Like a Dog Walking on its Hind Legs”: Krugman’s Minsky Model

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I recent­ly fired a stray shot at Paul Krug­man over his joke paper “The The­o­ry of Inter­stel­lar Trade” (Krug­man 2010), for which I have duly apol­o­gized. How­ev­er in that apol­o­gy I not­ed that Krug­man has also recent­ly pub­lished a draft aca­d­e­m­ic paper pre­sent­ing a New Key­ne­sian mod­el of debt defla­tion, “Debt, Delever­ag­ing, and the Liq­uid­i­ty Trap: A Fish­er-Min­sky-Koo approach” (Eggerts­son and Krug­man 2010), and I observed that I wish this paper was in fact a joke. Here’s why (this is a mod­i­fied extract from my forth­com­ing sec­ond edi­tion of Debunk­ing Eco­nom­ics, which will be pub­lished by Zed Books in about Sep­tem­ber or Octo­ber this year).

Though I applaud Krug­man for being prob­a­bly the first neo­clas­si­cal econ­o­mist to attempt to mod­el Min­sky after decades of ignor­ing him, the mod­el itself embod­ies every­thing that is bad in neo­clas­si­cal eco­nom­ics.

This reflect poor­ly, not so much Krugman—who has done the best he can with the neo­clas­si­cal toolset to mod­el what he thinks Min­sky said—but on the toolset itself, which is utter­ly inap­pro­pri­ate for under­stand­ing the econ­o­my in which we actu­al­ly live.

There is a pat­tern to neo­clas­si­cal attempts to increase the real­ism of their mod­els that is as pre­dictable as sunrise—but nowhere near as beau­ti­ful. The author takes the core model—which can­not gen­er­ate the real world phe­nom­e­non under discussion—and then adds some twist to the basic assump­tions which, hey presto, gen­er­ate the phe­nom­e­non in some high­ly styl­ized way. The math­e­mat­ics (or geom­e­try) of the twist is expli­cat­ed, pol­i­cy con­clu­sions (if any) are then drawn, and the paper ends.

The flaw with this game is the very start­ing point, and since Min­sky put it best, I’ll use his words to explain it:

Can “It”—a Great Depression—happen again? And if “It” can hap­pen, why did­n’t “It” occur in the years since World War II? These are ques­tions that nat­u­ral­ly fol­low from both the his­tor­i­cal record and the com­par­a­tive suc­cess of the past thir­ty-five years. To answer these ques­tions it is nec­es­sary to have an eco­nom­ic the­o­ry which makes great depres­sions one of the pos­si­ble states in which our type of cap­i­tal­ist econ­o­my can find itself. (Min­sky 1982, p. xii; empha­sis added)

The flaw in the neo­clas­si­cal game is that it nev­er achieves Min­sky’s final objec­tive, because the “twist” that the author adds to the basic assump­tions of the neo­clas­si­cal mod­el are nev­er incor­po­rat­ed into its core. The basic the­o­ry there­fore remains one in which the key phe­nom­e­non under investigation—in this case, the cru­cial one Min­sky high­lights of how Depres­sions come about—cannot hap­pen. The core the­o­ry remains unaltered—rather like a dog that learns how to walk on its hind legs, but which then reverts to four legged loco­mo­tion when the per­for­mance is over.

Fig­ure 1:;

Krug­man him­self is unlike­ly to stop walk­ing on two legs—he enjoys stand­ing out in the crowd of neo­clas­si­cal quadrupeds—but the pack will return to form once this cri­sis ulti­mate­ly gives way to tran­quil­i­ty.

The scholarship of ignorance and the ignorance of scholarship

Krug­man’s paper cites 19 works, three of which are non-neoclassical—Fisher’s clas­sic 1933 “debt defla­tion” paper, Min­sky’s last book Sta­bi­liz­ing an Unsta­ble Econ­o­my (Min­sky 1986), and Richard Koo’s The Holy Grail of Macro­eco­nom­ics: Lessons from Japan’s Great Reces­sion (Koo 2009). The oth­er 16 include one empir­i­cal study (McK­in­sey Glob­al Insti­tute 2010) and 15 neo­clas­si­cal papers writ­ten between 1989 (Bernanke and Gertler 1989) and 2010 (Wood­ford 2010)—5 of which are papers by Krug­man or his co-author.

