Debunk­ing Macro­eco­nom­ics

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I have just had the fol­low­ing paper pub­lished in the freely acces­si­ble online jour­nal Eco­nomic Analy­sis and Pol­icy, which is pub­lished by the Queens­land branch of the Eco­nomic Soci­ety of Aus­tralia.The cita­tion is:

Keen, S. (2011). “Debunk­ing Macro­eco­nom­ics.” Eco­nomic Analy­sis & Pol­icy 41(3): 147–167.

I’ve been pub­lished in peer-reviewed jour­nals that are freely acces­si­ble online before of course—such as the Eco­nom­ics E-jour­nal paper “Solv­ing the Para­dox of Mon­e­tary Prof­its”. I think Eco­nomic Analy­sis and Pol­icy does a bet­ter job of blend­ing the old paper-style jour­nal with the new, with a home page that emu­lates the cover of a paper jour­nal while pro­vid­ing hot links to the papers from that page.

The paper can be down­loaded from this link, and you can down­load the whole issue from here. If you enjoy my analy­sis, I rec­om­mend also down­load­ing Mark McGovern’s paper “Beyond the Aus­tralian Debt Dream­time: Recog­nis­ing Imbal­ances”. Here is the abstract to Mark’s paper:

Sadly, all the efforts of a gen­er­a­tion of Aus­tralian men and women have only made them more indebted to the rest of the world. Australia’s exter­nal net wealth is neg­a­tive, soon pass­ing minus $900b on an accel­er­at­ing down­ward tra­jec­tory. This ongo­ing dis­si­pa­tion of national resources is unsus­tain­able. Aus­tralians live in a debt dream­time, one from which the rest of the world has been rudely awak­ened. After years of inad­e­quate poli­cies, the nation has a large exter­nal debt and sig­nif­i­cant gov­ern­ment expo­sures. Ser­vic­ing pres­sures are grow­ing as ris­ing uncer­tain­ties per­me­ate global credit mar­kets. Reserve Bank poli­cies are wors­en­ing Australia’s exter­nal posi­tion and need­lessly dri­ving up inter­nal costs. Major pol­icy rethink­ing is war­ranted. Rel­e­vant issues are still lit­tle con­sid­ered, crowded out of dia­logues by com­fort­ing myths that accom­pany the Aus­tralian Debt Dream­time. Imbal­ances need proper recog­ni­tion with new approaches and strate­gies devel­oped. Auto­matic cor­rec­tions will not occur as his­tory and cur­rent over­seas expe­ri­ences demon­strate. A real awak­en­ing, improved posi­tion­ing and a touch of luck are required if Aus­tralians are to avoid being seri­ously impov­er­ished by world events and their own con­fused Dream­ing.

This paper sum­marises the argu­ments I make at much greater length on macro­eco­nom­ics in the sec­ond edi­tion of Debunk­ing Eco­nom­ics. The one exten­sion to that argu­ment here is a more detailed dis­cus­sion of Hicks’s IS-LM model–and in par­tic­u­lar, Hicks’s admis­sion in 1981 that IS-LM was a pre-Key­ne­sian, neo­clas­si­cal model dat­ing from 1934, which his 1936 “review” of the Gen­eral The­ory falsely passed off as a model of Keynes’s Gen­eral The­ory.


The fail­ure of neo­clas­si­cal mod­els to warn of the eco­nomic cri­sis has led to some rare soul search­ing in a dis­ci­pline not known for such intro­spec­tion. The dom­i­nant reac­tion within the pro­fes­sion has been to admit the fail­ure, but to argue that there is no need for a dras­tic revi­sion of eco­nomic the­ory.

I reject this com­fort­able con­clu­sion, and argue instead that this cri­sis illus­trates the point made before­hand by Robert Solow, that mod­els in which macro­eco­nomic patholo­gies are impos­si­ble are not ade­quate mod­els of cap­i­tal­ism. Hicks’s cri­tique of his own IS-LM model also indi­cates that, though patholo­gies can be imposed on an IS-LM model, it is also inap­pro­pri­ate for macro­eco­nomic analy­sis because of its false impo­si­tion of equi­lib­rium con­di­tions derived from Wal­ras’ Law. I then focus upon what I see as the key weak­ness in the neo­clas­si­cal approach to macro­eco­nom­ics which applies to both DSGE and IS-LM mod­els: the false assump­tion that the money sup­ply is exoge­nous. After out­lin­ing the alter­na­tive endoge­nous money per­spec­tive, I show that Wal­ras’ Law must be gen­er­al­ized for a credit econ­omy to what I call the “Wal­ras-Schum­peter-Min­sky Law”. The empir­i­cal data strongly sup­ports this per­spec­tive, empha­siz­ing the need for a “root and branch” reform of macro­eco­nom­ics.

Defend­ing the inde­fen­si­ble

That mod­ern neo­clas­si­cal macro­eco­nomic mod­els failed to fore­warn of the eco­nomic cri­sis that began in 2007 is undis­puted. What is in dis­pute is the impli­ca­tions this should have for macro­eco­nomic the­ory.

Promi­nent mem­bers of the dis­ci­pline have argued that there should be no con­se­quences. Ben Bernanke (Bernanke 2010), recent Nobel Prize lau­re­ate Thomas Sar­gent (Rol­nick 2010) and the found­ing edi­tor of the AER: Macro Olivier Blan­chard (Blan­chard et al. 2010) have all asserted that neo­clas­si­cal mod­els helped guide pol­icy dur­ing the good times, and should not be aban­doned sim­ply because they did not see the bad times com­ing. Bernanke’s argu­ment is rep­re­sen­ta­tive of this per­spec­tive:

the recent finan­cial cri­sis was more a fail­ure of eco­nomic engi­neer­ing and eco­nomic man­age­ment than of what I have called eco­nomic sci­ence…

Do these fail­ures of stan­dard macro­eco­nomic mod­els mean that they are irrel­e­vant or at least sig­nif­i­cantly flawed? I think the answer is a qual­i­fied no. Eco­nomic mod­els are use­ful only in the con­text for which they are designed. Most of the time, includ­ing dur­ing reces­sions, seri­ous finan­cial insta­bil­ity is not an issue. The stan­dard mod­els were designed for these non-cri­sis peri­ods, and they have proven quite use­ful in that con­text. Notably, they were part of the intel­lec­tual frame­work that helped deliver low infla­tion and macro­eco­nomic sta­bil­ity in most indus­trial coun­tries dur­ing the two decades that began in the mid-1980s.’ (Bernanke 2010, pp. 3, 17; empha­sis added)

I make no apol­ogy for describ­ing this argu­ment as spe­cious, on at least two grounds.

