An Attack on Paul Krugman

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By Michael Edesess

 Source: Advi­sor Per­spec­tives

A foun­da­tion­al prin­ci­ple of mod­ern eco­nom­ics is that the cre­ation of cred­it leads to eco­nom­ic growth. That pre­cept under­lies need for quan­ti­ta­tive eas­ing, and it is cen­tral to the ques­tion of what role mon­e­tary pol­i­cy can and should play in stim­u­lat­ing a faster recov­ery from the Great Reces­sion. It is also the sub­ject of a debate between one of the world’s most promi­nent eco­nom­ic schol­ars, Paul Krug­man, and a feisty Aus­tralian econ­o­mist, Steve Keen.

Krug­man is an unusu­al­ly pub­lic fig­ure for an aca­d­e­m­ic. The Nobel Prize-win­ner and Prince­ton pro­fes­sor is also a wide­ly-read New York Times colum­nist and pro­lif­ic blog­ger, with the gift – unusu­al for some­one in so wonky a pro­fes­sion – of clear and per­sua­sive prose. He has earned a large and pas­sion­ate audi­ence, among them both ardent acolytes and rabid detrac­tors. Krug­man rep­re­sents the main­stream of neo­clas­si­cal eco­nom­ics, which believes that a com­bi­na­tion of cen­tral bank mon­e­tary pol­i­cy and gov­ern­ment fis­cal pol­i­cy can mod­er­ate the busi­ness cycle.

Among the dis­si­dents is Keen, the author of a provoca­tive book, Debunk­ing Eco­nom­ics. By his own admis­sion, Keen is proud­ly out of the main­stream, but also able (“because of imped­i­ments like aca­d­e­m­ic tenure,” he says in his book) to chal­lenge it with­out fatal ret­ri­bu­tion. Keen thinks cen­tral bank con­trols are not as effec­tive as Krug­man believes, because pri­vate banks can cre­ate mon­ey in the form of debt through a process that is beyond the cen­tral bank’s con­trol. Because of that, the econ­o­my will reg­u­lar­ly expe­ri­ence “finan­cial insta­bil­i­ty,” as advo­cat­ed by Keynes’s dis­ci­ple Hyman Min­sky.

The debate in the blo­gos­phere between those in the Krug­man camp and those in the Keen camp has gen­er­at­ed more heat than light; but the core of the debate is whether or not pri­vate banks can cre­ate mon­ey “out of thin air” to their heart’s con­tent, by extend­ing cred­it – leav­ing the cen­tral bank with no choice but to sanc­tion this mon­ey cre­ation.

Keen has tak­en aim at Krug­man, and about a month ago Krug­man, wel­com­ing the chal­lenge(at least ini­tial­ly), respond­ed to Keen sev­er­al times on his blog, set­ting off a furor in the eco­nom­ics blo­gos­phere that has rever­ber­at­ed well beyond it.

I reviewed the exchange between Keen and Krug­man, as well as much of the volu­mi­nous blog traf­fic of com­menters weigh­ing in, often to sup­port one side or the oth­er. I also con­duct­ed a per­son­al phone inter­view with Keen. (I con­tact­ed Krug­man through The New York Times to ask for an inter­view but did not receive a response.) These efforts shed new light for me on this debate, which I share below.

The cri­sis in eco­nom­ics

Eco­nom­ics is in a state of fer­ment; I would like to be able to say it is like physics before Ein­stein, but eco­nom­ics is not remote­ly com­pa­ra­ble to New­ton­ian physics, and no Ein­stein-esque econ­o­mist is going to per­fect it.