Was this the best he could have done? Hard­ly! For starters, the one Min­sky ref­er­ence he used was, in my opin­ion, Min­sky’s worst book—and I’m speak­ing as some­one in a posi­tion to know. Any­one want­i­ng to get a han­dle on the Finan­cial Insta­bil­i­ty Hypoth­e­sis from Min­sky him­self would be far bet­ter advised to read the essays in Can “It” Hap­pen Again? (Min­sky 1982), or his orig­i­nal book John May­nard Keynes (Min­sky 1975)—which despite its title is not a biog­ra­phy, but the first full state­ment of the hypoth­e­sis.

Krug­man’s igno­rance of Min­sky pri­or to the cri­sis was par for the course amongst neo­clas­si­cal authors, since they only read papers pub­lished in what they call the lead­ing journals—such as the Amer­i­can Eco­nom­ic Review—which rou­tine­ly reject non-neo­clas­si­cal papers with­out even ref­er­ee­ing them.

Almost all aca­d­e­m­ic papers on or by Min­sky have been pub­lished in non-main­stream journals—the Amer­i­can Eco­nom­ic Review (AER), for exam­ple, has pub­lished a grand total of two papers on or by Min­sky, one in 1957 (Min­sky 1957) and the oth­er in 1971 (Min­sky 1971). If the AER and the oth­er so-called lead­ing jour­nals were all you con­sult­ed as you walked up and down the library aisles, you would­n’t even know that Min­sky existed—and most neo­clas­si­cals did­n’t know of him until after 2007.

Before the “Great Reces­sion” too, you might have been jus­ti­fied in ignor­ing the oth­er journals—such as the Jour­nal of Post Key­ne­sian Eco­nom­ics, the Jour­nal of Eco­nom­ic Issues, the Review of Polit­i­cal Econ­o­my (let alone the Nebras­ka Jour­nal of Eco­nom­ics and Busi­ness where sev­er­al of Hyman’s key papers were pub­lished) because these were “obvi­ous­ly” infe­ri­or jour­nals, where papers not good enough to make it into the AER, the Eco­nom­ic Jour­nal, Econo­met­ri­ca and so on were final­ly pub­lished.

But after the Great Reces­sion, when the authors who fore­saw the cri­sis came almost exclu­sive­ly from the non-neo­clas­si­cal world (Beze­mer 2009; Beze­mer 2010), and who were pub­lished almost exclu­sive­ly in the non-main­stream jour­nals, neo­clas­si­cal econ­o­mists like Krug­man should have eat­en hum­ble pie and con­sult­ed the jour­nals they once ignored.

That might have been dif­fi­cult once: which jour­nals would you look in, if all you knew was that the good stuff—the mod­els that actu­al­ly pre­dict­ed what hap­pened—had­n’t been pub­lished in the jour­nals you nor­mal­ly con­sult­ed? But today, with the Inter­net, that’s not a prob­lem. Aca­d­e­m­ic econ­o­mists have as their bib­li­o­graph­ic ver­sion of Google the online ser­vice Econ­lit, and there it’s impos­si­ble to do even a cur­so­ry search on Min­sky and not find lit­er­al­ly hun­dreds of papers on or by him. For exam­ple, a search last month on the key­words “Min­sky” and “mod­el” turned up 106 ref­er­ences (includ­ing three by yours tru­ly–Keen 1995; Keen 1996; Keen 2001, and one more will prob­a­bly be there now ; Keen 2011).

Fig­ure 2: The result of a search on “Min­sky” and “mod­el” in Econ­lit

27 of these are avail­able in linked full text (one of which is also by yours truly–Keen 1995; see Fig­ure 3), so that you can down­load them direct to your com­put­er from with­in Econ­lit, while oth­ers can be locat­ed by search­ing through oth­er online sources, with­out hav­ing to trun­dle off to a phys­i­cal library to get them. To not have any ref­er­ences at all from this rich lit­er­a­ture is sim­ply poor schol­ar­ship. Were Krug­man a stu­dent of mine, he’d get a fail for this part of his essay.

Fig­ure 3: My paper which is down­load­able direct­ly from Econ­lit

So in attempt­ing to mod­el a debt cri­sis in a cap­i­tal­ist econ­o­my, Krug­man has used as his guide Fish­er’s piv­otal paper, Min­sky’s worst book, and about 10 neo­clas­si­cal ref­er­ences writ­ten by some­one oth­er than him­self and his co-author. How did he fare?