Firstly, this argu­ment would only be tol­er­a­bly accept­able if neo­clas­si­cal eco­nom­ics also had well-devel­oped mod­els that were suit­able for peri­ods of cri­sis, but it does not. Sec­ondly, this blasé accep­tance that there can be bad times sits oddly against the tri­umphal­ism that char­ac­ter­ized neo­clas­si­cal dis­course on macro­eco­nom­ics prior to this cri­sis. This is best exem­pli­fied by Lucas’s Pres­i­den­tial Address to the Amer­i­can Eco­nomic Asso­ci­a­tion in 2003, in which he asserted that neo­clas­si­cal eco­nom­ics had suc­ceeded in elim­i­nat­ing the pos­si­bil­ity of extremely bad times like those we are now expe­ri­enc­ing:

Macro­eco­nom­ics was born as a dis­tinct field in the 1940’s, as a part of the intel­lec­tual response to the Great Depres­sion. The term then referred to the body of knowl­edge and exper­tise that we hoped would pre­vent the recur­rence of that eco­nomic dis­as­ter. My the­sis in this lec­ture is that macro­eco­nom­ics in this orig­i­nal sense has suc­ceeded: Its cen­tral prob­lem of depres­sion pre­ven­tion has been solved, for all prac­ti­cal pur­poses, and has in fact been solved for many decades.’ (Lucas, Jr. 2003, p. 1 ; empha­sis added)

The propo­si­tion that there can be sep­a­rate mod­els for good and bad times also implies that there is no causal link between good and bad times, which would be true if they were sim­ply the prod­uct of exoge­nous shocks to the macro­econ­omy. This is in fact how most neo­clas­si­cal mod­el­ers have reacted: by ret­ro­spec­tively treat­ing the cri­sis as being due, not merely to unprece­dent­edly large exoge­nous shocks, but shocks which var­ied in mag­ni­tude over time—while still remain­ing neg­a­tive rather than pos­i­tive:

the Great Reces­sion began in late 2007 and early 2008 with a series of adverse pref­er­ence and tech­nol­ogy shocks in roughly the same mix and of roughly the same mag­ni­tude as those that hit the United States at the onset of the pre­vi­ous two reces­sions…

The string of adverse pref­er­ence and tech­nol­ogy shocks con­tin­ued, how­ever, through­out 2008 and into 2009. More­over, these shocks grew larger in mag­ni­tude, adding sub­stan­tially not just to the length but also to the sever­ity of the great reces­sion…’ (Ire­land 2011, p. 48, see also McK­ib­bin and Stoeckel 2009)

The fact that these shocks came from the finan­cial sector—which the ordi­nary pub­lic would tend to regard as being part of the econ­omy, and there­fore to be more of an endoge­nous eco­nomic phe­nom­e­non than an exoge­nous event—has been treated as largely irrel­e­vant by lead­ing neo­clas­si­cals:

The cri­sis has shown that large adverse shocks can and do hap­pen. In this cri­sis, they came from the finan­cial sec­tor, but they could come from else­where in the future—the effects of a pan­demic on tourism and trade or the effects of a major ter­ror­ist attack on a large eco­nomic cen­ter.’ (Blan­chard, Dell’Ariccia and Mauro 2010, p. 207)

Given the sever­ity and per­sis­tence of this cri­sis, this is also spe­cious rea­son­ing: if the cri­sis was merely due to a large exoge­nous neg­a­tive shock, surely by now it would be over? Surely too, since the “shocks” emanated from the finance sec­tor, and the stan­dard neo­clas­si­cal doc­trine that per­mits a sep­a­ra­tion of eco­nom­ics from finance has now been empir­i­cally rejected (Fama and French 2004), the treat­ment of dis­tur­bances in the finance sec­tor as “exoge­nous” to the econ­omy should also be rejected?

These reac­tions of neo­clas­si­cal the­o­rists and mod­el­ers are there­fore no more than a plea that the core neo­clas­si­cal vision of the macro­econ­omy as a sta­ble sys­tem sub­ject to exoge­nous shocks should be pre­served, despite an unprece­dented empir­i­cal fail­ure. This propo­si­tion has been put openly by Blan­chard et al., amongst oth­ers:

It is impor­tant to start by stat­ing the obvi­ous, namely, that the baby should not be thrown out with the bath­wa­ter.’ (Blan­chard, Dell’Ariccia and Mauro 2010, p. 204)

How­ever, no lesser Neo­clas­si­cals than John Hicks (Hicks 1981) and Robert Solow (Solow 2003, 2001, 2008) have put the con­trary case that these babies— both today’s DSGE mod­els and the IS-LM model that pre­ceded them—should never have been con­ceived in the first place.

Hicks’s dis­own­ing of IS-LM appears to have dis­ap­peared with­out trace in neo­clas­si­cal lit­er­a­ture. Solow’s voice was at least acknowl­edged by Blan­chard when he pub­lished his excru­ci­at­ingly badly timed sur­vey of mod­ern macro­eco­nom­ics (Blan­chard 2009, Blan­chard 2008), in which he stated that:

after the explo­sion of the field in the 1970s, there has been enor­mous progress and sub­stan­tial con­ver­gence.„ largely because facts have a way of not going away, a largely shared vision both of fluc­tu­a­tions and of method­ol­ogy has emerged… Not every­thing is fine… But none of this is deadly. The state of macro is good.’ (Blan­chard 2009, p. 210; empha­sis added).

In a foot­note, he added “Oth­ers, I know, dis­agree with this opti­mistic assess­ment (for exam­ple, Solow 2008)”, but he did not engage at all with Solow’s cri­tique. As the globe is now in its fifth year of unre­lent­ing eco­nomic tur­moil, it is time Solow was lis­tened to.

Solow’s cri­tique of DSGE

Solow became a critic of neo­clas­si­cal macro­eco­nom­ics because he was sim­ply incred­u­lous that the growth model he devel­oped could be even con­sid­ered as a basis for mod­el­ing the busi­ness cycle:

The pro­to­typ­i­cal real-busi­ness-cycle model … is noth­ing but the neo­clas­si­cal growth model…

The puz­zle I want to discuss—at least it seems to me to be a puz­zle, though part of the puz­zle is why it does not seem to be a puz­zle to many of my younger colleagues—is this. More than forty years ago, I … worked out … neo­clas­si­cal growth the­ory… [I]t was clear from the begin­ning what I thought it did not apply to, namely short-run fluc­tu­a­tions in aggre­gate out­put and employ­ment … the busi­ness cycle…

[N]ow … if you pick up an arti­cle today with the words ‘busi­ness cycle’ in the title, there is a fairly high prob­a­bil­ity that its basic the­o­ret­i­cal ori­en­ta­tion will be what is called ‘real busi­ness cycle the­ory’ and the under­ly­ing model will be … a slightly dressed up ver­sion of the neo­class­si­cal growth model. The ques­tion I want to cir­cle around is: how did that hap­pen?’ (Solow 2001, pp. 23, 19)

Solow iden­ti­fied the search for micro­foun­da­tions for macro­eco­nom­ics as the foun­tain­head of DSGE mod­el­ing, and though he sur­mised that “The orig­i­nal impulse to look for bet­ter or more explicit micro foun­da­tions was prob­a­bly rea­son­able” (Solow 2003, p. 1), he dis­missed the defense that micro­eco­nom­ics jus­ti­fied DSGE macro­eco­nomic mod­els as “a delu­sion”:

Sup­pose you wanted to defend the use of the Ram­sey model as the basis for a descrip­tive macro­eco­nom­ics. What could you say?… (I take it for granted that “real­ism” is not an eli­gi­ble defense.)

You could claim that it is not pos­si­ble to do bet­ter at this level of abstrac­tion; that there is no other tractable way to meet the claims of eco­nomic the­ory. I think this claim is a delu­sion.

We know from the Son­nen­schein-Man­tel-Debreu the­o­rems that the only uni­ver­sal empir­i­cal aggrega­tive impli­ca­tions of gen­eral equi­lib­rium the­ory are that excess demand func­tions should be con­tin­u­ous and homo­ge­neous of degree zero in prices, and should sat­isfy Wal­ras’ Law. Any­one is free to impose fur­ther restric­tions on a macro model, but they have to be jus­ti­fied for their own sweet sake, not as being required by the prin­ci­ples of eco­nomic the­ory.’ (Solow 2008, pp. 244)

Solow rejected both the “Salt­wa­ter” and “Fresh­wa­ter” approaches to macro­eco­nom­ics. The base model itself, the “Fresh­wa­ter” real busi­ness cycle model, was unsuit­able for macro­eco­nom­ics because it ruled out the very behav­ior that macro­eco­nom­ics is sup­posed to explain:

The pre­ferred model has a sin­gle rep­re­sen­ta­tive con­sumer opti­miz­ing over infi­nite time with per­fect fore­sight or ratio­nal expec­ta­tions, in an envi­ron­ment that real­izes the result­ing plans more or less flaw­lessly through per­fectly com­pet­i­tive for­ward-look­ing mar­kets for goods and labor, and per­fectly flex­i­ble prices and wages.

