I was approached by Bloomberg to write an 800-word feature on “The Future of Economics” for the World Economic Forum, which starts today in Davos. Here is the Bloomberg newsletter, with my commentary on page 5.
For its entire history, macroeconomics has been dominated by mathematical models that ignore the existence of money, debt and banking, and that perceive the economy’s movement through time as transitions from one state of equilibrium to another.
At any point in history, these would be heroic assumptions. Could it really be true that models without either money or instability are provably superior at predicting the economy’s future course than models in which money and banking exist, and in which the model economy can be out of equilibrium? If not, is it the case then that such models are simply too difficult to construct—that the best we can do is pretend that the economy doesn’t have banks or money, and that it’s always in equilibrium, even if we know these assumptions are false?
Before the crisis of 2007, few non-economists even asked those questions, because there seemed to be no need to challenge what economists did. The economy, after all, was going gangbusters. Professional economists, using the very latest mathematical models of the economy, took credit for its sterling performance, and predicted more of the same for the foreseeable future.
Robert Lucas, the father of “Rational Expectations Macroeconomics”, asserted that the “macroeconomics … has succeeded. Its central problem of depression prevention has been solved, for all practical purposes, and has in fact been solved for many decades.”[1] Ben Bernanke lauded “improved control of inflation” as the cause of “the Great Moderation”, which he described as “this welcome change in the economy.” [2] In June 2007, the OECD, guided by its macroeconomic model, opined that “the current economic situation is in many ways better than what we have experienced in years… Our central forecast remains indeed quite benign”. [3]
Then all hell broke loose, and almost five years later, it shows no signs of abating. Now non-economists are challenging what economists do, and finally realizing what a minority of dissidents within economics have long known: these assumptions are not merely heroic, they are both false and unnecessary. Money, debt and disequilibrium dynamics play crucial roles in the actual behaviour of the economy, and it is relatively easy to develop mathematical models which include money and banks, and in which the economy is always in disequilibrium. I should know: it’s what I do, and it’s why I was one of two mathematical economists who saw this crisis coming, and warned of it publicly before it happened (the other was the late Wynne Godley). [4]
For economics to have a future, it has to abandon the obsession with equilibrium modelling, and realistically incorporate money, banking and finance into macroeconomics. Both things are, as I’ve said, not hard to do.
The starting point for modelling any process in a true science is a position of disequilibrium—Newton, after all, modelled gravity by considering a falling apple, not one at rest! Economists have to abandon their fetish with “comparative statics” and instead model processes of change. Dynamics has to be the core of economic analysis, not equilibrium.
Money is also easily modelled by borrowing the basic tool of the accountant, double-entry bookkeeping. [5] Money and debt are created by bookkeeping entries, and the same paradigm can be used to derive dynamic models of the flow of money in one direction, propelling the movement of goods and financial assets in the other.
The difficulty in developing a monetary dynamic macroeconomics comes not from the tools themselves, but from the beliefs that have to be abandoned to employ them sensibly—from other assumptions that Neoclassical economists have made to “simplify” analysis that instead have made it almost impossible to understand the real world. There are enough of these to literally fill a book—to whit, my Debunking Economics [6]—but I’ll single out just three:
- “Rational” expectations—which really means assuming that everyone can accurately predict the future (and therefore avoid any calamities like the one we are in right now);
- Representative agents—which really means assuming that there’s only one person in the economy, who produces and consumes just one commodity; and
- Perceiving macroeconomics as applied microeconomics
This last false belief, and not a quest for greater realism, was the driving force behind the development of macroeconomics since WWII. It was a fool’s errand, since as physicists realized decades ago, “More Is Different”—to quote the title of a famous paper from Physics Nobel Laureate Philip Anderson. [7] Biology cannot be treated as merely applied chemistry, even though the elementary building blocks of living entities are chemicals, because properties emerge from the interactions of these chemicals that can’t be explained from the chemicals alone.
We call one of these emergent properties “Life”. We know a great deal about chemistry, but no chemist has as yet created life. The attempt to reduce macroeconomics to applied microeconomics was as futile a quest.
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[1] Robert E. Lucas, Jr, “Macroeconomic Priorities”, his 2003 Presidential Address to the American Economic Association, January 10, 2003. http://oldweb.econ.tu.ac.th/archan/chaiyuth/New%20growth%20theory%20Review%20in%20Thai/macro%20perspectives_lucas.pdf.
