Keen insight into the monetary economy

Lucas Papademos, former vice-president of the European Central Bank, has now been installed as the new Prime Minster of Greece. The imminent arrival of former European Commissioner Mario Monti as Prime Minister of Italy will get the post-Berlusconi era properly under way. This is to be an era of technocratic policy-making by market-approved placemen.

Defenders of democracy are deeply concerned about the way in which this process has evolved. It is not so much that crisis has precipitated change at the top of national governments. Nor even that these countries find themselves governed by interim governments that are appointed rather than elected. More concerning is the apparent erosion of sovereignty through the overt intervention of foreign governments in domestic affairs, and the apparent concentration of European power in the hands of the eight members of the Frankfurt Group, only two of whom are democratically elected politicians.

But this is not simply a crisis of politics and the economy. It is also a crisis of economic epistemology. Of economic knowledge. Paul Mason, BBC Newsnight’s Economics Editor, observed on Friday’s programme that “The economic orthodoxy of an entire generation of politicians seems to be failing. And they don’t know what to do.”

Mr Papademos and Mr Monti, as conventional economists, can be trusted to attempt to deliver the austerity the markets demand as their remedy for current economic ills. But it isn’t at all clear that this will improve the situation. We are largely travelling without a map.

Conventional macroeconomics is not a lot of help because its starting premise is that the economy, as a self-correcting system, shouldn’t suffer from prolonged recession or depression or generate persistent large-scale unemployment. In order to account for deep economic downturns the models have to be augmented with assumptions such as unexplained changes in preferences for leisure, repeated exogenous shocks, or persistent price rigidities in the labour market. It’s all a bit ad hoc.

While conventional economics may be struggling, many are searching for alternative economic theories that can provide a more satisfactory account of what is going on. Steve Keen’s work has attracted a lot of attention. He is one of the small number of unorthodox economists who in the early 2000s made a concrete prediction that a crash was coming. He recently received the Revere Award from the Real World Economics Review – having been voted the economist who most clearly warned of the coming crisis.

Keen has recently published the second, expanded edition of Debunking Economics:  the naked emperor dethroned? which represents a robust challenge to the orthodoxy. I read the first edition seven or eight years ago, when this was a topic of interest to a disparate band of  dissidents. The second edition will no doubt reach a much broader audience because it speaks to the most pressing economic issue of our time.

Keen’s starting point is a rejection of pretty much all the core tools of conventional economics. Static, equilibrium theorising is dismissed. Walrus’ law is rejected. Fundamental ideas such as the downward sloping demand curves are argued to be wrong. Not only that but, as Keen rightly points out, orthodox economists have demonstrated this to be the case – they’ve just kept quiet about it. Rational expectations and efficient markets are dismissed as logically and empirically deficient.

Many heterodox critics of conventional economics feel that its emphasis upon formalism, mathematics and abstraction miss something important in understanding the economy. Keen is not one of them. His view is that economics has stuck with the mathematical approaches of a previous era while thinking has moved on. It is a question of the wrong mathematics.

Keen draws on Keynes – but not Keynesianism – and Minsky to argue for the fundamental importance of time and uncertainty to understanding dynamic economic processes. He uses a top down approach to theorising in the spirit of Keynes, Minsky or Marx. Macroeconomics does not have to be reducible to microeconomics. Methodological individualism – the insistence that our understanding of markets must be rooted in the aggregation of the behaviour of individual actors – is rejected. Markets are seen as having emergent properties that are not susceptible to reductionist explanation. In place of equilibrium theorising and comparative statics, Keen seeks to develop models with rich dynamics drawing upon differential equations and complexity sciences. Such models can be stable but not static. They require simulation rather than analytical solution. Variables can oscillate – sometimes dramatically – around equilibrium values but never settle on equilibrium.

Foundational to Keen’s approach, drawing on Minsky, is the argument that an adequate economic theory should make “great depressions one of the possible states in which our type of capitalist economy can find itself”. Depressions have recurred over time. There were economic depressions before there was “Big Government” and fiscal or monetary policy on a large scale. So depressions cannot only be about inappropriate government action. They must be a product of the way in which capitalism functions as a system. Neoclassical theories based upon rapid readjustment to equilibrium leave no space for this possibility.