How could any­one expect a sen­si­ble short-to-medium-run macro­eco­nom­ics to come out of that set-up?…

I start from the pre­sump­tion that we want macro­eco­nom­ics to account for the occa­sional aggrega­tive patholo­gies that beset mod­ern cap­i­tal­ist economies, like reces­sions, inter­vals of stag­na­tion, infla­tion, “stagfla­tion,” not to men­tion neg­a­tive patholo­gies like unusu­ally good times. A model that rules out patholo­gies by def­i­n­i­tion is unlikely to help.’ (Solow 2003, p. 1; empha­sis added).

He dis­missed the “New Key­ne­sian” vari­ant that came to dom­i­nate the pro­fes­sion as no more than win­dow-dress­ing to improve the appar­ent fit of a bad model to the data:

The sim­pler sort of RBC model that I have been using for expos­i­tory pur­poses has had lit­tle or no empir­i­cal suc­cess, even with a very unde­mand­ing notion of ‘empir­i­cal suc­cess’. As a result, some of the freer spir­its in the RBC school have begun to loosen up the basic frame­work by allow­ing for ‘imper­fec­tions’ in the labor mar­ket, and even in the cap­i­tal mar­ket…

The model then sounds bet­ter and fits the data bet­ter. This is not sur­pris­ing: these imper­fec­tions were cho­sen by intel­li­gent econ­o­mists to make the mod­els work bet­ter...’ (Solow 2001, p. 26; empha­sis added)

One need not won­der how Solow would react to neo­clas­si­cal macro­econ­o­mists, after the cri­sis, adding not merely imper­fec­tions but adjustable exoge­nous shocks to improve the model’s fit to data that “imper­fec­tions” alone can­not explain, since he gave his opin­ion before­hand:

It is always pos­si­ble to claim that those “patholo­gies” are delu­sions, and the econ­omy is merely adjust­ing opti­mally to some exoge­nous shock. But why should rea­son­able peo­ple accept this?’ (Solow, 2003, p. 1; empha­sis added)

Though Solow saw the des­ti­na­tion that neo­clas­si­cal macro­eco­nom­ics had reached as an impasse, he pro­vided no alter­nate route for­ward. Some hark for a rever­sal of direc­tion back to IS-LM mod­els (Man­fred Gärt­ner and Flo­rian Jung, 2010), in which patholo­gies at least appear fea­si­ble. How­ever that route was blocked three decades ago by one John Hicks.

Hicks’s Cri­tique of IS-LM

In 1981, John Hicks admit­ted that, though regarded as a model of Keynes, IS-LM is neo­clas­si­cal model that pre­dates Keynes’s Gen­eral The­ory (J. M. Keynes, 1936). Hicks noted that though he first spelled out the IS-LM model in detail in “Mr. Keynes and the Clas­sics” (J. R. Hicks, 1937, his review of The Gen­eral The­ory), the model was first devel­oped in a less well-known paper, “Wages and Inter­est: The Dynamic Prob­lem” (J. R. Hicks, 1935). Hicks was adamant that this paper, and not “Mr. Keynes and the Classics”—let alone The Gen­eral The­ory itself—was the real foun­da­tion of the IS-LM model:

The other, much less well known, is even more rel­e­vant. “Wages and Inter­est: the Dynamic Prob­lem” was a first sketch of what was to become the “dynamic” model of Value and Cap­i­tal (1939). It is impor­tant here, because it shows (I think quite con­clu­sively) that that model was already in my mind before I wrote even the first of my papers on Keynes.’ (Hicks 1981, p. 140; empha­sis added)

Of course, that IS-LM is in fact a Neo­clas­si­cal model and not a Key­ne­sian one is no rea­son per se to dis­miss it: it could still be an ade­quate model of the macro econ­omy. But Hicks argued that on its own mer­its, it failed.

The model in “Wages and Inter­est” had an ultra-short-run of a week in a “bread econ­omy” in which prices were decided on a Mon­day and then applied for the remain­der of the week. But IS-LM, which Hicks described as “a trans­la­tion of Keynes’ non­flex­price model into my terms”, was a ““short-period,” … we shall not go far wrong if we think of it as a year” (John Hicks, 1981, p. 141). In Hicks’s model, events dur­ing the week were not allowed to affect anything—a device which Hicks described as “a very arti­fi­cial device, not (I would think now) much to be rec­om­mended”, but which let him treat expec­ta­tions as con­stant. There­fore, equi­lib­rium applied:

That is to say (it is equiv­a­lent to say­ing), we may fairly reckon that these mar­kets, with respect to these data, are in equi­lib­rium.’ (Hicks 1981, p. 146)

How­ever, this arti­fice could not be extended to a year, and used to derive an LM curve since:

for the pur­pose of gen­er­at­ing an LM curve, which is to rep­re­sent liq­uid­ity pref­er­ence, it will not do with­out amend­ment. For there is no sense in liq­uid­ity, unless expec­ta­tions are uncer­tain.’ (Hicks 1981, p. 152; empha­sis added)

This in turn meant that mar­kets had to be in disequilibrium—but IS-LM itself was derived from equi­lib­rium analy­sis, as Hicks also explained:

the idea of the IS-LM dia­gram came to me as a result of the work I had been doing on three-way exchange, con­ceived in a Wal­rasian man­ner. I had already found a way of rep­re­sent­ing three-way exchange on a two-dimen­sional dia­gram (to appear in due course in chap­ter 5 of Value and Cap­i­tal). As it appears there, it is a piece of sta­t­ics; but it was essen­tial to my approach (as already appears in “Wages and Inter­est: the Dynamic Prob­lem”) that sta­tic analy­sis of this sort could be car­ried over to “dynam­ics” by rede­f­i­n­i­tion of terms. So it was nat­ural for me to think that a sim­i­lar device could be used for the Keynes the­ory.’ (Hicks 1981, p. 141–142)

But in fact, extend­ing an equi­lib­rium model with a time­frame of a week to a time­frame of a year in which liq­uid­ity pref­er­ence played a key role led to a hope­less mud­dle which Hicks, with hind­sight, could now appre­ci­ate. His final judg­ment on his own model was scathing:

I accord­ingly con­clude that the only way in which IS-LM analy­sis use­fully survives—as any­thing more than a class­room gad­get, to be super­seded, later on, by some­thing better—is in appli­ca­tion to a par­tic­u­lar kind of causal analy­sis, where the use of equi­lib­rium meth­ods, even a dras­tic use of equi­lib­rium meth­ods, is not inap­pro­pri­ate…

When one turns to ques­tions of pol­icy … the use of equi­lib­rium meth­ods is still more sus­pect. … There can be no change of pol­icy if every­thing is to go on as expected—if the econ­omy is to remain in what (how­ever approx­i­mately) may be regarded as its exist­ing equi­lib­rium. It may be hoped that, after the change in pol­icy, the econ­omy will some­how, at some time in the future, set­tle into what may be regarded, in the same sense, as a new equi­lib­rium; but there must nec­es­sar­ily be a stage before that equi­lib­rium is reached. There must always be a prob­lem of tra­verse. For the study of a tra­verse, one has to have recourse to sequen­tial meth­ods of one kind or another.’ (Hicks 1981, p. 152–153)

