The crisis in economics & economic theory

1. The crisis in economics & economic theory Steve Keen University of Western Sydney Debunking Economics www.debtdeflation.com/blogs www.debunkingeconomics.com

2. Macroeconomics Before the Crisis: Triumphalism • “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.”(Lucas2003)

3. Macroeconomics Before the Crisis: Triumphalism • “As it turned out, the low-inflation era of the past two decades has seen not only significant improvements in economic growth and productivity • but also a marked reduction in economic volatility, both in the United States and abroad, a phenomenon that has been dubbed “the Great Moderation”. • Recessions have become less frequent and milder, and quarter-to-quarter volatility in output and employment has declined significantly as well. • The sources of the Great Moderation remain somewhat controversial, but as I have argued elsewhere, there is evidence for the view that improved control of inflation has contributed in important measure to this welcome change in the economy.” (Bernanke 2004)

4. Macroeconomics Before the Crisis: Triumphalism • “there has been enormous progress and substantial convergence… • Facts have a way of eventually forcing irrelevant theory out (one wishes it happened faster), and good theory also has a way of eventually forcing bad theory out. • The new tools developed by the New-Classicalscame to dominate. • The facts emphasized by the New-Keynesians forced imperfections back in the benchmark model. A largely common vision has emerged… • The state of macro is good…” (Blanchard 2008, 2009) • Published as working paper 1 year after crisis began!

5. And then there was an exogenous shock… • To “The Great Contraction” • From “The Great Moderation”… • & “The Jobless Recovery”

6. Macroeconomics After the Crisis: Evasion • “These models were designed to describe aggregate economic fluctuations during normal times when markets can bring borrowers and lenders together in orderly ways, not during financial crises and market breakdowns.” (Sargent in Rolnick 2010) • “Are … standard macroeconomic models … significantly flawed? I think the answer is a qualified no… • 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.” (Bernanke 2010) • “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)

7. Macroeconomics After the Crisis: Evasion • Permanently negativerandom exogenous shocks?… • “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; see also McKibbin and Stoeckel 2009)

8. Monetary Macroeconomic Realism • Non-neoclassical economic realism: • Endogenous crisis, not exogenous shock • Growth of private debt caused “Great Moderation” • Slowdown in growth of debt caused “Great Recession” • Crisis will continue until deleveraging ends • Neoclassical macro incapable of analysing these factors • Key problem: blindsided by “exogenous money” fallacy…

9. The exogenous money fallacy • Individuals/companies have two sources of spending: • Income • Increase in debt • Neoclassical theory counts the first, ignores the second • Debt transfers money from saver to borrower • Only distribution of debt matters, not aggregate level • Fisher's “Debt Deflation” theory ignored: • “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 … pure redistributions should have no significant macro-economic effects…” (Bernanke 2000)

10. The exogenous money fallacy • “Ignoring the foreign component, or looking at the world as a whole, the overall level of debt makes no difference to aggregate net worth—one person's liability is another person's asset… • In what follows, we begin by setting out a flexible-price endowment model in which “impatient” agents borrow from “patient” agents, but are subject to a debt limit.” (Krugman and Eggertsson2010) • “the debt we create is basically money we owe to ourselves, and the burden it imposes does not involve a real transfer of resources. • That’s not to say that high debt can’t cause problems — it certainly can. But these are problems of distribution and incentives, not the burden of debt as is commonly understood.” (Krugman 2011)

11. The exogenous money fallacy • Patient lends to Impatient • Patient’s spending power goes down • Impatient’s spending power goes up • No change in aggregate demand • Banks mere intermediaries (ignored in analysis)

12. The endogenous money reality • Logically & Empirically false • Lending is not “transfer from saver to borrower” • But money creation “out of nothing” • “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… • This method of obtaining money is the creation of purchasing power by banks… • 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) • New debt net source of new investment & speculation

13. Actual “endogenous money” process • Entrepreneur approaches bank for loan • Bank grants loan & creates deposit simultaneously • Alan Holmes, Senior V-P, New York Fed • “In the real world, banks extend credit, creating deposits in the process, and look for the reserves later.” (1969) Assets Liabilities • New loan puts additional spending power into circulation • Aggregate demand exceeds demand from income alone • Neoclassical macro wrong to ignore change in debt

14. “Endogenous money” changes everything • Explains why dynamics of debt caused boom and bust • Aggregate demand = Income + Change in Debt • Income (mainly) finances consumption • Change in debt (mainly) finances: • Investment (new factories, innovation) • Speculation (gambling on asset prices) • Spent on • New goods and services (the real economy) • Financial claims on existing assets (the FIRE economy) • Call this Net Asset Turnover: • Price of assets (DJIA, Case-Shiller Index) • Times quantity (Number of shares, houses) • Annual turnover (% sold each year)