The crit­i­cal state of eco­nom­ic the­o­ry has been exac­er­bat­ed by the finan­cial cri­sis, and numer­ous het­ero­dox­ies today bedev­il the neo­clas­si­cal main­stream – Post-Key­ne­sian­ism, fol­low­ers of Hyman Min­sky, Mod­ern Mon­e­tary The­o­ry, Aus­tri­an eco­nom­ics, even Marx­ist eco­nom­ics. These alter­na­tive ideasets have been chron­i­cled in The Econ­o­mist, and a par­tial cast of char­ac­ters has been mapped in The Wash­ing­ton Post. Most of the debate goes on in the blo­gos­phere, which is par­tic­u­lar­ly pro­lix on this sub­ject. I have noticed that vir­tu­al­ly all of the blog­gers are econ­o­mists – they may or may not be aca­d­e­mics, but they gen­er­al­ly have eco­nom­ics degrees.

The vol­ume of inter­net chat­ter among pro­fes­sion­al econ­o­mists is stag­ger­ing. A friend of mine was once chair­man of the Fed­er­al Reserve Bank of Kansas City. He is not an econ­o­mist but a busi­ness­man. (No, my friend is not Her­man Cain.) He told me that when he arrived in the posi­tion, he found that there were 170 econ­o­mists who report­ed to him – and he didn’t have the fog­gi­est idea what they were all doing with their time. Now that I’ve read so much of the blog­ging on this sub­ject, I think I could tell him. They are all kib­itz­ing about Fed pol­i­cy, read­ing charts and data and con­struct­ing mod­els.

The blog­gers are try­ing to deter­mine what cen­tral bank pol­i­cy should be. Some of the new schools of eco­nom­ics believe cen­tral banks like the Fed­er­al Reserve can cre­ate all the mon­ey they want with­out neg­a­tive con­se­quences. Oth­ers believe cen­tral banks shouldn’t exist at all. Some schools believe that, instead of try­ing to fine-tune a bal­ance between infla­tion and GDP growth, the Fed should just tar­get a con­stant rate of nom­i­nal GDP growth, to effect a bal­ance of infla­tion and GDP growth all in one bang. And oth­ers still, believe the cen­tral bank has lit­tle to say about it because booms and busts will occur what­ev­er it does (this is clos­est to the locus of the Keen-Krug­man debate.)

The core of the dis­pute

The cen­tral ques­tion in the Keen-Krug­man inter­change is whether banks can cre­ate mon­ey with com­plete free­dom, or whether they are effec­tive­ly con­strained by the actions of the cen­tral bank. The ques­tion at issue is whether banks can “cre­ate cred­it out of thin air,” a notion that seems to have been first advo­cat­ed by the econ­o­mist Joseph Schum­peter. Keen and oth­ers of his fac­tion say they can; Krug­man says they can’t.

But there are real­ly two aspects to the debate. The first is the gen­er­al charge that all of neo­clas­si­cal eco­nom­ic the­o­ry is bank­rupt because it is enthralled with equi­lib­ri­um, and there­fore it can­not mod­el or under­stand the dynam­ic evo­lu­tion­ary eco­nom­ic process. That is to say, the essen­tial nature of the econ­o­my is to be in disequi­lib­ri­um, so the­o­ries obsessed with equi­lib­ri­um can­not mod­el it.

This charge seems whol­ly valid to me. In answer to the mainstream’s defi­cien­cies, Keen said in my inter­view with him, “I want to elim­i­nate the neo­clas­si­cal main­stream and replace it with a Schum­peter­ian dynam­ic growth evo­lu­tion­ary main­stream.”

Schum­peter, you’ll recall, was the econ­o­mist who coined the term “cre­ative destruc­tion” to char­ac­ter­ize the cap­i­tal­ist eco­nom­ic process – a term beloved by near­ly all econ­o­mists, but of which it is dif­fi­cult to find any trace in main­stream eco­nom­ic mod­els. Says Keen, “Cre­ative destruc­tion doesn’t involve equi­lib­ri­um, so they leave it out com­plete­ly. It’s about how invest­ment comes in puls­es and waves … so you get an inher­ent expla­na­tion for the cycli­cal­i­ty of cap­i­tal­ism out of Schum­peter.”