Minsky without money (let alone endogenous money)

One thing I can com­pli­ment Krug­man for is hon­est­ly about the state of neo­clas­si­cal macro­eco­nom­ic mod­el­ing before the Great Reces­sion. His paper opens with the obser­va­tion that:

If there is a sin­gle word that appears most fre­quent­ly in dis­cus­sions of the eco­nom­ic prob­lems now afflict­ing both the Unit­ed States and Europe, that word is sure­ly “debt”” (Eggerts­son and Krug­man 2010, p. 1)

He then admits that pri­vate debt played no role in neo­clas­si­cal macro­eco­nom­ic mod­els before the cri­sis:

Giv­en both the promi­nence of debt in pop­u­lar dis­cus­sion of our cur­rent eco­nom­ic dif­fi­cul­ties and the long tra­di­tion of invok­ing debt as a key fac­tor in major eco­nom­ic con­trac­tions, one might have expect­ed debt to be at the heart of most main­stream macro­eco­nom­ic models—especially the analy­sis of mon­e­tary and fis­cal pol­i­cy. Per­haps some­what sur­pris­ing­ly, how­ev­er, it is quite com­mon to abstract alto­geth­er from this fea­ture of the econ­o­my. Even econ­o­mists try­ing to ana­lyze the prob­lems of mon­e­tary and fis­cal pol­i­cy at the zero low­er bound—and yes, that includes the authors—have often adopt­ed rep­re­sen­ta­tive-agent mod­els in which every­one is alike, and in which the shock that push­es the econ­o­my into a sit­u­a­tion in which even a zero inter­est rate isn’t low enough takes the form of a shift in every­one’s pref­er­ences. (p. 2; empha­sis added)

How­ev­er, from this mea cul­pa, it’s all down­hill, because Krug­man makes no fun­da­men­tal shift from a neo­clas­si­cal approach; all he does is mod­i­fy his base “New Key­ne­sian” mod­el to incor­po­rate debt as he per­ceives it. On this front, he falls into the neo­clas­si­cal trap of being inca­pable of con­ceiv­ing that aggre­gate debt can have a macro­eco­nom­ic impact:

Ignor­ing the for­eign com­po­nent, or look­ing at the world as a whole, the over­all lev­el of debt makes no dif­fer­ence to aggre­gate net worth — one per­son­’s lia­bil­i­ty is anoth­er per­son­’s asset. (p. 3)

This one sen­tence estab­lish­es that Krug­man has failed to com­pre­hend Min­sky, who realized—as did Schum­peter and Marx before him—that grow­ing debt in boosts aggre­gate demand. Min­sky put it this way:

If income is to grow, the finan­cial mar­kets… must gen­er­ate an aggre­gate demand that, aside from brief inter­vals, is ever ris­ing. For real aggre­gate demand to be increas­ing… it is nec­es­sary that cur­rent spend­ing plans, summed over all sec­tors, be greater than cur­rent received income … It fol­lows that over a peri­od dur­ing which eco­nom­ic growth takes place, at least some sec­tors finance a part of their spend­ing by emit­ting debt or sell­ing assets. (Min­sky 1982, p. 6)

Schum­peter made the same case in a more sys­tem­at­ic way, by focus­ing upon the role of entre­pre­neurs in cap­i­tal­ism. He made the point that an entre­pre­neur is some­one with an idea but not nec­es­sar­i­ly the finance need­ed to put that idea into motion. The entre­pre­neur there­fore must bor­row mon­ey to be able to pur­chase the goods and labor need­ed to turn her idea into a final prod­uct. This mon­ey, bor­rowed from a bank, adds to the demand for exist­ing goods and ser­vices gen­er­at­ed by the sale of those exist­ing goods and ser­vices:

THE fun­da­men­tal notion that the essence of eco­nom­ic devel­op­ment con­sists in a dif­fer­ent employ­ment of exist­ing ser­vices of labor and land leads us to the state­ment that the car­ry­ing out of new com­bi­na­tions takes place through the with­draw­al of ser­vices of labor and land from their pre­vi­ous employ­ments… this again leads us to two here­sies: first to the heresy that mon­ey, and then to the sec­ond heresy that also oth­er means of pay­ment, per­form an essen­tial func­tion, hence that process­es in terms of means of pay­ment are not mere­ly reflex­es of process­es in terms of goods. In every pos­si­ble strain, with rare una­nim­i­ty, even with impa­tience and moral and intel­lec­tu­al indig­na­tion, a very long line of the­o­rists have assured us of the oppo­site…