[2] Bernanke, B. S. (2004). Panel discussion: What Have We Learned Since October 1979? Conference on Reflections on Monetary Policy 25 Years after October 1979, St. Louis, Missouri, Federal Reserve Bank of St. Louis. http://www.federalreserve.gov/boarddocs/speeches/2004/20041008/default.htm.
[3] Cotis, J.-P. (2007). Editorial: Achieving Further Rebalancing. OECD Economic Outlook. OECD. Paris, OECD. 2007/1: 7-10. http://www.scribd.com/doc/43756565/Oecd-Economic-Outlook-2007
[4] Fortunately Godley (http://en.wikipedia.org/wiki/Wynne_Godley), has many young followers carrying on his work. For the list of economists who warned of the crisis, see Bezemer, D. J. (2009). “No One Saw This Coming”: Understanding Financial Crisis Through Accounting Models. Groningen, The Netherlands, Faculty of Economics University of Groningen. http://mpra.ub.uni-muenchen.de/15892/1/MPRA_paper_15892.pdf.
[5] For an example of modelling a simple 19th century paper money system, see http://www.economics-ejournal.org/economics/journalarticles/2010-31.
[6] Steve Keen (2011), Debunking Economics: the naked emperor dethroned?, Pluto Press, London. http://www.amazon.com/Debunking-Economics-Revised-Expanded-Dethroned/dp/1848139926/ref=sr_1_1?s=books&ie=UTF8&qid=1326839803&sr=1-1
[7] Anderson, P. W. (1972). “More Is Different.” Science 177(4047): 393-396. http://www.andersonlocalization.com/pdf/more_is_different.pdf.
Steve – Why not introduce a tool to assist ecconomists which was invented several thousand years ago. Aristotle and Plato used it and it was commonly used right up to late 20th century.
It was great for checking the validity of any assumption, axiom and theorum. If any of these failed then it was thrown out or re-written.
The tool of course is called logic.
I have been through some of your lectures and pretty much every fundamentle formulae fails the most cursory logic test. The most illogical being the rational consumer.
Hi Steve,
Did you have any luck with contacting Morgan Stanley about its financial debt to GDP ratio?
I emailed the author of the section that the graph appears in, but didn’t respond.
Also, I wondered if you’ve read any of the works by US economists Michael Albert and Robin Hahnel? They’ve done some of the pioneering work in analyzing the grievous flaws of markets and central planning.
Their book “A Quiet Revolution in Welfare Economics” (1990) is dense but well worth reading. They find that markets are as bad as central planning – in terms of efficiency and human development – though the adverse effects turn up in different ways.
Predictably their work has been entirely ignored, more so than that of Minsky, Robinson, etc.
Soros is on his way to Davos, I am told at http://r20.rs6.net/tn.jsp?llr=iqnuv6bab&et=1109134227553&s=113703&e=001pUwyNITY-LtEzmpwU-9Y2NJJuKxsVy60g-4QsQjHmt6HazW0Ia-B8b_LYZ-c-UZv4RbK1MrB0xkyYHAjiq61bh2rrna6P9E689MSfty9tpNLNA1FZXfglgYj2NGfLur-4whTsTXfRIWEr6TSf7Xaeabuq6hJH0T0.
In this quote he uses a few terms Steve might appreciate.
Soros draws on his past to argue that the global economic crisis is as significant, and unpredictable, as the end of communism. “The collapse of the Soviet system was a pretty extraordinary event, and we are currently experiencing something similar in the developed world, without fully realizing what’s happening.” To Soros, the spectacular debunking of the credo of efficient markets—the notion that markets are rational and can regulate themselves to avert disaster—“is comparable to the collapse of Marxism as a political system. The prevailing interpretation has turned out to be very misleading. It assumes perfect knowledge, which is very far removed from reality. We need to move from the Age of Reason to the Age of Fallibility in order to have a proper understanding of the problems.”
Steve, as a deflationist, how do you respond to the arguments that:
- banks need to lend out reserves in order not to make losses on interest payments on deposits, such that they can not keep money in reserve forever
- the central bank can induce banks to lend by charging a fee on excess reserves and vault cash
Can banks return money to depositors when the reserves become too much of a liability to them? Do you expect they will refuse new deposits at some point?