The sec­ond aspect is a chick­en-and-egg prob­lem: Do banks take in deposits and then lend, or do they loan first, then use the pro­ceeds of the loan to cre­ate deposits? It is not mere­ly a chick­en-and-egg ques­tion – those, like Keen, who say banks can cre­ate mon­ey out of thin air also say that the cen­tral bank must con­done, willy-nil­ly, this so-called “endoge­nous” mon­ey cre­ation. Krug­man, on the oth­er hand, says the cen­tral bank can con­trol the process. That is, he believes mon­ey is cre­at­ed only “exoge­nous­ly” by the cen­tral bank. Keen is a dis­ci­ple of Hyman Min­sky, who was a dis­ci­ple of John May­nard Keynes but also of Schum­peter. Min­sky believed that this process of banks cre­at­ing mon­ey, in the form of debt, would inevitably lead to fre­quent finan­cial bub­bles and crises.

Judg­ing from how much fever­ish blog­ging there has been sur­round­ing the Keen-Krug­man bat­tle alone, this is a thorny ques­tion to resolve one way or the oth­er. The amaz­ing thing is that, in this debate, one side or the oth­er will present what appears to be a very sim­ple proof that they are right – and yet the oth­er side is not per­suad­ed in the least.

What real­ly both­ers me about the debate

It is dif­fi­cult for a non-econ­o­mist to deci­pher the debates, which revolve around eso­teric ter­mi­nol­o­gy known only to the dis­putants – like “aggre­gate demand” and even “mon­ey.” Most peo­ple cer­tain­ly don’t know what econ­o­mists mean by “mon­ey.” A friend of mine told me he was at a meet­ing recent­ly with a num­ber of peo­ple, most of whom thought that when the cen­tral bank increased the mon­ey sup­ply it actu­al­ly phys­i­cal­ly print­ed cur­ren­cy – and all the peo­ple at the meet­ing were finan­cial advi­sors.

As I said, almost all of the debates are among econ­o­mists, bandy­ing about terms that are, in prin­ci­ple, quan­ti­fied aggre­gates of man­i­fest­ly intan­gi­ble, impre­cise­ly defined the­o­ret­i­cal objects like “aggre­gate demand,” “eco­nom­ic growth,” and “mon­ey” (not just cur­ren­cy), none of which can be mea­sured very accu­rate­ly, even if they are defined. Then they make step­wise argu­ments involv­ing causal­i­ty from one aggre­gate to anoth­er, like “an increase in mon­ey increas­es aggre­gate demand.” These feel to me like either ver­bal­ly con­struct­ed tau­tolo­gies, or over­sim­pli­fi­ca­tions of a more com­plex process.

For exam­ple in one of the most enlight­en­ing blog entries that I found dis­cussing the Krug­man-Keen debate, writ­ten by a Uni­ver­si­ty of Mass­a­chu­setts grad­u­ate stu­dent named Josh Mason, Mason actu­al­ly tries – I say “tries;” I do not think he suc­ceed­ed – to clar­i­fy what “aggre­gate demand” real­ly means. Is the ortho­dox view that aggre­gate demand is the same thing as aggre­gate income? Not quite, Mason says: “The ques­tion, as always, is which way causal­i­ty runs. The term ‘aggre­gate demand’ is short­hand for the argu­ment that causal­i­ty runs from aggre­gate expen­di­ture to aggre­gate income, where­as pre-Key­ne­sian ortho­doxy held that causal­i­ty ran strict­ly from income to expen­di­ture.”

But sure­ly causal­i­ty doesn’t only run one way. This was George Soros’s insight in the con­cept he calls “reflex­iv­i­ty;” in Soros’s appli­ca­tion, this means that the price implied bypro­ject­ed future earn­ings for an invest­ment can also be a cause of those earn­ings. Causal­i­ty runs both ways, com­pli­cat­ing the rela­tion­ship.

