The Economics Spring

The Economics Spring

Written by Dan Gay Thursday, 05 April 2012

For economics nerds like me the last week has been riveting. Paul Krugman, a Nobel-prizewinning member of the economics establishment, has been debating with Steve Keen, a radical who’s long argued that the conventional economics taught in universities is woefully unrealistic because it ignores important features of the real world like uncertainty, the role of banks, debt and how money is created.

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The Tipping Point

I may be wrong, but it looks like a tipping point. A host of concerned economy-watchers are beginning to understand that most economists failed to understand or predict the global economic crisis, and should therefore be deposed. Just as the despots of north Africa and the middle East crumbled in the face of a critical mass of popular opposition, so too mainstream economics is looking shaky in the fresh-faced glare of laymen.

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For an arcane debate about the role of money, it’s surprising how fast the Keen-Krugman debate has shot round the blogosphere. Like in the Arab spring, social media have played a critical part in exposing mainstream economics for the bullshit that it is.

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The debate’s even broken through to the cable channels. Russia Today (RT) gave Keen free rein in a five-minute interview. The FT’s Alphaville reposted the BBC interview with Keen last November, attracting a host of sympathetic comments.

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For anyone who doesn’t lurk on the fringes of economics, I can’t overstate just how remarkable this situation is. I remember buying Keen’s book, Debunking Economics: The Naked Emperor of the Social Sciences whilst studying for my mainstream MSc in economics in 2002. The book seemed like one of those sensible bits of radicalism that would, alas, never receive a popular airing. So far was it from received wisdom that no lecturer or journalist would acknowledge it, still less actually read it.

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Frustrated, I wrote a rant about economics, published here. It seemed to me that mainstream economics had fallen so in love with its mathematical tools, contrived in ivory towers, that it’d forgotten to look outside the window. Not much of what I studied seemed to reflect what i’d actually seen as a practising political economist in the real world.

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Dynamic Economists – an oxymoron?

When writing about the Asian crisis which began in 1997 i’d found that no, financial markets didn’t always tend toward equilibrium — and yet this was a central plank of conventional analysis, if not the main assumption. As Keen rightly says: "if it isn’t disequilbrium, then it isn’t economics…“disequilibrium” is so common in real sciences that they don’t even call it that: they call it dynamics. Any dynamic model of a process must start away from its equilibrium, because if you start it in its equilibrium, nothing happens. It’s about time that economists woke up to the need to model the economy dynamically."

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After interviewing scores of financial analysts i’d understood that the efficient markets hypothesis — which predicted that financial market prices always reflected all available information — had to be untrue, because otherwise there’d be no point in doing any analysis.

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Later, when I worked in developing countries i’d seen that homo economicus, the rational, self-interested utility maximiser, was a fiction dreamt up by a peculiar brand of academic who appeared never to have actually dirtied his hands by interacting with real people. The assumptions of some economic models sound like a joke, but their outcomes aren’t so funny because they influence policy.

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Some modellers (i’m serious) pretend that the economy consists of two consumers and two producers acting with perfect foresight, rationality and certainty — forever. Krugman, the object of Keen’s derision, argues that unrealistic assumptions are useful because they allow us to boil down models to a highly simplified version of the world that reflects only the essential dynamics necessary. We all use unrealistic models in everyday life, Krugman says, and economics just formalises this ordinary way of thinking.

Yes, but there’s a vast gulf between everyday rules of thumb and the mathematical models of the academy. Many models are so tightly specified and so unrealistic that they have very little bearing on the real world. You might well start with the assumption that, say, people have perfect foresight, and then relax that assumption later. But why bother, when people don’t have perfect foresight? Why not start from the realistic view that people are pretty poor at knowing the future?

Storming the Neo-classical Citadel

So the crisis in economics isn’t just some obscure spat between balding professors; it’s a crucial and deep-seated methodological conflict that goes to the heart of how we theorise about society and the economy. And because it’s economics, which affects things like how much people have to eat and how hard we work, it’s much more important than your normal academic showdown.

As Keen says, one of the reasons why he is suddenly in the public glare is that mainstream models didn’t predict the crisis, so we can ignore them. In the RT video he says that people are realising that, “we can’t leave economics to the economists”. Here’s another good quote: “Maybe we can break down the neoclassical citadel from the outside with the help of the public.”

Lots of mainstream economists for the first time discovered Keen’s hero, Hyman Minsky, in late 2007, calling it a ‘Minsky moment’. But Minsky has widely been misunderstood.

Minsky’s Actual View

To vastly oversimplify, Keen (drawing on Minsky) is essentially saying the following:

According to conventional views of the financial sector, banks take money from depositors, charge a small amount of interest, and lend it on to businesses and individuals. But in Keen’s Minskyan view, this conventional picture is precisely the wrong way round. Banks actually create money rather than just being neutral intermediaries between savers and borrowers.