From this it fol­lows, there­fore, that in real life total cred­it must be greater than it could be if there were only ful­ly cov­ered cred­it. The cred­it struc­ture projects not only beyond the exist­ing gold basis, but also beyond the exist­ing com­mod­i­ty basis. (Schum­peter 1934, pp. 95, 101; empha­sis added)

This argu­ment is a piv­otal part of my analy­sis, in which I define aggre­gate demand as the sum of income plus the change in debt—as reg­u­lar read­ers of this blog would know.

Krug­man also has no under­stand­ing of the endo­gene­ity of cred­it mon­ey—that banks cre­ate an increase in spend­ing pow­er by simul­ta­ne­ous­ly cre­at­ing mon­ey and debt. Lack­ing any appre­ci­a­tion of how mon­ey is cre­at­ed in a cred­it-based econ­o­my, Krug­man sees lend­ing as sim­ply a trans­fer of spend­ing pow­er from one agent to anoth­er, and nei­ther banks nor mon­ey exist in the mod­el he builds.

Instead, in place of the usu­al neo­clas­si­cal trick of mod­el­ing the entire econ­o­my as a sin­gle rep­re­sen­ta­tive agent, he mod­els it as two agents, one of whom is impa­tient while the oth­er is patient. Debt is sim­ply a trans­fer of spend­ing pow­er from the patient agent to the impa­tient one, and there­fore the debt itself has no macro­eco­nom­ic impact—it sim­ply trans­fers spend­ing pow­er from the patient agent to the impa­tient one. The only way this can have a macro­eco­nom­ic impact is if the “impa­tient” agent is some­how con­strained in ways that the patient agent is not, and that’s exact­ly how Krug­man con­cocts a macro­eco­nom­ic sto­ry out of this neo­clas­si­cal micro­eco­nom­ic fan­ta­sy:

In what fol­lows, we begin by set­ting out a flex­i­ble-price endow­ment mod­el in which “impa­tient” agents bor­row from “patient” agents [where what is bor­rowed is not mon­ey, but ““risk-free bonds denom­i­nat­ed in the con­sump­tion good” (p. 5)], but are sub­ject to a debt lim­it. If this debt lim­it is, for some rea­son, sud­den­ly reduced, the impa­tient agents are forced to cut spend­ing; if the required delever­ag­ing is large enough, the result can eas­i­ly be to push the econ­o­my up against the zero low­er bound. If debt takes the form of nom­i­nal oblig­a­tions, Fish­er­ian debt defla­tion mag­ni­fies the effect of the ini­tial shock. (Eggerts­son and Krug­man 2010, p. 3)

He then gen­er­al­izes this with “a sticky-price mod­el in which the delever­ag­ing shock affects out­put instead of, or as well as, prices” (p. 3), brings in nom­i­nal prices with­out mon­ey by imag­in­ing “that there is a nom­i­nal gov­ern­ment debt trad­ed in zero sup­ply… We need not explic­it­ly intro­duce the mon­ey sup­ply” (p. 9), mod­els pro­duc­tion under imper­fect com­pe­ti­tion (p. 11)—yes, the pre­ced­ing analy­sis was of a no-pro­duc­tion econ­o­my in which agents sim­ply trade exist­ing “endow­ments” of goods dis­trib­uted like Man­na from heaven—dds a Cen­tral Bank that sets the inter­est rate (in an econ­o­my with­out mon­ey) by fol­low­ing a Tay­lor Rule, and on it goes.

The math­e­mat­ics is com­pli­cat­ed, and real brain pow­er was exert­ed to devel­op the argument—just as, obvi­ous­ly, it takes real brain pow­er for a poo­dle to learn how to walk on its hind legs. But it is the wrong math­e­mat­ics because the analy­sis com­pares two equi­lib­ria sep­a­rat­ed by time rather than being tru­ly dynam­ic by ana­lyz­ing change over time regard­less of whether equi­lib­ri­um applies or not, and wast­ed brain pow­er because the ini­tial premise—that aggre­gate debt has no macro­eco­nom­ic effects—was false.