Hicks’s fun­da­men­tal con­clu­sion there­fore is that macro­eco­nomic analy­sis must assume dis­e­qui­lib­rium rather than equilibrium—and this does even more dam­age to IS-LM than Hicks him­self appre­ci­ated. To reduce macro­eco­nom­ics to the inter­play of sim­ply the goods and money mar­ket, Hicks had used the Wal­rasian assump­tion that, if n-1 mar­kets are in equi­lib­rium, then the nth mar­ket must also be in equi­lib­rium, so that he could ignore the mar­ket for loan­able funds:

One did not have to bother about the mar­ket for “loan­able funds,” since it appeared, on the Wal­ras anal­ogy, that if these two “mar­kets” were in equi­lib­rium, the third must be also. So I con­cluded that the inter­sec­tion of IS and LM deter­mined the equi­lib­rium of the sys­tem as a whole.’ (Hicks 1981, p. 142)

But this Wal­rasian logic cuts both ways: if dis­e­qui­lib­rium applies in one mar­ket, then at least one other—and prob­a­bly all others—must also be in dis­e­qui­lib­rium. There­fore, as soon as dis­e­qui­l­brium is acknowl­edged, mar­kets whose very exis­tence has been ignored in equi­lib­rium analysis—such as, obvi­ously in IS-LM, the labor market—can no longer be ignored. Their dis­e­qui­l­brium dynam­ics must now be con­sid­ered, and the IS-LM model can give no guid­ance as to how they will behave.

An alter­na­tive macro­eco­nom­ics

Solow’s key obser­va­tion is that macro­eco­nom­ics should seek to “account for the occa­sional aggrega­tive patholo­gies that beset mod­ern cap­i­tal­ist economies”. Hicks’s key con­tri­bu­tion was that macro­eco­nom­ics must be a study of dis­e­qui­l­brium dynamics—a point made decades ear­lier still by Irv­ing Fisher when he penned “The Debt-Defla­tion The­ory of Great Depres­sions”:

We may ten­ta­tively assume that, ordi­nar­ily and within wide lim­its, all, or almost all, eco­nomic vari­ables tend, in a gen­eral way, toward a sta­ble equi­lib­rium… But … New dis­tur­bances are, humanly speak­ing, sure to occur, so that, in actual fact, any vari­able is almost always above or below the ideal equi­lib­rium…

The­o­ret­i­cally there may be—in fact, at most times there must be—over-or under-pro­duc­tion, over- or under-con­sump­tion, over- or under-spend­ing, over- or under-sav­ing, over- or under-invest­ment, and over or under every­thing else. It is as absurd to assume that, for any long period of time, the vari­ables in the eco­nomic orga­ni­za­tion, or any part of them, will “stay put,” in per­fect equi­lib­rium, as to assume that the Atlantic Ocean can ever be with­out a wave.’ (Fisher 1933, p. 339; empha­sis added)

These prin­ci­ples point in the direc­tion first indi­cated by Hyman Min­sky, that since cap­i­tal­ist economies have expe­ri­enced Depres­sions in the past, to ade­quately model cap­i­tal­ism:

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. 5)

Minsky’s alter­na­tive was the “Finan­cial Insta­bil­ity Hypoth­e­sis”, and it was based on an explicit rejec­tion of the neo­clas­si­cal par­a­digm:

The abstract model of the neo­clas­si­cal syn­the­sis can­not gen­er­ate insta­bil­ity. When the neo­clas­si­cal syn­the­sis is con­structed, cap­i­tal assets, financ­ing arrange­ments that cen­ter around banks and money cre­ation, con­straints imposed by lia­bil­i­ties, and the prob­lems asso­ci­ated with knowl­edge about uncer­tain futures are all assumed away. For econ­o­mists and pol­icy-mak­ers to do bet­ter we have to aban­don the neo­clas­si­cal syn­the­sis.’ (Min­sky 1982 , p. 5)

I have devel­oped math­e­mat­i­cal mod­els of this hypoth­e­sis (Steve Keen, 1995, 2008, 2011b, 2000) which are based on a con­sid­ered rejec­tion of vir­tu­ally every pre­cept of neo­clas­si­cal the­ory. Explain­ing all these method­olog­i­cal deci­sions requires a book rather than a jour­nal paper (Steve Keen, 2011a), so here I will con­cen­trate on what expe­ri­ence has con­vinced me is the key rea­son why neo­clas­si­cal econ­o­mists failed to fore­see the cri­sis, and why to this day they can­not under­stand why it remains so intractable. This is their vision of how money is cre­ated.

Endoge­nous Money, Eco­nomic Growth and Dis­e­qui­lib­rium

Non-econ­o­mists might expect that eco­nomic mod­els of how money is cre­ated would be based on empir­i­cal research. There is such a model, but it is the province of the non-neo­clas­si­cal school of thought known as Post Key­ne­sian eco­nom­ics. Neo­clas­si­cal econ­o­mists have instead per­sisted with the “frac­tional reserve banking/money mul­ti­plier” model, which argues that banks need excess reserves before they can lend, that these are cre­ated ini­tially by an expan­sion of gov­ern­ment-cre­ated “fiat” money, and that a sequence of bank deposits by recip­i­ents of fiat money, and loans of all but a frac­tion of this deposit by banks, cre­ates credit money that is a mul­ti­ple of the ini­tial injec­tion of fiat money.

This is in turn mar­ried to a vision of banks as mere inter­me­di­aries, so that they can be for­mally ignored in macro­eco­nomic mod­el­ing. Finally, the level of pri­vate debt is also ignored in neo­clas­si­cal macro­eco­nom­ics, since a loan is regarded as sim­ply a trans­fer of spend­ing power from a saver to a bor­rower. With one person’s spend­ing power going down and another’s going up by the same amount, only the dis­tri­b­u­tion of debt could matter—not its aggre­gate level. As Bernanke explained, this is why Fisher’s “Debt Defla­tion” expla­na­tion of the Great Depres­sion was ignored by neo­clas­si­cal econ­o­mists:

Fisher’s idea was less influ­en­tial in aca­d­e­mic cir­cles, though, because of the coun­ter­ar­gu­ment that debt-defla­tion rep­re­sented no more than a redis­tri­b­u­tion from one group (debtors) to another (cred­i­tors). Absent implau­si­bly large dif­fer­ences in mar­ginal spend­ing propen­si­ties among the groups, it was sug­gested, pure redis­tri­b­u­tions should have no sig­nif­i­cant macro-eco­nomic effects…’ (Bernanke 2000, p. 24)

Over forty years ago, the then Senior Vice-Pres­i­dent of the New York Fed­eral Reserve, Alan Holmes, pointed out that this per­spec­tive in which the aggre­gate level of debt does not mat­ter, and banks are mere inter­me­di­aries between savers and lenders, was erro­neous. He argued that the view “that the bank­ing sys­tem only expands loans after the [Fed­eral Reserve] Sys­tem (or mar­ket fac­tors) have put reserves in the bank­ing sys­tem” was based on “a naive assump­tion”. Instead, he argued,

In the real world, banks extend credit, cre­at­ing deposits in the process, and look for the reserves later. The ques­tion then becomes one of whether and how the Fed­eral Reserve will accom­mo­date the demand for reserves. In the very short run, the Fed­eral Reserve has lit­tle or no choice about accom­mo­dat­ing that demand; over time, its influ­ence can obvi­ously be felt.’ (Holmes 1969, p. 73; empha­sis added)

Holmes was thus argu­ing that banks do not need deposits in order to lend—that in fact the act of lend­ing simul­ta­ne­ously cre­ates a match­ing deposit—and that banks can there­fore endoge­nously cre­ate new spend­ing power (new deposits) by issu­ing a loan, with­out thereby reduc­ing the spend­ing power of savers.