The biggest theoretical innovation Keen seeks – and he is not alone in this – is to argue for the recognition of the financial sector in economic theory and modelling. Not only that, but to recognise that money is different from other commodities. This may seem self-evident to most people. But many dominant economic models abstract from money or the financial system – there is no room for credit or debt. They effectively model barter economies. Given the importance of the financial system in the contemporary economy – and in the origins of the current crisis – this may seem extraordinary. But it is the case nonetheless.

Keen, in contrast, argues that understanding debt dynamics is fundamental to understanding the way the economy functions. More specifically, it is key to understanding both boom and slump. Most importantly, Keen argues it is essential to recognise that debt is privately created. It is the actions of private banks that drive the broad money supply and central banks have to accommodate. This is a complete reversal of conventional explanations that see monetary policy as having no significant effects on the real economy, the monetary base as an exogenous variable under the control of central bankers, and a money multiplier amplifying the effect of monetary expansion. The conventional explanation can give some justification for quantitative easing. The contrary explanation can account for why quantitative easing hasn’t (and won’t) work.

At the heart of economic dynamics, from Keen’s perspective, is the financial sector’s “innate desire to create debt”, because this is the way it makes money. This is also the reason why attempts to restrain the financial sector by imposing prudence are only ever temporary. Keen argues that “The incentives to create debt are so great for this sector that, over time, a debt-driven culture will replace prudence”. The pressures to relax regulatory oversight become irresistible.

This is not an argument focusing on the last few years. The use of debt to allow speculation in a Ponzi economy, rather than to invest in productive capacity, has been a worsening problem since the 1960s. Moreover, governments and monetary authorities have exacerbated the problems of over-indebtedness by seeking to sustain levels of economic activity with more debt and with bailouts that create moral hazard problems. Keen argues (p396) that:

[t]here is little doubt that [Alan] Greenspan’s actions in rescuing the financial sector from itself after numerous crises, … turned a potentially garden-variety depression in 1987 into the near-death experience of the Great Recession. The regulators, by delaying the inevitable for two decades, have made this crisis more intractable than it would have been without them.

It wouldn’t, by any chance, be the case that the favoured solution to the current difficulties in the Eurozone involves covering sovereign debt with ever more arcane financial engineering to increase leverage to almost astronomical levels? This is the orthodox response. As Roosevelt observed in his inaugural address in 1933, “Faced by failure of credit they have proposed only the lending of more money”.

The alternative is to recognise that this is just another attempt to postpone the inevitable. A more extensive debt jubilee than the Greek ‘voluntary’ haircut may be the necessary. But that doesn’t look politically feasible at the moment.

And institutionally we need not to be seduced by the sectional interests of big finance. We need to recognise that reinstating some of the restraints upon finance that were dismantled during the 1980s and 1990s is essential to reducing the oscillations of the monetary economy. The finance industry may be less profitable as a result. This may pose challenges for the UK in particular. But unless there is some adjustment to structures to curtail excess then excess will eventually return.

Keen’s work is a work in progress, as he himself recognises. The models need further development. And because they are simulations they raise epistemological questions of their own. Debunking economics is an informal introduction to Keen’s views and ideas. There are plenty of other introductions to his ideas knocking around as videos on the internet. A more academic statement of his approach can be found here (for those with access).

Keen’s argument represents a profound challenge to orthodox economics. He has, perhaps predictably, been dismissed and derided by some of those with a lot of intellectual capital invested in sustaining that orthodoxy. Others in whom the orthodoxy is deeply ingrained no doubt find his ideas incomprehensible. The understanding of the economy being offered is so radically different from their own.

Yet, with its emphasis upon dynamics, debt and disequilibrium – characteristics only too apparent in the real world economy – and its ability to model capitalist dynamics more effectively than conventional approaches it is an approach that demands serious consideration.

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Image: © Roman Levin –

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