Is a legitimate objection to point 2 that banks can simply issue “sterile” loans, for example to their own management which then promises not to spend the money such that there is no default risk and no circulation of money, essentially the same thing as just stuffing the money into a mattress (since doing it in the more direct way, i.e. vault cash, could also be penalized)?
Nice Steve…
you should keep challenging their economic “manhood”…even civil engineers, designing immobile structures, factor dynamics into their analysis, in fact dynamic forces often drive the design (wind, seismic, fluttering, resonance etc). Boring old low-tech civil engineers have been doing this since before WWII, learning from their catastrophes and failures. Geologists ridiculed plate tectonics but then the evidence piled up and 100 years later, the geology models are completely different and very dynamic… why can’t economist face the music like other scientists and engineers.
Haven’t followed up yet Phillip–too much else on! But the first Director of CfESI starts next week, so hopefully that sort of thing will be in his bailiwick.
I’ll introduce him on the blog very shortly.
Reserves circulate LCT, and borrowing is a two-way street. Banks can want to lend all they want;unless customers concur and borrow, the banks’s lending capacity will go unutilised.
The best argument against the “print money will cause hyperinflation” case is the data. US Bank reserves are through the roof, and lending hasn’t taken off, and neither has inflation.
Good article about the Irish situation
“This rule says that in order to get out of the debt mess, the lenders and the borrowers must pay. Given what the data is telling us, it is amazing that the line has been held for so long, without massive default. Indeed, what is more amazing still is that the national narrative has been dictated for so long by the lenders who, having lent the various players in the country over 600pc of income, are clearly the villains in this story. If anyone wants evidence of reckless lending, there it is straight in front of your eyes.”
http://www.davidmcwilliams.ie/2012/01/25/private-debt-so-enormous-that-default-is-only-option?utm_source=dlvr.it&utm_medium=twitter&utm_campaign=private-debt-so-enormous-that-default-is-only-option
I was just reading some of the comments on the above page I mentioned, apparently the Irish are bringing new personal insolvency laws. The commenter makes the point that when everyone’s homes are repossessed just what are the lenders going to do with them.
They’ll probably leave everyone in their houses even if they can’t pay their mortgage for fear of driving the values even lower. The situation over there sounds like a modern day potato famine.
The citizen’s dividend is the natural and sane transition from, and in all likelihood eventual replacement for the wage. Every economic downturn is characterized by a greater than normal lack of purchasing power and every recovery is characterized by a less than normal lack of same. Supplementing everyone’s purchasing power, unemployed AND employed in perpetuity with such a dividend would make the economic system more robust and less prone to imbalance and change the consumer financial paradigm from one of scarcity and insecurity to relative abundance and security. Of course the retail business paradigm would likewise change due to there being sufficient demand. Last but not least if consumers had enough purchasing power to fully liquidate production in any given period of production this would make individuals the determining factor in economic policy with their sufficient purchasing power money-vote, instead of too big to fail banks, too big government or too big domestic or trans-national producers. Then with a discount on all prices at the point of retail sale making it an unobtrusive macro-economic mechanism not some overweening central planning we could level the cost of production and the cost of consumption. Together with the strict regulation of speculative instruments economies could be appropriately”unstable” and yet liberating to their various citizens. Like economics that miss reality by the use of false assumptions, so focus on merely making the system function without truly liberating the citizens who live in those systems…..we can miss a rather valuable point. Humans and their well being ought to be the focus of systems…..not some inadequate purpose like profit or work for its own sake.
Consider Elizabethan England. They didn’t have antibiotics or cybernation, but they did have like 150 holidays a year and a golden age in literature. Nowadays we have antobiotics and cybernation along with wage and debt slavery and the Arts for the most part, while they may or may not be illuminating, are largely fraught with hopelessness, impending disaster and other less than confident thoughts and emotions. Something is amiss.
Why not consider Distributism as the basis for the economic, financial and monetary systems? How much more human good and less greed could result from systems based on confidence, hope, individual security, a sense of grace (abundance) and the intention that the individual be free instead of ones based on insecurity, hopelessness, scarcity and the will to power of systems over the individual?
Steve Hummel, The only way I can see that getting off the ground is that the 1% are prepared to let go of a little for the benefit of other 99%. Add to that expanding population and depleting resources. I’m not against it, just that the 1% has all the power so I doubt they’d settle for mediocrity.
