An outbreak of communication

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Any­one who has been moti­vat­ed to read eco­nom­ics for the very first time by the eco­nom­ic cri­sis that began in 2007 should have real­ized at least one thing: that com­mu­ni­ca­tion between econ­o­mists resem­bles the Tow­er of Babel after the con­found­ing of tongues. Econ­o­mists who speak in one tongue hear what those in anoth­er say, but com­plete­ly fail to under­stand it—and then shout back some­thing that is just as incom­pre­hen­si­ble to the oth­ers’ ears.

So I hap­pi­ly doff my cap here to Nick Rowe, who con­tributes to the “Worth­while Cana­di­an Ini­tia­tive” blog, for tak­ing us from the Tow­er of Babel to the Roset­ta Stone. In a blog post enti­tled “What Steve Keen is maybe try­ing to say”, he very accu­rate­ly trans­lat­ed what I have been say­ing about the role of pri­vate debt in aggre­gate demand into lan­guage that Neo­clas­si­cal econ­o­mists can under­stand.

In fact, Nick did bet­ter than that: my argu­ment is reg­u­lar­ly accused of vio­lat­ing account­ing iden­ti­ties, and Nick showed that—as he for­mu­lat­ed it—my argu­ment respect­ed account­ing iden­ti­ties.

My argument—which I’ll state here in its untrans­lat­ed form, sub­ject to all the usu­al crit­i­cisms of dou­ble-count­ing and vio­lat­ing account­ing identities—is that effec­tive demand is the sum of income plus the change in debt. The con­ven­tion­al case—which is accept­ed across sev­er­al eco­nom­ic tongues, includ­ing many in the Post Key­ne­sian school with which I’m nor­mal­ly associated—is that aggre­gate demand is aggre­gate income, and debt does­n’t come into it. My approach leads me to expect sig­nif­i­cant causal rela­tion­ships between changes in pri­vate debt and the lev­el of eco­nom­ic activ­i­ty. Neo­clas­si­cal econ­o­mists, on the oth­er hand, gen­er­al­ly argue that changes in pri­vate debt amount to “pure redis­tri­b­u­tions [which] should have no sig­nif­i­cant macro-eco­nom­ic effects…” (Bernanke 2000, p. 24)

Nick­’s trans­la­tion of my argu­ment was as fol­lows:

Aggre­gate actu­al nom­i­nal income equals aggre­gate expect­ed nom­i­nal income plus amount of new mon­ey cre­at­ed by the bank­ing sys­tem minus increase in the stock of mon­ey demand­ed.

Noth­ing in the above vio­lates any nation­al income account­ing iden­ti­ty.

As I com­ment­ed on Nick­’s blog, I’m 100% hap­py with this trans­la­tion. Nick con­tin­ued with a sto­ry of agent behav­iors and expec­ta­tions to explain his trans­la­tion:

Here’s the intu­ition:

Start with aggre­gate planned and actu­al and expect­ed income and expen­di­ture all equal. Now sup­pose that some­thing changes, and every indi­vid­ual plans to bor­row an extra $100 from the bank­ing sys­tem and spend that extra $100 dur­ing the com­ing month. He does not plan to hold that extra $100 in his chequing account at the end of the month (the quan­ti­ty of mon­ey demand­ed is unchanged, in oth­er words). And sup­pose that the bank­ing sys­tem lends an extra $100 to every indi­vid­ual and does this by cre­at­ing $100 more mon­ey. The indi­vid­u­als are bor­row­ing $100 because they plan to spend $100 more than they expect to earn dur­ing the com­ing month.

Now if the aver­age indi­vid­ual knew that every oth­er indi­vid­ual was also plan­ning to bor­row and spend an extra $100, and could put two and two togeth­er and fig­ure out that this would mean his own income would rise by $100, he would imme­di­ate­ly revise his plans on how much to bor­row and spend. Under full infor­ma­tion and ful­ly ratio­nal expec­ta­tions we could­n’t have aggre­gate planned expen­di­ture dif­fer­ent from aggre­gate expect­ed income for the same com­ing month.

But maybe the aver­age indi­vid­ual does not know that every oth­er indi­vid­ual is doing the same thing. Or maybe he does know this, but thinks their extra expen­di­ture will increase some­one else’s income and not his. Aggre­gate expect­ed income, which is what we are talk­ing about here, is not the same as expect­ed aggre­gate income. The first aggre­gates across indi­vid­u­als’ expec­ta­tions of their own incomes; the sec­ond is (some­one’s) expec­ta­tion of aggre­gate income. It would be per­fect­ly pos­si­ble to build a mod­el in which indi­vid­u­als face a Lucasian sig­nal-pro­cess­ing prob­lem and can­not dis­tin­guish aggregate/nominal from indi­vid­ual-speci­fic/re­al shocks.

So at the end of the month the aver­age indi­vid­ual is sur­prised to dis­cov­er that his income was $100 more than he expect­ed it to be, and that he has $100 more in his chequing account than he expect­ed to have and planned to have. This means the actu­al quan­ti­ty of mon­ey is $100 greater than the quan­ti­ty of mon­ey demand­ed. And next month he will revise his plans and expec­ta­tions because of this sur­prise. How he revis­es his plans and expec­ta­tions will depend on whether he thinks this is a tem­po­rary or a per­ma­nent shock, which has its own sig­nal-pro­cess­ing prob­lem. And these revised plans may cre­ate more sur­pris­es the fol­low­ing month.

Nick also real­ized some­thing which is quite cru­cial: that this is an argu­ment about an econ­o­my in dis­e­qui­lib­ri­um:

We are talk­ing about a Hayekian process in which indi­vid­u­als’ plans and expec­ta­tions are mutu­al­ly incon­sis­tent in aggre­gate. We are talk­ing about a dis­e­qui­lib­ri­um process in which peo­ple’s plans and expec­ta­tions get revised in the light of the sur­pris­es that occur because of that mutu­al incon­sis­ten­cy.

Nick­’s trans­la­tion of my argu­ment into terms that Neo­clas­si­cal econ­o­mists (and accoun­tants) can under­stand could lead to some sig­nif­i­cant changes in eco­nom­ics from that school. Cer­tain­ly, it pro­vides a way to inter­pret phe­nom­e­na like those high­light­ed in Fig­ure 1—the extreme­ly high cor­re­la­tion between changes in pri­vate debt and the lev­el of eco­nom­ic activity—which are oth­er­wise anom­alies if changes in debt are “pure redis­tri­b­u­tions” as Bernanke argued.

Fig­ure 1: Change in pri­vate debt & unemployment–correlation ‑0.9

This may be dif­fi­cult to achieve, since as Nick not­ed this is a dis­e­qui­lib­ri­um argu­ment, and Neo­clas­si­cal eco­nom­ics is tra­di­tion­al­ly couched in terms of equi­lib­ri­um process­es. But I cer­tain­ly hope that it does lead to a changed appre­ci­a­tion of the role of banks, debt and mon­ey in Neo­clas­si­cal eco­nom­ics. After all, it’s progress towards real­ism that mat­ters in eco­nom­ics, far more so than who achieves it.

I’ll close by thank­ing Nick once more for mov­ing us fur­ther down the path towards real­ism, and away from Babel.

Short­ly I’ll pro­vide a fol­low-up to Nick­’s post that puts the argu­ment about the role of change in debt in effec­tive demand into math­e­mat­i­cal form. Warning—it will def­i­nite­ly qual­i­fy for an “extra-super-wonk­ish” award.

Bernanke BS. 2000. Essays on the Great Depres­sion. Prince­ton: Prince­ton Uni­ver­si­ty Press.



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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.