This expe­ri­ence-based judg­ment was sub­se­quently con­firmed by empir­i­cal research by the Post Key­ne­sian econ­o­mist Basil Moore (Basil J. Moore, 1979, 1988, 2001, 1983), and even by the founders of Real Busi­ness Cycle the­ory (Finn E. Kyd­land and Edward C. Prescott, 1990). This led to the devel­op­ment of the model of “endoge­nous money”, in which a loan is regarded not a trans­fer of spend­ing power from a saver to a lender, but a cre­ation of spend­ing power for the bor­rower by the bank ab ini­tio. This mod­ern Post Key­ne­sian the­ory in fact redis­cov­ered an argu­ment first put by Schum­peter, that banks cre­ate money sim­ply by an account­ing oper­a­tion: a loan extended to a bor­rower cre­ates both debt and spend­ing power “out of noth­ing”:

It is always a ques­tion, not of trans­form­ing pur­chas­ing power which already exists in someone’s pos­ses­sion, but of the cre­ation of new pur­chas­ing power out of noth­ing…’ (Schum­peter 1934, p. 73)

This means that the increase in debt actu­ally adds to aggre­gate demand, so that total spend­ing is the sum of both incomes gen­er­ated in “the cir­cu­lar flow” —which pri­mar­ily finances consumption—plus the growth in debt—which pri­mar­ily finances invest­ment. Since this con­cept is so for­eign to neo­clas­si­cal econ­o­mists, it is worth cit­ing Schum­peter at length on it here:

the entrepreneur—in prin­ci­ple and as a rule—does need credit, in the sense of a tem­po­rary trans­fer to him of pur­chas­ing power, in order to pro­duce at all, to be able to carry out his new com­bi­na­tions, to become an entre­pre­neur. And this pur­chas­ing power does not flow towards him auto­mat­i­cally, as to the pro­ducer in the cir­cu­lar flow, by the sale of what he pro­duced in pre­ced­ing peri­ods. If he does not hap­pen to pos­sess it … he must bor­row it… He can only become an entre­pre­neur by pre­vi­ously becom­ing a debtor… his becom­ing a debtor arises from the neces­sity of the case and is not some­thing abnor­mal, an acci­den­tal event to be explained by par­tic­u­lar cir­cum­stances. What he first wants is credit. Before he requires any goods what­ever, he requires pur­chas­ing power. He is the typ­i­cal debtor in cap­i­tal­ist soci­ety.’ (see also Biggs and Mayer 2010, Biggs et al. 2010, Schum­peter 1934, p. 102)

Schum­peter does not deny that some invest­ment is financed by a trans­fer of exist­ing funds from savers—hence result­ing in a fall in spend­ing by saver-con­sumers and an off­set­ting increase in spend­ing by bor­rower-investors, with no over­all macro­eco­nomic impli­ca­tions. But he insists that the pri­mary source of investor spend­ing comes from the endoge­nous expan­sion of the money sup­ply, which gives spend­ing power to entre­pre­neurs with­out sac­ri­fic­ing the exist­ing spend­ing power of savers, so that ris­ing debt does have macro­eco­nomic effects:

Even though the con­ven­tional answer to our ques­tion is not obvi­ously absurd, yet there is another method of obtain­ing money for this pur­pose, which … does not pre­sup­pose the exis­tence of accu­mu­lated results of pre­vi­ous devel­op­ment, and hence may be con­sid­ered as the only one which is avail­able in strict logic. This method of obtain­ing money is the cre­ation of pur­chas­ing power by banks…’ (Schum­peter 1934, p. 73)

This leads Schum­peter to what he hap­pily describes as a “heresy… that processes in terms of means of pay­ment are not merely reflexes of processes in terms of goods” (Joseph Alois Schum­peter, 1934, p. 95). Instead, in a grow­ing cap­i­tal­ist econ­omy, aggre­gate demand is the sum of demand from the sale of goods and ser­vices plus demand from the growth in credit-money, where the lat­ter is the pri­mary source of invest­ment. Fama and French con­firmed this hypoth­e­sized rela­tion­ship between change in debt and invest­ment in an empir­i­cal study:

These cor­re­la­tions con­firm the impres­sion that debt plays a key role in accom­mo­dat­ing year-by-year vari­a­tion in invest­ment.’ (Fama and French 1999, p. 1954)

This com­bi­na­tion of the endoge­nous expan­sion of spend­ing power by bank lend­ing, plus the use of that by entre­pre­neurs to finance invest­ment, means that the change in the level of pri­vate debt does have macro­eco­nomic significance—and it plays a cen­tral role in Schumpeter’s the­ory of the busi­ness cycle. How­ever it is not the end of the mat­ter, because entre­pre­neurs are not the only ones who bor­row money: so do key actors in Minsky’s expla­na­tion for Great Depres­sions, “Ponzi Financiers”.

These bor­row­ers do not pri­mar­ily invest with bor­rowed money, but buy exist­ing assets, and hope to profit by sell­ing those assets on a ris­ing mar­ket. Unlike Schumpeter’s entre­pre­neurs, whose debts today can be repaid from prof­its tomor­row, Ponzi Financiers always have debt ser­vic­ing costs than exceed the cash flows from the assets they pur­chase with bor­rowed money. They there­fore must expand their debts or sell assets to con­tinue func­tion­ing:

A Ponzi finance unit is a spec­u­la­tive financ­ing unit for which the income com­po­nent of the near term cash flows falls short of the near term inter­est pay­ments on debt so that for some time in the future the out­stand­ing debt will grow due to inter­est on exist­ing debt… Ponzi units can ful­fill their pay­ment com­mit­ments on debts only by bor­row­ing (or dis­pos­ing of assets)… a Ponzi unit must increase its out­stand­ing debts.’ (Min­sky 1982, p. 24)

There­fore in a credit-based econ­omy, there are three sources of aggre­gate demand, and three ways in which this demand is expended:

  1. Demand from income earned by sell­ing goods and ser­vices, which pri­mar­ily finances con­sump­tion;
  2. Demand from ris­ing entre­pre­neur­ial debt, which pri­mar­ily finances invest­ment; and
  3. Demand from ris­ing Ponzi debt, which pri­mar­ily finances the pur­chase of exist­ing assets.

Schumpeter’s and Minsky’s per­spec­tives thus enable us to inte­grate credit, asset mar­kets and dis­e­qui­lib­rium analy­sis into an alter­na­tive macro­eco­nom­ics. In a credit econ­omy, aggre­gate demand is the sum of income plus the change in debt, and this demand is expended on both goods and ser­vices and pur­chases of exist­ing assets. Debt there­fore has both pos­i­tive and neg­a­tive con­no­ta­tions for the econ­omy: it finances the expan­sion of eco­nomic activ­ity via inno­va­tion and invest­ment, but it can also cause asset bub­bles and even­tu­ally, an eco­nomic cri­sis if too much of this debt is directed to Ponzi Finance. This is pre­cisely what occurred in the last two decades.

Com­par­ing Endoge­nous Money to “the Money Mul­ti­plier”

As is well known, Bernanke blamed the Fed for caus­ing the Great Depres­sion:

there is now over­whelm­ing evi­dence that the main fac­tor depress­ing aggre­gate demand was a world­wide con­trac­tion in world money sup­plies. This mon­e­tary col­lapse was itself the result of a poorly man­aged and tech­ni­cally flawed inter­na­tional mon­e­tary sys­tem (the gold stan­dard, as recon­sti­tuted after World War I).’ (Bernanke 2000, p. ix)

The money mul­ti­plier the­ory of money cre­ation played a large role in his argu­ment that the Great Depres­sion was trig­gered by the Fed­eral Reserve’s reduc­tion of the US base money sup­ply between June 1928 and June 1931:

the United States is the only coun­try in which the dis­cre­tionary com­po­nent of pol­icy was arguably sig­nif­i­cantly desta­bi­liz­ing… the ratio of mon­e­tary base to inter­na­tional reserves … fell con­sis­tently in the United States from … 1928:II … through the sec­ond quar­ter of 1931. As a result, U.S. nom­i­nal money growth was pre­cisely zero between 1928:IV and 1929:IV, despite both gold inflows and an increase in the money mul­ti­plier.

