It’s Hard Being a Bear (Part Four): Good Economic Theory

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I delayed publishing this on the blog because I thought it was worth submitting it to a newspaper for first publication on the anniversary of the Lehman Brothers collapse. That has occurred: a slightly edited version of this post (for reasons only of length, I hasten to add!) is in today’s Sydney Morning Herald (page 4 of the print version), WA Today, and probably several other newspapers in the Fairfax chain.

You have just come from your annual medical checkup, where your doctor assures you that you are in robust health.

Walking jauntily down the street, you bump into a practitioner of alternative medicine. He takes one look at you and declares “You have a serious tumour! It must be removed or you will die”.

You ignore him as you always have, and continue your merry way down the street. One day later, a stabbing pain suddenly cripples you, and you collapse to the pavement.

In agony, your call your doctor, who initially refuses to send an ambulance because he knows you are well.

When you lapse into a coma and stop talking mid-sentence, your doctor concludes that perhaps something is wrong, and sends an ambulance to take you to hospital.

Initially the doctor waits for you to revive spontaneously, because he still knows there’s nothing really wrong with you. But as your pulse starts to weaken, he reluctantly calls a retired doctor who had experience of a similar inexplicable malady in the distant past.

She prescribes massive doses of tranquilisers, painkillers, vitamins, and oxygen—all substances that had been removed from the medical panoply due to recent advances in medical theory. Reluctantly, your doctor follows his retired colleague’s advice—and miraculously, you start to revive.

After a year of expensive medical treatment, you return to the same robust health you displayed before your inexplicable illness. Triumphant, if somewhat puzzled, your doctor declares you well once more, and releases you from intensive care.

As you stride confidently away from the hospital, you have the misfortune to once again bump into the practitioner of alternative medicine.

“But they haven’t removed the tumour!”, he declares.

One shouldn’t have to spell out the details of such an analogy, but in times of widespread denial, one has to:

  • You are the economy;
  • The tumour is a massive accumulation of private debt;
  • Your doctor is Neoclassical Economics, and the retired colleague is a so-called “Keynesian” Economist — who doesn’t know it, since her medical textbooks were poorly written, but he’s actually following another economist called Paul Samuelson, not Keynes (and your doctor’s textbooks are so bad they don’t warrant discussion);
  • The alternative medicine practitioner follows Hyman Minsky’s “Financial Instability Hypothesis” (which is based on what Keynes actually did say—as well as the wisdom of Joseph Schumpeter and, in whispers, Karl Marx);
  • The moment you hit the pavement is the beginning of the Subprime Crisis; The collapse of Lehman Brothers is the moment when you slip into a coma; and
  • The day the doctor takes you off life support and declares all is well … is next month.

The final reason for me being a bear is that I am that practitioner of alternative medicine. Minsky’s “Financial Instability Hypothesis” has been ignored by conventional economists for reasons that are both ideological and delusional. A small band of “Post-Keynesian” economists, of whom I am one, have kept this theory alive.

According to Minsky’s theory:

  • Capitalist economies can and do periodically experience financial crises (something that believers in the dominant “Neoclassical” approach to economics vehemently denied until reality—in the form of the Global Financial Crisis—slapped them in the face last year);
  • These financial crises are caused by debt-financed speculation on asset prices, which leads to bubbles in asset prices;
  • These bubbles must eventually burst, because they add nothing to the economy’s productive capacity while simultaneously increasing the debt-servicing burden the economy faces;
  • When they burst, asset prices collapse but the debt remains;
  • The attempts by both borrowers and lenders to reduce leverage reduces aggregate demand, causing a recession;
  • If the economy survives such a crisis, it can go through the same process again, with another boom driving debt up even higher, followed by yet another crash; but
  • Ultimately this process has to lead to a level of debt that is so great that another revival becomes impossible since no-one is willing to take on any more debt. Then a Depression ensues.

That is where we were … in 1987. The great tragedy of today is that naïve Neoclassical economists like Alan Greenspan and Ben Bernanke allowed this process to continue for another three or more cycles than would have occurred without their rescues.

