Neat, Plausible, & Wrong: The deluded discipline of economics

Neat, Plausible, & Wrong:The deluded discipline of economics Steve Keen University of Western Sydney Debunking Economics www.debtdeflation.com/blogs www.debunkingeconomics.com www.cfesi.org

The Era of Crises • Crises? What Crises? • Climatic Crisis of Global Warming • Energy Crisis of Peak Oil • Financial Crisis of 2007 • First two “hotly” denied by some • Climate change denialistsvs scientists • Peak Oil Sceptics vs geologists • 3rd undeniable—it’s already happened, and ongoing • If others occur, can’t complain “Why weren’t we warned?” • Numerous warnings by relevant scientists for decades • Climate Change (Keeling 1958; Meadows 1972) • Peak Oil (King Hubbert 1956) • Will occur because advice of professionals ignored

An era of crisis • Economic & Financial Crisis very different • Consensus of economists gave no warning at all • In fact predicted blissful economic future • Crisis occurred because professional advice followed! • How could economics be so wrong? • Discipline holds tenaciously to “Neoclassical” beliefs • Despite logical flaws • Despite empirical failings • Explanation partly ideological • Justifies existing distribution of wealth & power • But unsatisfactory total answer • Most economists deny “ideological” badge • Following advice also destroyed wealth, power • Tenacity of belief has deeper, subtler cause…

Neat, Plausible, and Wrong • “Success” of neoclassical economics in a nutshell: • “Explanations exist; • they have existed for all time; • there is always a well-known solution • to every human problem… • neat, plausible, and wrong” (H. L. Mencken) • Fundamental flaws in theory… • Even manifest empirical failure to predict 2007 crisis… • Ignored because neoclassical theory is “neat & plausible” • To defeat it • “Wrong” has to trump “neat & plausible” • Need “complex, sensible & generally right” alternative • Ambition of “Debunking Economics II” • Wider audience than DE I: neoclassicals as well, because…

A paradoxical but transcendental truth… • Neoclassical economists don’t understand neoclassical economics • Before the Crisis: founding editor of AER: Macro • “The state of macro is good… • “Dynamic Stochastic General Equilibrium” model is… • “simple, analytically convenient, and has largely replaced the IS-LM model as the basic model of fluctuations in graduate courses… • Unlike the IS-LM model, it is formally, rather than informally, derived from optimization by firms and consumers.” (Blanchard 2009)

After the crisis… • “The great moderation lulled macroeconomists and policymakers alike in the belief that we knew how to conduct macroeconomic policy. • The crisis clearly forces us to question that assessment… • It is important to start by stating the obvious, namely, that the baby should not be thrown out with the bathwater…” (Blanchard, Dell'Ariccia et al. 2010) • Wrong: this baby should never have been conceived • Base of DSGE macro is Solow-Ramsey growth model • Yet Solow rejects DSGE models!

Solow rejects DSGE • Robert Solow 2001 • “The prototypical real-business-cycle model goes like this. There is a single, immortal household—a representative consumer—that earns wages from supplying labor. It also owns the single price-taking firm… • This is nothing but the neoclassical growth model… • [When I built it] … It was clear … what I thought it did not apply to, namely short-run fluctuations ... the business cycle... • Now ... an article today [on the] 'business cycle' … will be ... a slightly dressed up version of the neoclassical growth model. • The question I want to circle around is: how did that happen?”

Solow: SMD conditions invalidate DSGE • “Suppose you wanted to defend the use of the Ramsey model as the basis for a descriptive macroeconomics. What could you say? ... • You could claim 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…” (Solow 2008) • Sonnenschein-Mantel-Debreu: demand curve for a single market can have any (polynomial) shape at all • Even study of a single market can’t be reduced to study of a single utility-maximizing agent • Yet Neoclassical DSGE macro models the whole economy as a single utility-maximizing agent

SMD: “Anything goes” for market demand curves • SMD Conditions (Sonnenschein 1973): • Market demand curves do not obey the „Law of Demand“ • Even if summing „well behaved“ individual demand curves Market Friday = + P Crusoe P P q q • Proof by contradiction: • Assume market demand curves do obey Law of Demand • Derive conditions under which this is true • Contradict initial assumption • Therefore they don‘t obey the „Law“ of Demand Q