The year 1930 was even worse in this respect: between 1929:IV and 1930:IV, nom­i­nal money in the United States fell by almost 6 [per­cent]… The prox­i­mate cause of this decline in M1 was con­tin­ued con­trac­tion in the ratio of base to reserves, which rein­forced rather than off­set declines in the money mul­ti­plier. This tight­en­ing … locates much of the blame for the early (pre-1931) slow­down in world mon­e­tary aggre­gates with the Fed­eral Reserve.’ (Ben S. Bernanke, 2000, p. 153)

Bernanke’s sta­tis­ti­cal evi­dence focused on the rela­tion­ship between change in M1 and the level of unem­ploy­ment. Using a longer and more detailed series for M1 than Bernanke used (Fried­man and Schwartz 1963, Table A1), there is indeed a robust neg­a­tive cor­re­la­tion between change in M1 and unem­ploy­ment (see Fig­ure 1; unem­ploy­ment is inverted on the right hand axis to show the neg­a­tive cor­re­la­tion more clearly). The R2 is –0.33 for the whole period, –0.31 for 1920–1930 and a strong –0.67 for 1930–1940.

Fig­ure 1: Change in M1 and Unem­ploy­ment, 1920–1940

How­ever M1 includes money cre­ated by the banks, and blam­ing the Fed­eral Reserve for its col­lapse in the 1930s takes the money mul­ti­plier for granted as a valid expla­na­tion of money creation—which the endoge­nous money approach dis­putes. Only M0 or Base Money is strictly under the Fed’s con­trol, and (using the St Louis FRED AMBSL data), the rela­tion­ship between unem­ploy­ment and that part of the money sup­ply over which the Fed has undis­puted con­trol is very dif­fer­ent (see Fig­ure 2). The cor­re­la­tion for the whole time period now has the wrong sign (+0.44); more­over there is a break in the rela­tion­ship. In the period 1920–1930, the cor­re­la­tion is small with the cor­rect sign (-0.22); in the period 1930–1940, it is small with the wrong sign (+0.28).

Fig­ure 2: Change in Base Money and Unem­ploy­ment, 1920–1940

There is also a break in the rela­tion­ship between changes in M0 and changes in M1. In the 1920s, the cor­re­la­tion was strong and pos­i­tive (+0.89)—in line with the “money mul­ti­plier” argu­ment. But in the 1930s, while still pos­i­tive it was much weaker (+0.34). From the data too, it is obvi­ous that the 1930s Fed was try­ing to boost the money sup­ply from 1931 till 1937. It then reduced its stim­u­lus in 1937 when it falsely believed that the cri­sis was over as unem­ploy­ment began to fall, only to see it start to rise once again from 11 back to 20 per­cent. Shocked, it rapidly reversed direc­tion, increas­ing base money by more than 20 per­cent per annum from mid-1938 on. Arguably the direc­tion of cau­sa­tion was not that changes in M0 and M1 drive unem­ploy­ment, but that changes in unem­ploy­ment drive Fed­eral Reserve pol­icy and hence changes in M0—but with lit­tle impact on the over­all growth of the money sup­ply and hence lit­tle impact upon eco­nomic activ­ity.

Clearly the “The Fed Did It” argu­ment is on shaky grounds with respect to the Great Depres­sion, and as Bernanke is now find­ing out the hard way, it is an even more sus­pect argu­ment today. Firstly the rela­tion­ship of growth in M3 to unem­ploy­ment is even stronger than the M1 to unem­ploy­ment rela­tion from 1920–1940: the R2 is –0.7 for the whole period.

Fig­ure 3: M3 Change and Unem­ploy­ment are strongly neg­a­tively cor­re­lated (R^2 = –0.72)

How­ever the M0 to unem­ploy­ment cor­re­la­tion has the wrong sign, and is even stronger than the wrong cor­re­la­tion for the 1930s at +0.51 (see Fig­ure 4). The biggest boost to Base Money in recorded his­tory did lit­tle to avert the col­lapse into the Great Reces­sion, and repeated boosts are doing very lit­tle to end it.

Fig­ure 4: The Cor­re­la­tion of M0 Change and Unem­ploy­ment has the “Wrong” Sign

The “Money Mul­ti­plier” also has even less effect on the money sup­ply itself now than back in the Great Depres­sion: the cor­re­la­tion between changes in M0 and changes in M3 is effec­tively zero for the whole period since 1990 (-0.07), strongly of the wrong sign for the pre-cri­sis period from 1990–2008 (-0.55), and only barely pos­i­tive for the post-cri­sis period (+0.14).

Fig­ure 5: Change in M0 has no Cor­re­la­tion with Change in M3

In con­trast, the endoge­nous money analy­sis of both the Great Depres­sion and the “Great Con­trac­tion” ( is sub­stan­tially more robust. To test the endoge­nous money expla­na­tion, I put the propo­si­tion that aggre­gate demand is the sum of income plus the change in debt, and that this is expended on both goods and ser­vices and pur­chases of exist­ing assets, in an equa­tion where the left hand side rep­re­sents mon­e­tary flows and the right hand side rep­re­sents the mon­e­tary value of phys­i­cal sup­plies and turnover of finan­cial claims on phys­i­cal assets:


NAT stands for “Net Asset Turnover”, which can be fac­tored into the price index for assets PA, times their quan­tity QA, times the turnover TA expressed as a frac­tion of the num­ber of assets 


The endoge­nous money hypoth­e­sis thus asserts that there is a rela­tion­ship between the change in debt and the level of both eco­nomic activ­ity (GDP) and activ­ity on asset mar­kets. Since the strength of this rela­tion­ship vis-a-vis the impact of income on eco­nomic activ­ity and asset mar­kets depends on the size of the change in debt rela­tion to the level of income, in the fol­low­ing cor­re­la­tions I con­sider change in debt rel­a­tive to GDP rather than change in debt per se.

The cor­re­la­tion between change in debt and unem­ploy­ment is far stronger than the cor­re­la­tion between change in M1 and unem­ploy­ment dur­ing both peri­ods:

Fig­ure 6: Change in Debt Dri­ves Eco­nomic Per­for­mance

Fig­ure 7: Change in Debt Dri­ves Eco­nomic Per­for­mance

Sim­i­larly, there is a rela­tion­ship between the accel­er­a­tion of debt and both the rate of change of GDP (Biggs and Mayer 2010, Biggs, Mayer and Pick 2010) and the change in asset prices:



This rela­tion can be seen as a gen­er­al­iza­tion of Bernanke’s “Finan­cial Accel­er­a­tor” (Bernanke et al. 1996) to both asset mar­kets as well as goods mar­kets, and with­out the false Neo­clas­si­cal restric­tion that only the dis­tri­b­u­tion of debt, and not its aggre­gate rate of change, has macro­eco­nomic sig­nif­i­cance.

The data strongly sup­port the endoge­nous money propo­si­tion that the accel­er­a­tion of debt has macro­eco­nomic sig­nif­i­cance. The cor­re­la­tion between credit accel­er­a­tion and change in unem­ploy­ment in the 1920–40 period is sig­nif­i­cant and has the cor­rect sign.