15. “Endogenous money” changes everything • Aggregate accounting balance is not “Walras’ Law” • “Aggregate Demand is Aggregate Supply” • But “Walras-Schumpeter-Minsky Law” • Income + Change in Debt = GDP + NAT • Growth accounting balance is • Change in Income; • Plus Acceleration in Debt (Change in the change…) • Equals • Change in GDP plus • Change in NAT • Most of which is Change in Share & House Prices

16. “Endogenous money” changes everything • Basic Logic: Debt asset prices change in drives acceleration

17. “Endogenous money” changes everything • Since accelerating debt causes asset price bubbles • Bubbles must burst, because acceleration must end • Just like a car can’t accelerate forever • At maximum velocity, acceleration is zero • Applying this to: • Why the economy boomed from 1993-2007 • Why it crashed in 2007 • Why asset markets crashed as well

18. Boom & Bust: debt-charged growth & collapse • Rising private debt boosted demand by $4 trillion at peak • Falling debt cut demand by $2.8 trillion at trough • From $18.3 to $11.5 trillion in just 2 years

19. Partial Government Rescue • Government debt also creates money • “Fiat” rather than Credit • Government deficit partially offset private deleveraging • From $18.7 to $13 trillion in 2 years • Without government deficit, aggregate demand would be • $1 trillion lower • $300 billion less than GDP • Politicians obsess on government debt, but…

20. Partial Government Rescue • Rise in government debt 30% GDP • Dwarfed by 47% fall in private debt

21. “The Great Recession” • Fall in debt-financed demand drove unemployment

22. “The Great Recession” • Acceleration drives change in unemployment

23. Stock market boom and bust • Debt acceleration drives asset prices—up and down

24. Housing bubble and bust • More obvious for mortgage debt & house prices:

25. From facts to theory… • Neoclassical failure to foresee crisis inevitable: • “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… • A model that rules out pathologies by definition is unlikely to help.’”(Solow [Nobel Prize Winner!] in 2003)

26. Towards a monetary macroeconomics • All methodological choices of neoclassical macro wrong: • Disequilibrium & dynamics, not equilibrium & statics • Social classes, not isolated individuals • Money not barter • Foundations: Marx, Schumpeter, Sraffa, Keynes, Fisher, Kalecki, Minsky, Goodwin, Graziani • Integrated in Minsky’s Financial Instability Hypothesis • Focus: a model that can generate a Great Depression: • Anything else isn’t a model of capitalism

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

28. The Financial Instability Hypothesis • Economy in historical time • Debt-induced recession in recent past • Firms and banks conservative re debt/equity, assets • Only conservative projects are funded • Recovery means most projects succeed • Firms and banks revise risk premiums • Accepted debt/equity ratio rises • Assets revalued upwards… • “Stability is destabilising” • Period of tranquility causes expectations to rise… • Self-fulfilling expectations • Decline in risk aversion causes increase in investment • Investment expansion causes economy to grow faster • Rising expectations leads to “The Euphoric Economy”…

29. The Financial Instability Hypothesis • Asset prices rise: speculation on assets profitable • Increased willingness to lend increases money supply • Money supply endogenous, not controlled by CB • Riskier investments enabled, asset speculation rises • The emergence of “Ponzi” financiers • Cash flow less than debt servicing costs • Profit by selling assets on rising market • Interest-rate insensitive demand for finance • Rising debt levels & interest rates lead to crisis • Rising rates make conservative projects speculative • Non-Ponzi investors sell assets to service debts • Entry of new sellers floods asset markets • Rising trend of asset prices falters or reverses

30. The Financial Instability Hypothesis • Boom turns to bust • Ponzi financiers first to go bankrupt • Can no longer sell assets for a profit • Debt servicing on assets far exceeds cash flows • Asset prices collapse, increasing debt/equity ratios • Endogenous expansion of money supply reverses • Investment evaporates; economic growth slows • Economy enters a debt-induced recession • Back where we started... • Process repeats once debt levels fall • But starts from higher debt to GDP level • Final crisis where debt burden overwhelms economy • Modeling Minsky…

31. Keen 1995 Model Foundations: Nonlinear dynamics • Growth Cycle model (Goodwin 1967, Blatt 1983) • Capital K determines output Y via the accelerator: • Y determines employment L via productivity a: • L determines employment rate l via population N: • l determines rate of change of wages w via Phillips Curve • Integral of w determines W (given initial value) • Y-W determines profits P and thus Investment I… • Closes the loop:

32. Modelling Minsky & Endogenous Money… • Goodwin model: • Debt essential element to introduce Minsky • For debt, essential that capitalists wish to invest more than they earn • “Debt seems to be the residual variable in financing decisions. Investment increases debt, and higher earnings tend to reduce debt.” (Fama & French 1997) • “The source of financing most correlated with investment is long-term debt… These correlations confirm the impression that debt plays a key role in accommodating year-by-year variation in investment.” (Fama & French 1998)

33. Modelling Minsky & Endogenous Money… • Results in 3-dimensional system: Wages share of output Employment ratio Debt to output ratio • Equilibrium of system locally stable but globally unstable • “Inverse tangent” route to chaos

34. Sensitive dependence on initial conditions.. • Outcome depends on initial conditions: • Close to equilibrium, convergence; • Far from equilibrium, divergence into debt-induced depression:

35. Sensitive dependence on initial conditions.. • Debt dynamics behind very different outcomes: • 1995 model included Government as “homeostatic stabilizer” • Current work—converting to strictly monetary model

36. Theoretical dynamics of debt: Minsky + Circuit • Monetary model of capitalism built from combination of: • Goodwin’s growth cycle • Minsky’s Financial Instability Hypothesis • Circuit theory of endogenous money creation • Product: “Monetary Circuit Theory”—MCT • Graziani, Circuit Theory • “any monetary payment must therefore be a triangular transaction, involving at least three agents, the payer, the payee, and the bank. Real money is therefore credit money.” (Graziani, 1989, p. 3) • Strictly monetary model developed from double-entry bookkeeping

37. Explicitly Monetary Minsky Model • Input financial relations in Table: • System of dynamic equations derived automatically: • Illustrating this in Mathcad…

38. Explicit Money Minsky Model • Strictly monetary macro model developed • Linked to production via • nonlinear investment, lending & debt repayment functions • Dynamic pricing equation • Generalized (3 factor) “Phillips curve” • As in original Phillips papers but ignored by neoclassicals • Complex nonlinear dynamic system results… Full 11-equation ODE system in Mathcad…

39. Explicitly Monetary Minsky Model • New monetary macroeconomics can explain the crisis

40. Multi-sectoral extension • Extended to multiple sectors with • Input-output relations in financial flows table • Replicated “Goodwin” cycle model of production • Currently implemented as multiple columns in 2D matrix • Objective: represent as multidimensional “hypercube”

41. Multi-sectoral extension • Generates multi-sectoral limit cycle

42. Multi-sectoral extension • Financial and income distribution dynamics: • Reforming economics • Accessible monetary macroeconomics with Minsky

43. A new tool for dynamic macroeconomics • Economists still practicing “comparative statics” • “[We] were doing comparative statics… there are a variety of problems in economics … where you want to understand how some kind of shock will affect some equilibrating variable… • It’s often helpful to do the analysis in two stages. First, you ask how some desired quantities would change holding the equilibrating variable constant; then you ask how that variable has to change to restore equilibrium…” (Paul Krugman 2012) • Useless technique for non-equilibrating real world • Need to get new students to do dynamics instead • But current tools unsuitable for economics…

44. Minsky: dynamic monetary modelling • E.g., monetary flow model in Vissim: • Same model in bookkeeping format: • Enter “Minsky” • Melding systems dynamics with accounting

45. Minsky: dynamic monetary modelling • And accounting… • Very early prototype (Tcl/Tk) • But can do flowchart modelling… • Ambition: economic equivalent of meteorological modelling…

46. Minsky: dynamic monetary modelling • Table becomes Hypercube • Twist one way—multiple sectors • Twist the other—multiple banks • Multiple tables: trade & finance flows between national economies • There’s just one more thing… We need help!!!

47. Minsky: dynamic monetary modelling • First INET Grant ($128K) runs out July 2012 • Were going to apply for ARC Linkage Grant $500K • INET agreed to pay $40K p.a. to this • Last year 2 rounds, 1st round funding by August • Jan 10th 2012 ARC says 1 round only funding July 2013! • We need $ to keep single programmer going till then • INET will provide $40K if we get additional funding • Coding assistance in GPL project • Assistance in both respects needed

48. Deleveraging for … 2 decades? • At current rate, get to 1970 debt level by 2025 It won’t be a smooth ride down…

49. Volatility rules • It hasn’t been—and won’t be—a smooth ride down…

50. Acceleration Dynamics • Why they’re weird… • Why asset markets lead… • Velocity: addition to aggregate demand • Acceleration • Change in aggregate demand • Change in asset prices As velocity falls Peak Acceleration Peak Velocity Acceleration rises