I am par­tic­u­lar­ly baf­fled by these debates, because my back­ground is in pure math­e­mat­ics. Eco­nom­ics pre­tends to be math­e­mat­ics, but it is not math­e­mat­ics. There is a major dif­fer­ence. No math­e­mati­cian uses a term in a for­mu­la, or a state­ment of a the­o­rem, unless that term has first been defined with excru­ci­at­ing pre­ci­sion. Hence, there is no ques­tion of what the term means, let alone any debate that is car­ried on only because two dis­putants have dif­fer­ent con­cepts of the mean­ing of their terms. As a result, a very sim­ple proof of some­thing will invari­ably per­suade the oth­er side. The cost of this, how­ev­er, is that math­e­mat­ics is strict­ly lim­it­ed in what it can define and prove.

In eco­nom­ics, it is com­plete­ly dif­fer­ent. Terms are used in for­mu­las with­out ever hav­ing been pre­cise­ly defined. Econ­o­mists may think they’ve defined them, but they should try read­ing some real math­e­mat­ics to see what a pre­cise def­i­n­i­tion tru­ly is. The econ­o­mists, I think, leave the work of def­i­n­i­tion to be inferred from the way the terms are used in the for­mu­las. This, to me, is weird – but I sup­pose it could work, and it does work some­times, but more often it leads to ridicu­lous debates that leave mat­ters of real impor­tance unex­am­ined.

That seems to be the case in the Keen-Krug­man face­off. The most cen­tral terms – infla­tion and GDP – are so rid­dled with mea­sure­ment prob­lems that they are almost arbi­trary fic­tions, a real­i­ty with which no one ever grap­ples. There is nev­er so much as a nod to the fact that a large body of intel­li­gent peo­ple believe that eco­nom­ic growth, by math­e­mat­i­cal neces­si­ty, can­not con­tin­ue for­ev­er, or even for long – yet efforts to define clear­ly enough what “eco­nom­ic growth” means in order to close the gap with this exter­nal (and some­times inter­nal) body of thought are rarely seen in debates among econ­o­mists.

Under­stand­ing Min­sky in com­mon-sense terms

I think eco­nom­ics often becomes clear­er if you dis­dain the abstrac­tions and think in more ordi­nary terms.

The econ­o­mist Ran­dall Wray, a dis­ci­ple of Min­sky, makes things a lit­tle clear­er by point­ing out that Min­sky said that any­body can cre­ate mon­ey out of thin air, by loan­ing to some­one else. That at least gets us to stop think­ing that we can only dis­cuss aggre­gates of ill-defined mon­e­tary units medi­at­ed by insti­tu­tions.

As an exper­i­ment, I tried think­ing about it this way. Sup­pose there is a com­mu­ni­ty in which some par­tic­u­lar­ly well-respect­ed per­son – let’s call her Ms. X – is not only held to have high cred­i­bil­i­ty, but is also assumed to have a sig­nif­i­cant wealth, or access there­to.

Ms. X lends her cred­i­bil­i­ty – not to say, some­times, explic­it­ly her cred­it – to numer­ous peo­ple in the com­mu­ni­ty in whom she believes. Her hon­or and sense of respon­si­bil­i­ty are of such a high order that she tends to com­mand these same qual­i­ties in oth­ers. Hence, her cred­i­bil­i­ty and/or cred­it tend to rub off on, and to be extend­ed to, any­one for whom she vouch­es – and she vouch­es for many peo­ple.

Hence, for exam­ple, an inno­v­a­tive writer of children’s books wish­es to try cre­at­ing a line of books using spe­cial­ized exper­tise that can be pro­vid­ed by an arts and crafts sup­pli­er in the com­mu­ni­ty. Ms. X rec­om­mends the book writer to the arts and crafts sup­pli­er, vouch­ing that the book writer is some­one whom Ms. X esteems and stands behind. The book writer asks the sup­pli­er to pro­vide cer­tain mate­ri­als and exper­tise to facil­i­tate her inno­va­tion.