In 2008, they did it again—only with methods they would have disparaged a mere year earlier (“Rational Expectations Macroeconomics”, a modern neoclassical fad, preaches that government intervention can’t influence the level of economic activity at all—yet another belief that reality has recently crucified). This time, while the rescue has worked, the recovery they expect afterwards can’t happen—because there’s almost no-one left who will willingly take on any more debt.

This time, there’s no re-leveraging way out. The tumour of debt has to be removed.

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216 Responses to It’s Hard Being a Bear (Part Four): Good Economic Theory

  1. scepticus says:

    “It’s the skewed allocation of power that maintains a distortion out of ‘equilibrium’.”

    Now that I do agree with. Since our society will always be lopsided, between government and private sectors, between capitalists and workers, between borrowers and savers, there will never be an equilibrium.

    The notion that a perfectly balanced society is possible, and that once achieved, it would stay that way is wrong, and so are economic schools of though which postulate these goals, like marxism and austrian economics. In any case the definition of balance is subjective. Also this is not how democracy works, it works on a majority voting system, in which the system in theory would be skewed towards the majority. Not perfect, but feel free to propose an alternative that doesn’t boil down to a tyranny of a minority.

    Therefore we ought to plan accordingly and aim to mitigate existing and anticipated lopsidedness as opposed to trying to eliminate it.

  2. Joe B says:


    I’ll actually paraphrase Anarcho a bit here – in Austrian theory, Equilibrium is the point at which the market for a particular good clears and supply=demand. Entrepreneurial activity throws the system out of equilibrium by changing either supply or demand for any particular good, and it is doing this constantly. Such disruptions often occur before any equilibrium price is reached as buyers and sellers enter and leave the market.

    Concepts like “equilibrium” and “markets clear” are only used in a dynamic sense, or an instantaneous static sense.

    From Rothbard’s Man, Economy, and State (

    “We must always remember, however, that while a final equilibrium is the goal toward which the economy is moving at any particular time, changes in the data alter this position and therefore shift the direction of movement. Therefore, there is nothing in a dynamic world that is ethically better about a final equilibrium position.” (p. 323)

    That whole section (p. 321-329) on the “evenly rotating economy” construct addresses both equilibrium and Austrian methodology in general.

    Entrepreneurs profit only by redressing lopsidedness. This is in fact the Austrian definition of “profit.” “Loss” is what they get when their perceptions of lopsidedness were wrong.

    Furthermore, this is only relevant to analysis of a single pair of goods (in barter, although “dollars” could be one of these goods), not an entire economy.

    And most importantly, Austrian economics doesn’t propose any goals – it only seeks to describe the mechanism by which prices and choices influence each other. Even austro-libertarian ethics does not propose equilibrium as a goal, and it certainly doesn’t aim for a “perfectly balanced society”. Only a free, peaceful and sustainable (if occasionally volatile) one.

    Using the actual Austrian interpretation of equilibrium, I agree with Rustypenny’s statement.

    Again, I’m only trying to clarify Austrian theory with this comment since it has been misrepresented yet again.

  3. scepticus says:

    Well, maybe I’m misinterpreting rp’s argument but he seems to suggest that power distortions should be removed to allow equilibrium.

    Also he says that when prices are high suppliers will step up to produce more and lower prices. Except this does not work when the rate of interest on all non-monetary goods are lower than the rate of interest on money.

    Clearly there situations in which his simple law of supply and demand does not apply, and that is because money is not a veil over barter, and that fact right there, is the biggest distortion there is and it renders any notion of equilibrium concept non-sensical. Money, as steve never tires of pointing out is not neutral, and would not be even if it were made entiorely of gold coin.

    This is an expression of lop-sidedness, or power in the hands of holders of money versus holders of labour, yet austrian theory has to deny the non neutrality of money to be self-consistent. It is the reason why, for example, they deny the existence of the paradox of thrift.