Clive, a small citizen’s dividend could actually be done without costing the taxpayer much by simplifying the tax and benefits system.
The three changes that would be necessary would be
1) Abolish the income tax personal allowance
2) Abolish the current benefits system
3) Use the extra revenue and the money saved in administration and social payments to fund a tax free citizens dividend payable to all citizens via the tax authorities.
The citizens dividend would more than match the loss of the personal allowance to the employed and the loss of benefit to the unemployed. The only people who would lose out would be the bureaucrats who formerly administered Social Security.
Derek I’m not against the idea. I’m just not so sure those at the top could be convinced to run with the idea. Can you explain to me what you include include in the current benefits system?
Clive,
Do the 1% really have all of the power? Actually we’re just a William Jennings Bryan or Martin Luther King, Jr. away from a mass social movement that could herd the entire political apparatus toward the sanity of Distributism. History has plenty of examples of such including Ghandi, the aforementioned King or even the invidious example of Hitler, who before his witch’s kitchen of militarism, fascism, hatred and anti-semitism went to seed was able to economically transform Germany in the middle of the Great Depression by oratory and a non debt based monetary system.
Derek R,
With a truly Distributist economic and monetary system you could do a whole lot more than that. How about eliminating welfare taxes? How about fazing out Social Security? Just DISTRIBUTE such monies, not RE-distribute them. And in fact distribute more than what you’ve been re-distributing……its obviously not been enough to keep the economy functioning properly as is. Directly distributing a dividend frees up additional purchasing power to the individual through the immediate and/or rapid elimination of these taxes. Government should fund itself not rely on a private monetary system to rip everyone off via taxation and then dominate the political apparatus to its own narrow interests to boot. Yes, yes its potentially problematic, but I assert much less so than the current system, and with the proper checks and balances should evolve into like a fourth branch of government, and more important than checks and balances kept true to its mandates…..the economic liberation of the individual, the transformation of consumer finance and the avoidance of inflation or deflation through the macro-economic balancing of the economy.
Distributism is not to be mischaracterized as utopian. There would still be a need for work of course, and likely more of it because its mechanisms would increase demand and enterprise. And yet freeing the individual from the absolute necessity of work enables technological efficiencies to be considered without the stinging trade off of unemployment. This in turn could lighten and hasten the likely difficult process of change from a fossil fuels economy, and even enable us to in many instances consume less by wasting much less.
Steve, Bring it on, the thing I’m hoping for out of this depression is entire change of the system (Ponzi) as we no it. Not so sure about Hitler though, “non debt based monetary system” put in simple terms, he didn’t pay anyone.
Jack Lang tried something similar in the 30′s and look what happened to him.
Excuse the spelling on the last post, still celebrating AU day.
Clive,
Interesting history there with Lang. Being American I was ignorant of it. Social Credit, the Distributist economic and monetary theory I’ve basically been describing here lately had in some ways a similar experience in Alberta, Canada of having its provincial program thwarted at the federal level. Thats why a mass social movement is required first. The financial and economic interests would be able to easily stop a less than federal political movement.
A good objective history of Social Credit can be found in Frances Hutchinson’s book Understanding the Financial System: Social Credit Rediscovered.
@lctesla
Money in bank reserves does not contribute to demand for transactions – so doesn’t contribute to inflation
You need to use the Keynesian version of the Cambridge quantity formula with k – the inverse of monetary velocity
There is some interesting work on the post keynsian velocity multiplier recently, from Moore and Gechert – but the maths are all over the place and stock-flow inconsistent.
The risk is if banks and firms do have excess reserves when balance sheets recover we could again see a return to malinvestment and over-investment – and inflation – but that is some way down the line. Ironically history teaches us the best way to avoid this trap is to actively destroy old capital – either through technical obsolescence or war – not that I am advocating the second!
“The risk is if banks and firms do have excess reserves when balance sheets recover we could again see a return to malinvestment and over-investment – and inflation”
Only if the interest rate on those reserves are too low, and they have capital spare to deploy. That’s the second element of Functional Finance – interest rates set at a level to deliver the optimal amount of investment.
Steve,
Considering your suggested policies regarding assets – shares and property – what effect would a 100% capital gains tax have on the economy?