Banks don’t have to rely on their cash reserves; they can lend money without bothering about the actual amount of money they’ve taken in from you and me. That delay when a cash machine is whirring isn’t it referring to head office to see how much the bank can afford. People and companies can (and did, during the build-up to the crisis) run up massive overdrafts, well in excess of what they actually earn. So investment leads to savings, rather than savings creating investment. Banks aren’t just passive bystanders — they literally make money. This view is supported by a host of independent-minded central bankers, many of who have revised their views in the wake of the crisis.

This leads to the second main point: that economic output is made up of income and debt, and that debt is in turn is comprised of both good debt which is used to invest in new, useful things and bad, ponzi debt that goes on existing assets. (Some borrowing can be spent on consumption as well).

Much of the last decade or more of economic growth in the rich world was based on hot air. Debt was being spent on property, shares and bonds, creating fake wealth and further inflating the economy. Credit cards were flung at consumers with abandon. Interest rates at historic lows fuelled this vacuous economic growth, effectively creating free money. It’s even worse than that — the 2-3% interest rates currently charged for UK mortgages are below inflation, which means that home-owners are effectively being paid to borrow.

Debt - what Debt?

Amazingly, mainstream economists don’t see a role for debt. Krugman’s seminal article for the New York Times, How Did Economists Get it so Wrong? never mentions private debt. Yet private debt was clearly completely central to the crisis, as shown by the following diagrams.

There’s also a bit of ideology at work here. The main political parties have all subscribed to the notion that the government spent too much and that we have to pay the public debt down. Clearly this view plays well to those who argue that governments should always be small. But the top graph shows that after the second world war US private debt gradually climbed to its highest level in over a century, its peak coinciding with the crisis. The solution to the crisis will involve private deleveraging, a process which is already beginning.

If you look at the bottom graph, UK financial companies are by far the worst culprits. Their debt exploded in the last two decades to about four-and-a-half times the annual output of the economy, whilst household and non-financial debt rose by a smaller proportion — each roughly doubling over the same period compared with GDP.

Last ditch - Krugman plays the Man not the Ball

As a matter of fact, public debt isn’t at historic highs, and at least in the UK and the US borrowing costs are so low that the government doesn’t have to pay much to service this debt.

Krugman’s final answer to Keen is revealing. He resorts to wilful mischaracterisation of Keen’s point of view, pretending that Keen doesn’t understand basic new Keynesian views about sticky prices and wage rigidities. It’s a dishonest and dismissive tactic which shows Krugman’s unwillingness to challenge his own basic conceptions, not to mention the extent to which he is wedded to an outdated version of economics. Can’t he actually engage with his opponent’s view, rather than attacking a caricature of it?

Maybe the mainstream is out of ideas, and it can’t come up with genuine challenges to the new alternatives proposed by people like Keen? Maybe this is the real Minsky moment?

Next week it’s the third annual conference of the Institute for New Economic Thinking in Berlin, where Keen will be speaking. It’ll be interesting to see what he has to say.

Dan Gay

Dan Gay

Political economist working on trade policy in developing countries.


Latest from Dan Gay


  • Comment Link AndyMMT Tuesday, 10 April 2012 19:32 posted by AndyMMT

    What I found really interesting about the debate is the amount of people that pilled into Paul Krugman telling him he was wrong, it didnt seem to be just the MMTers/Post Keynesians and supporters, I saw bankers and all sorts in comments all over. A lot was harsh on Krugman (although he was wrong!) as he generally supports fiscal policies.

  • Comment Link Robin Smith Tuesday, 10 April 2012 20:00 posted by Robin Smith

    This is ironic:

    "Steve Keen, a radical who’s long argued that the conventional economics taught in universities is woefully unrealistic because it ignores important features of the real world like uncertainty, the role of banks, debt and how money is created."

    Yet he forgets to mention the bigger factors in Mortgage assets and land rents.

    Victim become perpetrator?

  • Comment Link Raf Manji Tuesday, 10 April 2012 22:59 posted by Raf Manji

    You should also check out the work of Lowell Manning who has developed his own model of the debt based economy. A selection of his work can be found at www.

  • Comment Link Peter Ascroft Wednesday, 11 April 2012 08:19 posted by Peter Ascroft

    (Some borrowing can be spent on consumption as well).

    Pity that this essential point is in parenthesis as though its an afterthought-the great con perpetrated by the New Labour "Project" was the Orwellian hijacking of vocabulary so that "Public Sector Spending"became "Public Sector Investment" in order to validate the huge increases in unsustainable public debt-the reality being that a large proportion of the increase in public debt (as with private debt) was not "invested" but was merely consumed and therefore of a one off nature with no future return-

  • Comment Link Fredrik Wednesday, 11 April 2012 13:02 posted by Fredrik

    I'm always surprised how dirty the mainstream plays when any of their views are threatened. It's always misquoting, misrepresenting, top-down argumentation from a position of authority.

    Not only in economics of course. Much of modern western ideological elites behave that way in all kind of questions.

    I have always wondered if people are indoctrinated or if they are lying. It's scary though and a real problem that won't be fixed.

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