Market demand curve any polynomial at all • Only way to avoid this: • Assume all consumers have identical tastes • So there is only one consumer! • Assume that tastes don’t change with income • So there is only one commodity! • Contradicts starting assumption: • Two consumers with different tastes • Two different commodities • Proof by contradiction that “Law of Demand” does not apply to market demand curve • How did Neoclassical economists react?…

Should abandon methodological individualism… • A very few reacted rationally: • Alan Kirman 1989 • “If we are to progress further we may well be forced to theories in terms of groups who have collectively coherent behavior. • Thus demand and expenditure functions if they are to be set against reality must be defined at some reasonably high level of aggregation. • The idea that we should start at the level of the isolated individual is one which we may well have to abandon.” • But most reacted irrationally…

Representative agent madness instead • Gorman 1953 • “we will show that there is just one community indifference locus through each point if, and only if, the Engel curves for different individuals at the same prices are parallel straight lines… • The necessary and sufficient condition quoted above is intuitively reasonable. • It says, in effect, that an extra unit of purchasing power should be spent in the same way no matter to whom it is given.” • Intuitively reasonable? • No, it’s intuitively rubbish! • Textbooks reproduced the rubbish…

Textbooks hide SMD results from undergrads • Samuelson and Nordhaus 2010 • “The market demand curve is found by adding together the quantities demanded by all individuals at each price. • Does the market demand curve obey the law of downward-sloping demand? It certainly does…” • A provably false statement misleading undergraduates • Varian 1984 • “it is sometimes convenient to think of the aggregate demand as the demand of some ‘representative consumer’… • The conditions under which this can be done are rather stringent, but a discussion of this issue is beyond the scope of this book…” • A vague statement reassuring PhD students

Macro an “emergent property” • Real meaning of SMD conditions • Macroeconomic behavior an “emergent property” of interaction of agents in a complex system • Cannot deduce behavior of macroeconomy from behavior of utility-maximizing individuals • Cannot reduce macroeconomics to “applied microeconomics” • But that is what DSGE models do! • Fallacy of “Strong Reductionism” • Believe “macroeconomics is applied microeconomics” • But SMD conditions prove otherwise • “macroeconomics cannot be applied microeconomics”

Fallacy of Strong Reductionism • Can’t deduce even market behavior from model of individual behavior • Let alone deduce macro behavior from individual • Common knowledge in real sciences: Anderson, “More is Different”, Science (1972) • The behavior of large and complex aggregates of elementary particles, it turns out, is not to be understood in terms of a simple extrapolation of the properties of a few particles. • Instead, at each level of complexity entirely new properties appear, and the understanding of the new behaviors requires research which I think is as fundamental in its nature as any other.”

Fallacy of Strong Reductionism • “one may array the sciences roughly linearly in a hierarchy, according to the idea: “The elementary entities of science X obey the laws of science Y” • But this hierarchy does not imply that science X is “just applied Y”. At each stage entirely new laws, concepts, and generalizations are necessary, requiring inspiration and creativity to just as great a degree as in the previous one. Psychology is not applied biology, nor is biology applied chemistry.”

Poor Scholarship basis of neoclassical economics • And “macroeconomics is not applied microeconomics”! • Neoclassical “Strong Reductionism” maintained by: • Poor scholarship; • Poor technique; & • Ideology • Poor scholarship: • Most Neoclassical economists don’t read their own literature but rely upon sanitized textbook version • Act as if theory vindicated • Don’t know that theory contradicted • Lack of knowledge of SMD conditions just one instance of collective neoclassical ignorance of neoclassical economics

Poor Scholarship basis of neoclassical economics • Even Solow shows poor scholarship: • “For a while the dominant framework for thinking about the short run was roughly ‘Keynesian'. • I use that label for convenience; I have absolutely no interest in 'what Keynes really meant'. • To be more specific, the framework I mean is what is sometimes called 'American Keynesianism' as taught to many thousands of students by Paul Samuelson's textbook and a long line of followers.” (Solow 2001) • Yet he wonders why his Growth Model misinterpreted! • Bad Scholarship—DSGE developers didn’t heed his advice about limitations of Neoclassical growth model • Same poor scholarship he applies to Keynes!