Fig­ure 8: Debt Accel­er­a­tion and Unem­ploy­ment Change, 1920–1940

The cor­re­la­tion for the period 1990-Now is stronger still (-0.75) and in fact is larger than the cor­re­la­tion of change in M3 with the level of unemployment—let alone its rate of change.

Fig­ure 9: Debt Accel­er­a­tion and Unem­ploy­ment Change, 1990–2012

The cor­re­la­tion of the accel­er­a­tion of debt with change in asset prices is also sub­stan­tial. In strong con­trast to the now dis­cred­ited Effi­cient Mar­kets Hypoth­e­sis claim that debt plays no role in deter­min­ing the value of even a sin­gle cor­po­ra­tion, the accel­er­a­tion of debt has a sub­stan­tial influ­ence upon the change in val­u­a­tion of the entire asset mar­ket.

Fig­ure 10: Credit Accel­er­a­tion & the DJIA, 1922–1940

Fig­ure 11: Credit Accel­er­a­tion and the DJIA, 1990-Now

This is espe­cially marked in the case of hous­ing, when the accel­er­a­tion of mort­gage debt can be iso­lated. The cor­re­la­tion of the accel­er­a­tion of mort­gage debt with the change in real house prices is 0.8.

Fig­ure 12: Mort­gage Accel­er­a­tion and Change in Real House Prices

Since debt can­not accel­er­ate indef­i­nitely, this is also why asset bub­bles, ulti­mately, have to crash—and there­fore also a rea­son why macro­eco­nomic pol­icy should attempt to pre­vent them in the first place.

Con­clu­sion: towards a new macro­eco­nom­ics

The analy­sis here is still only pre­lim­i­nary, but the data gives far stronger empir­i­cal sup­port to the endoge­nous money, credit-dri­ven per­spec­tive than to the neo­clas­si­cal. For both the­o­ret­i­cal and empir­i­cal rea­sons, Neo­clas­si­cal macro­eco­nom­ics does indeed deserve to be “thrown out with the bath­wa­ter”, and a new dynamic, dis­e­qui­lib­rium macro­eco­nom­ics con­structed in its stead.

Fail­ure to hon­estly con­front the the­o­ret­i­cal weak­nesses and empir­i­cal fail­ures of the dom­i­nant school of eco­nom­ics will not pre­serve it. Indeed, con­tin­u­ing to ignore the gulf between the pre­dic­tions of neo­clas­si­cal eco­nomic mod­els and the state of the econ­omy will sim­ply accel­er­ate the steep decline in the pub­lic respect accorded to econ­o­mists since this cri­sis began. Ulti­mately, com­pla­cency and denial will lead eco­nom­ics back to the posi­tion of dis­dain that Keynes described so well dur­ing the last Depres­sion:

But although the doc­trine itself has remained unques­tioned by ortho­dox econ­o­mists up to a late date, its sig­nal fail­ure for pur­poses of sci­en­tific pre­dic­tion has greatly impaired, in the course of time, the pres­tige of its prac­ti­tion­ers. For pro­fes­sional econ­o­mists, after Malthus, were appar­ently unmoved by the lack of cor­re­spon­dence between the results of their the­ory and the facts of obser­va­tion; a dis­crep­ancy which the ordi­nary man has not failed to observe, with the result of his grow­ing unwill­ing­ness to accord to econ­o­mists that mea­sure of respect which he gives to other groups of sci­en­tists whose the­o­ret­i­cal results are con­firmed by obser­va­tion when they are applied to the facts. (J. M. Keynes, 1936, p. 33)


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Keen, S. (1995). Finance and Eco­nomic Break­down: Mod­el­ing Minsky’s ‘Finan­cial Insta­bil­ity Hypoth­e­sis’, Jour­nal of Post Key­ne­sian Eco­nom­ics. 17: 607–35.

Keen, S. (2000). The Non­lin­ear Eco­nom­ics of Debt Defla­tion, in: W.A. Bar­nett, C. Chiarella, S. Keen, R. Marks, and H. Schn­abl (eds.), Com­merce, Com­plex­ity, and Evo­lu­tion: Top­ics in Eco­nom­ics, Finance, Mar­ket­ing, and Man­age­ment: Pro­ceed­ings of the Twelfth Inter­na­tional Sym­po­sium in Eco­nomic The­ory and Econo­met­rics. New York: Cam­bridge Uni­ver­sity Press: 83–110.

Keen, S. (2008). Keynes’s ‘Revolv­ing Fund of Finance’ and Trans­ac­tions in the Cir­cuit, in: R. Wray and M. Forstater (eds.) Keynes and Macro­eco­nom­ics after 70 Years. Chel­tenham: Edward Elgar: 259–78.

Keen, S. (2011a). Debunk­ing Eco­nom­ics: The Naked Emperor Dethroned?. Lon­don: Zed Books.

Keen, S. (2011b). A Mon­e­tary Min­sky Model of the Great Mod­er­a­tion and the Great Reces­sion, Jour­nal of Eco­nomic Behav­ior & Orga­ni­za­tion. Forth­com­ing.

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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.
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  • alain­ton


    What do you mean by ‘net’ spend­ing — if financed by taxes or bonds or even finan­cial repression/seigniorage or asset sales how can it be infla­tion­ary — its just a sec­toral trans­fer pay­ment and reflux puts it back in cir­cu­la­tion? What I am try­ing to get at is that mon­e­tary cir­cuit the­ory — or even MMT/MCT hybrids — seem to imply a rede­f­i­n­i­tion of expansionary/contractionary fis­cal pol­icy — whether it is expan­sion­ary or con­trac­tionary depends on the net change in debt cre­ated money not the change in gov­ern­ment expen­di­ture per se. Aus­ter­ity is defla­tion­ary because of the pay­ing down of debt. Infla­tion of spe­cific asset classes wont be infla­tion­ary net unless there is mon­e­tary expan­sion to chase the assets.

  • koonyeow

    Title: Just Express­ing Myself, Reloaded

    From Lyon­wiss:

    You should have men­tioned the sub­stance of many posts in this thread: “What sov­er­eign debt cri­sis? The Euro­peans and Amer­i­cans are only imag­in­ing things.” Smells like MMT?

    I have accepted the fact that I am an igno­ra­mus.

  • mahaish

    What do you mean by ‘net’ spend­ing – if financed by taxes or bonds or even finan­cial repression/seigniorage or asset sales how can it be infla­tion­ary – its just a sec­toral trans­fer pay­ment and reflux puts it back in cir­cu­la­tion?”

    hi alain­ton

    g(gov spend­ing) > t(taxes) = net spend­ing

    or in terms of the gov­ern­ments oper­at­ing accounts at the cen­tral bank,

    the deb­its from those accounts are greater than the cred­its from those accounts.

    i dont really have an argue­ment with what you have pro­posed, except to say that the word financed is a incor­rect descrip­tion of what hap­pens, since its the ini­tial reserve add from the deficit that actu­ally funds the reserve sub­tract when reserves or deposits are swapped for trea­sury secu­ri­ties.

    its a bank­ing sys­tem reserve oper­a­tion

    but again the sys­tem wide bal­ance sheet effect may be neu­tral, but localised effects may be dif­fer­ent,

    so for exam­ple a multi bil­lion dol­lar gov­ern­ment office build­ing pro­gram as a con­se­quence of the cur­rent gov­ern­ment deficit whose infla­tion­ary effects have sup­poss­edly been neu­tralised by debt issuance , has led to no less than 10 cranes lit­ter­ing the land­scape in a radius less than 10 km from where i live,leading to no doubt envi­ous looks from our friends in shang­hai 😉

    lead­ing to all sorts of inter­est­ing inflas­tionary effects on the labour mar­ket, the prop­erty rental mar­ket, etce etc.