Wouldn’t this force individuals and firms to invest purely for the income/cash flows from purchasing assets/running a business? With all capital gains taxed away, then there is no incentive to use debt to speculate on assets.
Clive wrote: Derek I’m not against the idea. I’m just not so sure those at the top could be convinced to run with the idea. Can you explain to me what you include include in the current benefits system?
Fair enough, Clive. There’s little doubt that those at the top are against it. That’s become evident whenever the idea has been seriously proposed.
As for what would be included from the current benefits, the answer is “as much as possible”, so as to be able to add as much of the money previously spent on the administration of the system (particularly that spent on enforcing means-testing rules) to the Citizens Dividend itself.
Every country’s Social Security system is different but for the Australian case I could see Age Pension, NewStart Allowance, AuStudy payment, AbStudy payment, Special Benefit, Youth Allowance, Sickness allowance, Disability Support Pension and Carer Payment being replaced with a CD payment, provided that the CD payment was at least as large as any of these.
If the CD payment was also made to children (perhaps at a reduced age-related level) via their legal guardian, it could also replace Parenting Payment, Child Carer Allowance, Double Orphan Pension and Maternity payment.
But the devil is in the details with this sort of thing. I don’t know enough about the financial details of the Australian system to say who would be better and who worse off. So I will freely admit that I am relying on savings in administration costs gained by radical simplification of the system (and in particular the abolition of means-testing) to fund a large enough CD that it would ensure that the poor would be no worse off than they are now.
Steve Keen: The best argument against the “print money will cause hyperinflation” case is the data.
Hi Steve
I thought Hyperinflation was more of a political event caused when people lost faith in a currency/country – typically when the printing presses are running hot, but not just because of it.
The Spanish increased their gold coins by 100+% when they looted the Inca’s (gold has never recovered since) but they didn’t suffer from hyperinflation. It meant gold was worth less but still acceptable as a currency.
I think the key difference is that when the printing press is running and people no longer accept the currency as payment/trade then you get hyperinflation, before that it is just normal inflation.
@NeilW
You seem to be referring to Lerner’s ‘second law’ of functional finance
“The second law of Functional Finance is that the government should borrow money only if it is desirable that the public should have less money and more government bonds…This might be desirable if otherwise the rate of interest would be reduced too low . . . and thus induce too much investment, thus bringing about inflation.”
Two problems – a government nowadays borrows money because it has debts – the baseline position is not zero debt.
The second problem is that he gave no indication of what policy mix between interest rates and riasing debt – as controlling government debt is also used to control aggregate demand. Which policy instrument to use? This seems to violate Tinbergen’s law http://www.mail-archive.com/futurework@dijkstra.uwaterloo.ca/msg05430.html
Dont tweak two policy variables when you can tweak one.
Most of the MMT literatiure seems to focus on the government deficit instrument and not interest rates? What to do in a situation of stagflation AND high government debt? Is their an MMT version of a Taylor rule? Much MMT writings seems to be 100% concerned with fiscal policy rules rather than monetary policy, and if monetary policy does enter into it a ZIRP is advocated – which by the way I dont get as a flat maturity curve is as we have seen is a sure route to bank bankruptcy and deleveraging, banks can no longer borrow short and lend long.
Steve,
This McKinsey report is similar to the Morgan Stanley one.
http://www.google.com.au/url?sa=t&rct=j&q=%22the%20composition%20of%20debt%20varies%20widely%22&source=web&cd=3&ved=0CEQQFjAC&url=http%3A%2F%2Fwww.mckinsey.com%2F~%2Fmedia%2FMcKinsey%2Fdotcom%2FInsights%2520and%2520pubs%2FMGI%2FResearch%2FFinancial%2520Markets%2FDebt%2520and%2520deleveraging%2520-%2520Uneven%2520progress%2FMGI_Debt_and_deleveraging_Uneven_progress_to_growth_Executive_summary.ashx&ei=cQIiT7b4I8aXiAeE5bmhBA&usg=AFQjCNFVCl9sDqC1ZtAzbMGVaNCUIq26mA&cad=rja
Australia (debt to GDP ratio)
Household debt: 105% (personal debt clearly added to household debt)
Business: 59%
Financial: 91%
Government: 21%
Total: 277%
Title: koonyeow’s Wish
I think that epistemology (theory of knowledge) should be taught at every school. Bribe our children to learn it if we have to.