Poor Scholarship basis of neoclassical economics • Rabid Neoclassicals even worse—e.g., Lucas & Becker: • “I thought … that people attending the conference might be arguing about Axel Leijonhufvud’s thesis that IS-LM was a distortion of Keynes, but … I’m going to think about IS-LM and Keynesian economics as being synonyms. • I remember when Leijonhufvud’s book came out and I asked my colleague Gary Becker if he thought Hicks had got the General Theory right with his IS-LM diagram. • Gary said, “Well, I don’t know, but I hope he did, because if it wasn’t for Hicks I never would have made any sense out of that damn book.” • That’s kind of the way I feel, too, so I’m hoping Hicks got it right.” (Lucas 2004)

Equilibrium fetish the core neoclassical weakness • But Hicks rejected IS-LM two decades earlier: • A pre-Keynesian model masquerading as Keynes • “that model was already in my mind before I wrote even the first of my papers on Keynes…” • “the only way in which IS-LM analysis usefully survives—as anything more than a classroom gadget … is … where the use of equilibrium methods … is not inappropriate…” (Hicks 1980). • Poor technique as well as poor scholarship: • “Equilibrium fetish” the core problem • Believe equilibrium must be assumed for modelling • Yet dynamic disequilibrium modelling commonplace in all real sciences

Equilibrium fetish the core neoclassical weakness • Today’s dominant PhD textbook by Mas-Colell: • “A characteristic feature that distinguishes economics from other scientific fields is that, for us, the equations of equilibrium constitute the center of our discipline. • Other sciences, such as physics or even ecology, put comparatively more emphasis on the determination of dynamic laws of change. • In contrast, up to now, we have hardly mentioned dynamics. • The reason, informally speaking, is that economists are good (or so we hope) at recognizing a state of equilibrium but poor at predicting how an economy in disequilibrium will evolve.” (Mas-Colell 1995) • Leading policy-making economists just as bad:

Bernanke an “expert” on Great Depression? • No: An expert at developing explanations of Great Depression which are consistent with neoclassical theory • Ignores alternative views: • “Hyman Minsky and Charles Kindleberger have in several places argued for the inherent instability of the financial system but in doing so have had to depart from the assumption of rational economic behavior… • I do not deny the possible importance of irrationality in economic life; however it seems that the best research strategy is to push the rationality postulate as far as it will go.” (Bernanke 2000) • That’s it for Bernanke’s consideration of Minsky!

The Bankruptcy of Neoclassical Economics • Neoclassical theory wrong from first principles: • Treats complex monetary exchange as barter • Assumes macroeconomy is stable • Ignores social class • Treats entire economy a single agent • Despite SMD proof that this can’t be done • Obliterates uncertainty • “Rational” as capacity to foresee the future; • Uses empirically falsified “money multiplier” model of money creation; and • Ignores credit and debt.

A tentative, but not-bankrupt, alternative • A new macroeconomics must do the exact opposite: • Economy as inherently monetary; • Model the economy dynamically; • Social classes rather than isolated agents; • Rational but not prophetic behavior; • Endogenous creation of money by banking sector; and • Credit and Debt have pivotal roles • Starting point: a credit-aware perspective on demand • Not “Walras’ Law” but… • The Walras-Schumpeter-Minsky Law

The Walras-Schumpeter-Minsky Law • Neoclassical belief: Walras’ Law • “Sum of excess demands is zero” • i.e., Aggregate Demand is Aggregate Supply • No role for credit • Empirical reality: credit matters • Even Neoclassicals admit it (but do nothing about it!): • “Introducing money and credit into growth theory in a way that accounts for the cyclical behavior of monetary as well as real aggregates is an important open problem in economics.” (Kydland & Prescott 1990) • Consequence: Walras’ Law incomplete in credit economy…

The Walras-Schumpeter-Minsky Law • Schumpeter Theory of Economic Development, 1934 • “THE fundamental notion that the essence of economic development consists in a different employment of existing services of labor and land … leads us to … heresies … money … performs an essential function, … • From this it follows, therefore, that in real life total credit must be greater than it could be if there were only fully covered credit. The credit structure projects … beyond the existing commodity basis.”