These agree­ments or col­lab­o­ra­tions can be cement­ed through loan agree­ments, with Ms. X as coun­ter­sign­er or exten­der of cred­it, or mere­ly through a tac­it under­ly­ing pre­sump­tion of Ms. X as guar­an­tor, in cash or in kind. After all, aren’t all exchanges and col­lab­o­ra­tions some com­bi­na­tion of exten­sions both of cred­it in strict mon­e­tary terms, as well as in the broad­er sense – the sense mean­ing trust or expec­ta­tions of even­tu­al com­pen­sato­ry treat­ment?

The point is that, with the gen­er­al lev­el of cred­it extend­ed by Ms. X to many peo­ple, eco­nom­ic activ­i­ty will no doubt increase. “Aggre­gate demand” will increase. “Mon­ey” will increase. These state­ments are true not because they are true in some quan­ti­ta­tive sense, but because they are true qual­i­ta­tive­ly – the degree to which the eco­nom­ic activ­i­ty, the aggre­gate demand, and even the “mon­ey” all increase could prob­a­bly be mea­sured, after a fash­ion, but it would be very approx­i­mate.

The source of all the con­fu­sion, in my view, is the idea that if you can’t mea­sure some­thing and mod­el it math­e­mat­i­cal­ly, it has no mean­ing. There is too much math­e­mat­ics used and expect­ed in eco­nom­ics, and too much of it is of poor qual­i­ty and dis­torts the ideas it is meant to under­gird. Keen agrees. “If you’re actu­al­ly aware of the lim­i­ta­tions of math­e­mat­ics, you say, ‘Well, this is a guide, but I could have missed some­thing,’” he told me. “So there’s more mod­esty in a prop­er non-equi­lib­ri­um dynam­ic mod­el­ing approach than you’ll ever get out of neo­clas­si­cal equi­lib­ri­um mod­el­ing.”

To go on with the Ms. X anal­o­gy, the eco­nom­ic growth that her spread­ing trust engen­ders is del­i­cate. If she overex­tends – if she stands behind more peo­ple than she can actu­al­ly back up, or if she has mis­cal­cu­lat­ed the trust­wor­thi­ness or cred­i­bil­i­ty of some of her mentees – her own cred­i­bil­i­ty – and through her, theirs – may suf­fer ero­sion. You can see how things could col­lapse quick­ly. This is, I believe, a sim­ple ver­sion of the Min­sky finan­cial insta­bil­i­ty hypoth­e­sis.

This sim­ple nar­ra­tive con­firms that cre­at­ing “cred­it” in the broad sense – trust and con­fi­dence in your trad­ing part­ners and col­lab­o­ra­tors – can help spawn eco­nom­ic activ­i­ty, though it can also cre­ate a cred­it bub­ble that can break. But if the sole and entire pur­pose of this exer­cise were to get it put into for­mu­las, you can see how you might lose a lot of the tex­ture. Per­haps it’s pos­si­ble, but if you do it too soon, and too impre­cise­ly, you’ll cre­ate a Babel in which peo­ple fight over the for­mu­las, instead of over what’s actu­al­ly going on.

Michael Edesess is an accom­plished math­e­mati­cian and econ­o­mist with expe­ri­ence in the invest­ment, ener­gy, envi­ron­ment and sus­tain­able devel­op­ment fields. He is a Vis­it­ing Fel­low at the Hong Kong Advanced Insti­tute for Cross-Dis­ci­pli­nary Stud­ies, as well as a part­ner and chief invest­ment offi­cer of Den­ver-based Fair Advi­sors. In 2007, he authored a book about the invest­ment ser­vices indus­try titled The Big Invest­ment Lie, pub­lished by Berrett-Koehler.

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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.