  4. scepticus says:

    I meant ‘deny the neutrality of money’.

  5. Steve Keen says:

    I think you meant what you actually wrote scepticus–double negatives can get confusing!

    Would you like me to delete this revision?

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  7. Citydoc says:

    I’m interested to hear what the group’s response would be to the following question:

    In the next 5 years, do you think the US will:

    (a) Be like Japan (i.e a deflation economy).

    (b) Be like Zimbabwe (i.e hyperinflation economy).

    (c) Default on its foriegn debt.

    (d) Be a write-off with the BRIC countries (Brazil,
    Russia, India, China) taking over.

    (e) Be unable to sell anymore US Treasuries to
    China and the rest of the world.

    (f) None of the above (So what will it be?).

  8. boma says:

    Hi all

    I seem to remember there was a fair amount of discussion on this blog towards the end of last year regarding the merits of holding physical cash. Well now the figures are out:

    “HOUSEHOLDS are still hoarding $4 billion in cash that was pulled out of the banks in September and October last year, during what the Reserve Bank has revealed was a panic run.”

    “At the peak of the global financial crisis, the run threatened to exhaust the Reserve Bank’s stocks of $50 and $100 notes and it had to print more to meet the extraordinary demand, the bank’s annual report released yesterday shows.”,28124,26089580-5018001,00.html

    So now we know why the government was so keen to enact the bank deposit guarantee.

  9. Philip says:


    (a) I think that this is the likely outcome, though given the level of deleveraging, it could be over more quickly than the Lost Decade the Japanese have experienced. Unfortunately, the second wave of defaults on option-arms and alt-a mortgages is coming soon, 2010-2012.

    As the analysis by Mish has shown, the US is already experiencing the signs of deflation.

    I don’t see (b) happening. Those who believe that this outcome will occur are those who adhere to the money-multiplier model of money creation. As Keen has pointed out, substantial inflation will not occur unless fiat creation is larger than the destruction of credit. Neoclassical policy will ensure this will not occur.

    (c) is nonsense. The US public debt to GDP ratio is currently 81%. This is very serviceable, and there is room for more debt spending. As I have noted before, Japan has a public debt to GDP ratio of 170% (quite possibly more) and nobody is saying that Japan is going to default on its debt and go bankrupt. The people who claim (c) are the morons who missed a $US43 trillion private debt bubble, now at 350% of GDP.

    Despite its current problems, (d) is unlikely to occur even though the BRIC have made economic inroads. The US is far too big and powerful to be ‘taken’ over in any meaningful sense. However, the BRIC have massive internal problems to deal with first before they can even consider becoming contestants with the world’s superpower.

    (e) is a long way off yet, despite reports that it is become more difficult for the Treasury to sell its securities. In order to keep the yuan undervalued, China will need to keep on purchasing Treasury securities to ensure the health of its export markets. Despite claims that ‘foreigners’ own the US debt, they account for only 28% of the ownership of US federal debt securities.

  10. Ernie says:

    Very interesting debate on inflation vs deflation between Daniel R. Amerman & Michael ‘Mish’ Shedlock on the Financial Sence news hour. Steve Keen gets a good mention.

    – Ernie.

  11. elliottwave says:


    Come on mate that was not good for Steve to be linked to that silly man who really made a fool of himself.

    If i was Steve i would ask for an apology from Mish.

  12. Ernie says:


    Mish is actually been held in pretty high regard in the blogsphere.

    – Ernie.

  13. elliottwave says:

    Not after people hear the debate.

    He made a fool of himself.

  14. Citydoc says:


    Thanks for your informative response.

  15. Steve Keen says:

    I have listened to about half this debate so far, and feel that Mish accounted for himself very well, and presented the arguments he attributed to me very well.

    The argument against Mish seems to come down to “deflation has only happened with gold-backed currencies”. Deflation certainly was more prevalent in the 19th century, but this argument underplays the long run experience of Japan of tipping between trivial inflation and moderate deflation for the past 17 years.

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