The Walras-Schumpeter-Minsky Law • Minsky, “Can “It” Happen Again”, 1963: • “If income is to grow, the financial markets … must generate an aggregate demand that, aside from brief intervals, is ever rising. • For real aggregate demand to be increasing, . . . it is necessary that current spending plans … be greater than current received income • and that some market technique exist by which aggregate spending in excess of aggregate anticipated income can be financed. • It follows that over a period during which economic growth takes place, at least some sectors finance a part of their spending by emitting debt or selling assets.”

The Walras-Schumpeter-Minsky Law • Endogenous creation of money crucial: • “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) • “during a period of tranquility, … there will be a decline in the value of the insurance that the holding of money bestows. This will lead to both a rise in the price of capital assets and … Ponzi finance. • In this way the financial system endogenously generates at least part of the finance needed by the increased investment demand that follows a rise in the price of capital assets.” (Minsky 1980)

The Walras-Schumpeter-Minsky Law • In credit economy, aggregate demand • includes growth in debt • is spent on both goods (GDP) and existing assets • Aggregate demand consists of: • Expenditure financed by sale of goods (Walras); • + debt-financed entrepreneurial demand (Schumpeter); • + debt-financed Ponzi Finance demand (Minsky) • The Walras-Schumpeter-Minsky Law • Aggregate Demand = GDP + Change in Debt • AD = Income + DDebt = GDP + Net Asset Growth (NAG) • NAG = D(PA * QA * TA) • D AD = D GDP + DDDebt • = DGDP + DNAG

The Walras-Schumpeter-Minsky Law • Private debt 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) • “overall level of debt makes no difference … one person's liability is another person's asset.” (Krugman 2010) • Neoclassicals wrong: private debt matters • 3 factors: Level (compared to GDP), Rate of Change, & Acceleration (Credit Accelerator)

Private Debt and Depressions • Private debt bubbles caused “Roaring Twenties” & “Noughty Nineties” • Bubble burst when level of debt to GDP became extreme • Bursting of bubbles caused Great Depression & Great Recession

Change in Private Debt & Unemployment • Change in Private Debt drives both booms and busts R2=-0.79 R2=-0.96 • Differences Now vs 1920s-30s • Bigger debt-driven boom Now than Then • Business less indebted now, households & finance more • Much bigger/faster Government response to crisis • Faster turnaround in fall in private debt

Credit Accelerator & Turning Points • Great Depression & Great Recession both commenced with collapse in Credit Accelerator R2=-0.50 R2=-0.75 • Recent apparent recovery in US economy largely due to slowdown in rate of decline of private debt—a positive Credit Accelerator (CA) • Trend back to decelerating debt key factor driving US economy & asset markets down

Credit Accelerator & Asset Markets • Asset markets • Bubble when debt accelerates • Crash when it decelerates • Crisis continuing because level of debt unprecedented • “Deleveraging rules”, & will till debt drastically reduced

A 3-headed Hydra: Level, Change & Acceleration • Private debt highest ever and falling rapidly • But rate of decline slowing down • “Phantom recovery” with positive Credit Accelerator

Modeling the dynamics of debt • “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) • Minsky’s alternative: the “Financial Instability Hypothesis”

Minsky’s FIH: dynamic-disequilibrium-debt model • 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

The Euphoric Economy • 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

The Assets Boom and Bust • Ponzi financiers 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 • My work: converting this from verbal description to mathematical model…

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 • Physical side: Goodwin put into mathematical form Marx’s “growth cycle” model in Capital I, Ch. 25: • “The mechanism of the process of capitalist production removes the very obstacles that it temporarily creates. The price of labor falls again to a level corresponding with the needs of the self-expansion of capital, whether the level be below, the same as, or above the one which was normal before the rise of wages took place…”

Keen 1995 Model Foundations: Nonlinear dynamics • Inherently cyclical growth (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:

Monetary Circuit Theory • Basic process of endogenous money creation • Entrepreneur approaches bank for loan • Bank grants loan & creates deposit simultaneously • Alan Holmes, Senior Vice-President New York Fed, 1969: • “In the real world, banks extend credit, creating deposits in the process, and look for the reserves later.” (1969, p. 73) Assets Liabilities • New loan puts additional spending power into circulation • Modeling this using strictly monetary framework:

Explicitly Monetary Minsky Model • Input financial relations in Table: Relax—there are no equations in the book… • System of dynamic equations derived automatically:

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

Debunking Economics 2nd Edition… • For more details:

References • Anderson, P. W. (1972). "More Is Different." Science177(4047): 393-396. • Bezemer, D. J. (2009). ““No One Saw This Coming”: Understanding Financial Crisis Through Accounting Models.” Groningen, The Netherlands, Faculty of Economics University of Groningen. • Blatt, J. M. (1983). Dynamic economic systems : a post-Keynesian approach. Armonk, N.Y, M.E. Sharpe. • Bezemer, D. J. (2010). "Understanding financial crisis through accounting models." Accounting, Organizations and Society 35(7): 676-688. • Clark, J. B. (1898). "The Future of Economic Theory." The Quarterly Journal of Economics13(1): 1-14. • Fama, E. F. and K. R. French (1999). "The Corporate Cost of Capital and the Return on Corporate Investment." Journal of Finance 54(6): 1939-1967. • Fama, E. F. and K. R. French (2002). "Testing Trade-Off and Pecking Order Predictions about Dividends and Debt." Review of Financial Studies 15(1): 1-33. • Friedman, M. (1969). The Optimum Quantity of Money. The Optimum Quantity of Money and Other Essays. Chicago, MacMillan: 1-50. • Goodwin, R. (1967). A growth cycle. Socialism, Capitalism and Economic Growth. C. H. Feinstein. Cambridge, Cambridge University Press: 54-58. • Keen, S. (1995). "Finance and Economic Breakdown: Modeling Minsky's 'Financial Instability Hypothesis.'." Journal of Post Keynesian Economics 17(4): 607-635. • Keen, S. (2011). "A monetary Minsky model of the Great Moderation and the Great Recession." Journal of Economic Behavior & OrganizationIn Press, Corrected Proof. • Kirman, A. (1989). "The Intrinsic Limits of Modern Economic Theory: The Emperor Has No Clothes." Economic Journal 99(395): 126-139.

References • Lucas, R. E., Jr. (1972). Econometric Testing of the Natural Rate Hypothesis. The Econometrics of Price Determination Conference, October 30-31 1970. O. Eckstein. Washington, D.C., Board of Governors of the Federal Reserve System and Social Science Research Council: 50-59. • Lucas, R. E., Jr. (2004). "Keynote Address to the 2003 HOPE Conference: My Keynesian Education." History of Political Economy36: 12-24. • Kydland, F. E. and E. C. Prescott (1990). "Business Cycles: Real Facts and a Monetary Myth." Federal Reserve Bank of Minneapolis Quarterly Review 14(2): 3-18. • Marx, K. and F. Engels (1885). Capital II. Moscow, Progress Publishers. • Minsky, H. P. (1982). Can "it" happen again? : essays on instability and finance. Armonk, N.Y., M.E. Sharpe. • Samuelson, P. A. and W. D. Nordhaus (2010). Microeconomics. New York, McGraw- Hill Irwin. • Schumpeter, J. A. (1934). The theory of economic development : an inquiry into profits, capital, credit, interest and the business cycle. Cambridge, Massachusetts, Harvard University Press. • Shafer, W. and H. Sonnenschein (1993). “Market demand and excess demand functions”. Handbook of Mathematical Economics. K. J. Arrow and M. D. Intriligator, Elsevier. 2: 671-693. • Sonnenschein, H. (1973). "Do Walras' Identity and Continuity Characterize the Class of Community Excess Demand Functions?" Journal of Economic Theory 6(4): 345-354. • Varian, H. R. (1984, 1992). Microeconomic analysis. New York, W.W. Norton.

Neat, Plausible, & Wrong: The deluded discipline of economics