Krug­man at least acknowl­edges the for­mer problem—that the dynam­ics are crude:

The major lim­i­ta­tion of this analy­sis, as we see it, is its reliance on strate­gi­cal­ly crude dynam­ics. To sim­pli­fy the analy­sis, we think of all the action as tak­ing place with­in a sin­gle, aggre­gat­ed short run, with debt paid down to sus­tain­able lev­els and prices returned to full ex ante flex­i­bil­i­ty by the time the next peri­od begins. (p. 23)

But even here, I doubt that he would con­sid­er gen­uine dynam­ic mod­el­ing with­out the clum­sy neo­clas­si­cal device of assum­ing that all eco­nom­ic process­es involve move­ments from one equi­lib­ri­um to anoth­er. Cer­tain­ly this paper remains true to the per­spec­tive he gave in 1996 when speak­ing to the Euro­pean Asso­ci­a­tion for Evo­lu­tion­ary Polit­i­cal Econ­o­my:

I like to think that I am more open-mind­ed about alter­na­tive approach­es to eco­nom­ics than most, but I am basi­cal­ly a max­i­miza­tion-and-equi­lib­ri­um kind of guy. Indeed, I am quite fanat­i­cal about defend­ing the rel­e­vance of stan­dard eco­nom­ic mod­els in many sit­u­a­tions…

He described him­self as an “evo­lu­tion groupie” to this audi­ence, but then made the telling obser­va­tion that:

Most econ­o­mists who try to apply evo­lu­tion­ary con­cepts start from some deep dis­sat­is­fac­tion with eco­nom­ics as it is. I won’t say that I am entire­ly hap­py with the state of eco­nom­ics. But let us be hon­est: I have done very well with­in the world of con­ven­tion­al eco­nom­ics. I have pushed the enve­lope, but not bro­ken it, and have received very wide­spread accep­tance for my ideas. What this means is that I may have more sym­pa­thy for stan­dard eco­nom­ics than most of you. My crit­i­cisms are those of some­one who loves the field and has seen that affec­tion repaid.

Krug­man’s obser­va­tions on method­ol­o­gy in this speech also high­light why he was inca­pable of tru­ly com­pre­hend­ing Minsky—because he still starts from the premise that neo­clas­si­cal eco­nom­ics itself has proven to be false, that macro­eco­nom­ics must be based on indi­vid­ual behav­ior:

Eco­nom­ics is about what indi­vid­u­als do: not class­es, not “cor­re­la­tions of forces”, but indi­vid­ual actors. This is not to deny the rel­e­vance of high­er lev­els of analy­sis, but they must be ground­ed in indi­vid­ual behav­ior. Method­olog­i­cal indi­vid­u­al­ism is of the essence. (Krug­man 1996; emphases added)

No it’s not: method­olog­i­cal indi­vid­u­al­ism is part of the prob­lem, as the Son­nen­schein-Man­tel-Debreu con­di­tions establish—a point that neo­clas­si­cal econ­o­mists have failed to com­pre­hend, but whose import was real­ized by Alan Kir­man:

If we are to progress fur­ther we may well be forced to the­o­rise in terms of groups who have col­lec­tive­ly coher­ent behav­iour. Thus demand and expen­di­ture func­tions if they are to be set against real­i­ty must be defined at some rea­son­ably high lev­el of aggre­ga­tion. The idea that we should start at the lev­el of the iso­lat­ed indi­vid­ual is one which we may well have to aban­don. (Kir­man 1989, p. 138)

So while Krug­man reach­es some pol­i­cy con­clu­sions with which I concur—such as argu­ing against gov­ern­ment aus­ter­i­ty pro­grams dur­ing a debt-defla­tion­ary crisis—his analy­sis is proof for the pros­e­cu­tion that even “cut­ting edge” neo­clas­si­cal eco­nom­ics, by con­tin­u­ing to ignore the role of aggre­gate debt, is part of the prob­lem of the Great Reces­sion, not part of its solu­tion.


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About Steve Keen

I am Professor of Economics and Head of Economics, History and Politics at Kingston University London, and a long time critic of conventional economic thought. As well as attacking mainstream thought in Debunking Economics, I am also developing an alternative dynamic approach to economic modelling. The key issue I am tackling here is the prospect for a debt-deflation on the back of the enormous private debts accumulated globally, and our very low rate of inflation.