    the bank­ing sys­tem reserve effect may be neu­tral, but the deposits that get cre­ated as a con­se­quence of the deficit may have inter­est­ing infla­tion­ary effects,

    but i digress, since my orig­i­nal argue­ment was , that whether the bank or non bank pri­vate sec­tor held that net spend­ing as deposits , reserves or bonds, the dis­tinc­tion that bonds are poten­tially less infla­tion­ary than cold hard cash is highly ques­tion­able, given the liq­uid nature of both, and given the short term bond yield is a proxy for the inter­bank rate which sets the para­me­ters for the yield on non gov­ern­ment debt 

    whether it is expan­sion­ary or con­trac­tionary depends on the net change in debt cre­ated money not the change in gov­ern­ment expen­di­ture per se.”

    again we can agree to an extent but not com­pletely. the deficit can be lever­aged by the pri­vate sec­tor if the deposits cre­ated by that deficit end up in non bank bal­ance sheets- the fhog is a prime exam­ple,

    and yes the credit engine may be the sig­nif­i­cant dri­ver on the way up to the top of a eco­nomic expan­sion


    when the gov­ern­ment deficit is run­ning at over 4% of gdp
    since 2009 , and the gov­ern­ment debt has dou­bled from 11% to 22% of gdp since 2009, the effect of that gov­ern­ment spend­ing on non bank bal­ance sheets can stop del­e­varag­ing in its tracks , and inde­fi­nately if the gov­ern­ment had a mind to.

    this is not to dis­count the effect of cen­tral bank rate cuts

    now the deficit and the gov­ern­ment spend­ing mul­ti­plyer might push the credit engine along, but a bud­get sur­plus in account­ing and sec­toral terms amounts to pri­vate sec­tor dis­av­ing, and would be like pour­ing fuel on the fire in a credit con­trac­tion, espe­cially if there are mul­ti­plyer effects involved,

    the pri­vate sec­tor dis­av­ing caused in part by gov­ern­ment sav­ing and a credit con­trac­tion can be lethal.

    so again i have to dis­agree to an extent , in that the finan­cial bal­ance of the gov­ern­ment can have sig­nif­i­cant expan­sion­ary and con­trac­tionary effects, 

    its the non bank bal­ance sheet effects of the gov­ern­ment fis­cal posi­tion com­bined with cen­tral bank manip­u­la­tion of the yield curve, and a lit­tle help from china that goes a good way to explain­ing why we havent had a major down­turn in this coun­try unlike oth­ers,

  • alain­ton

    To fol­low up another MMT flaw is that gov­ern­ment sur­plus must equal pri­vate sec­tor deficit. It not how gov­ern­ment debt enlargement/paydown works, which is via a net increase or decrease of Tbill redemp­tions over issues or addi­tion­ally for pay­downs pur­chases in the sec­ondary secu­ri­ties mar­ket. In a pay­down there is no pri­vate sec­tor deficit, rather the sys­tem is bal­anced by a net increase or decrease in total money sup­ply or more strictly the future yield curve for changes to money sup­ply. The mis­take comes from treat­ing sec­toral bal­ances in a sta­tic frame­work, as if they are changes to stocks not flows.

  • mahaish

    stocks or flows , we cant change account­ing real­ity alain­ton,

    a deficit is a bank­ing sys­tem reserve add,

    the gov­ern­ment adds to the stock of reserves, and the pri­vate bank and non bank sec­tor with the help of the cen­tral bank can effect the com­po­si­tion of the reserve add and cre­ate flows from one class of assett to another.

    so what you describe is essen­tially a assett swap or liq­uid­ity swap, 

    the pri­vate bank or non bank sec­tor can­not change total amount of the reserve add(or net assetts ) a deficit cre­ates.

    the pri­vate sec­tor can cer­tainly lever­age the net asset increase, but in terms of hor­i­zon­tal money the bal­ance sheet effect for the pri­vate sec­tor is zero, and no increase in net assetts.

  • alain­ton


    The sit­u­a­tion you describe only applies to com­pul­sory reserve require­ments on banks with the cen­tral bank and assumes the cen­tral bank is on the state side of the bal­ance sheet. First it is a slight of hand and sec­ondly this form of seignor­age is only a small com­po­nent of deficit financ­ing in most mod­ern states.

    It is much bet­ter to think of a deficit as a secu­rity add as most pur­chases of T bills are pen­sion funds need­ing to pay cur­rent matu­ri­ties.

    I agree with the point about dis­av­ing and how gov­ern­ment debt reduc­tion leads to con­trac­tion of the money sup­ply — which is the point I was first mak­ing. You dont need to worry so much about the inter­me­di­a­tion of bank reserves –it is sec­on­da­try- what ever the mech­a­nism used — and there are many the key issue is whether or not the debt man­age­ment mea­sures expand or con­tract the money supply/effective demand.

    Being less sta­tic — gov­ern­ment debt reduc­tion is imme­di­ate reduc­tion of the money sup­ply, gov­ern­ment debt increase through bond yields is a com­mit­ment to expand the money sup­ply in the future. Now direct cash injec­tions has an imme­di­ate effect. Bonds yields are the key macro­eco­nomic reg­u­la­tor. As you say it sets the floor on the inter­bank rate — now we are get­ting into the com­plex area of whether or not there is a debt ‘crowd­ing out’ effect. If you hold to the post keyn­sian idea of a ‘veloc­ity mul­ti­plier’ rather than a money mul­ti­plier then the key issue is whether the veloc­ity is the sec­tor being taxed is greater than the sec­tor gov­ern­ment is spend­ing on. Dis­av­ing from idle bal­ances spent on infra­struc­ture would seem to be an exam­ple of ‘crowd­ing in’ to my mind, which is why i favour the recent sug­ges­tion that bonds have to be financed domes­ti­cally.

  • goidcc

    Hi Mr. Keen,
    I just fin­ished read­ing your lat­est book. It is very inter­est­ing. Thank you for explain­ing com­pli­cated con­cepts by mak­ing them so easy to read. 

    I have one ques­tion. In your book and most of your papers you are assum­ing that firms take loans to pro­duce prod­ucts. Whay haven’t you con­sid­ered house­holds tak­ing loans for thier con­sump­tion. In Amer­ica many home­own­ers took loans using thier homes as col­lat­eral to con­sume more. I am sure this could play an impor­tant role. Maybe you would like to add house­hold loans in your sim­u­la­tions and see how it plays out. Then you can add dif­fer­ent bailout schemes that the govt can use to help the econ­omy.

    Thank you.


  • Thanks AK,

    I have included house­hold con­sump­tion as part of an unpub­lished model, linked to an asset price bub­ble. How­ever it will take time to add the dynam­ics of the asset mar­ket as well. The model in DE II was sim­ply to illus­trate how a credit money sys­tem works. Later work will be on how that sys­tem crashes–and fund­ing Ponzi schemes like the sub­prime fiasco is a major part of that story.

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  • Ken Mac­In­tyre

    Apolo­gies for com­ing to this dis­cus­sion so late. A com­ment on ‘neo­clas­si­cal mod­els helped guide pol­icy dur­ing the good times, and should not be aban­doned sim­ply because they did not see the bad times com­ing.’ It is exactly the same as say­ing that the car nav­i­ga­tion sys­tem that took you over a cliff can­not be junked because, hey, it worked ok in the three miles before you got to the cliff edge. Any soft­ware com­pany that came up with that excuse would not be allowed to man­u­fac­ture nav­i­ga­tion sys­tems. Spe­cious as you say.

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