that paid for the borrowing by a change in income distribution was the working class, not the capitalists, not until the crisis hits and then they both lost money and the banking sector will go as the whole economy collapses.
So one thing when I look at the data is how this simple model captured what has happened in the past twenty years. As the level of debt has risen, workers’ income have fallen, capitalists’ haven’t, until the final crisis hit. So in that sense what we see is the playing through of a complex, financial system, where even though generally speaking it was the capitalists who took out the debt under the subprime bubble, the burden of that debt repayment ended up falling on what workers got in wages compared to output of the overall economy. So the fundamental problem comes down again to letting the financial sector get out of control. You can’t get rid of inequality in capitalism, you can certainly reduce it, and the best way to do that is stop the financial sector from taking over the economy in a Ponzi scheme.
Christine Shearer: You pose a seemingly radical solution in your book: jubilee, or the cancellation of private debts. But you make this argument as an economist: that it is the only way to free economies for productive growth, because the private debt-to-GDP ratio has just grown too large to be serviceable – is that correct?
Steve Keen: Yeah. [Economist] Michael Hudson put it beautifully in the simple phrase that “Debts that can’t be repaid, won’t be repaid.” If you try to repay them all you do is increase, of course, the amount of debt you have to pay further down the track. We’re talking about private debt here because with private debt you have to borrow money from somebody else, the government in the US can in effect borrow money from itself, so it does not face quite the same limitations but the public sector does, and you keep rescheduling private debt and try to find ways to preserve levels of debt that should have never been offered in the first place, you accumulate more of the problem down the track.
So the best thing you can do is reduce the level of debt. but the trouble is not only did banks produce too much debt and give too many loans to borrowers, they also then sold that debt through securitization to the public, so in the past when you said, ‘Let’s eliminate the debts,’ only the banking sector would suffer. If you did that now, not just the banking sector but a large sector of the public would suffer as well. So what I’ve proposed is what I call a modern debt jubilee, where you have quantitative easing and rather than give money to the banks, you give money to the public, but it goes into their bank accounts, and the very first use of that money has to be paying the debt down. Now that would mean, for a start, is that anyone who was in debt would have their debt level reduced, and banks would be unaffected in terms of their solvency because their money-making assets like loans would fall, but their cash assets would rise, and anybody in the public who had no debt would suddenly have an injection of cash. Now their income strength would fall, because it would be reduced in the value of the loans, but they’d have less income coming out of the debt in the future, and they’d have a cash reserve they could send out in the meantime.
So the idea is to have a jubilee that focuses on a reduction in income simply on the group who should have a reduction in income, and that is the finance sector, while trying to minimize the damage being down to the rest of the economy, and try to minimize the damage done by massive deleveraging so that, if we don’t do anything systemic about it, it might give us twenty years of a downturn before we finally start to stabilize.
Christine Shearer is a postdoctoral fellow at the University of California, Santa Barbara, and a researcher for CoalSwarm, part of SourceWatch. She is Managing Editor of Conducive, and author of Kivalina: A Climate Change Story (Haymarket Books, 2011).
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