339: Debt, Demand and Neoclassical Confusion

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Dr. Steve Keen

KMO welcomes Steve Keen, author of Debunking Economics back to the C-Realm to discuss the particulars of Steve’s recent blogosphere joust with Paul Krugman. Steve explains that Neoclassical economists, like Krugman, do not include debt, banks, money or energy in their economic models which puts them at a distant remove from the real world systems they are supposed describe and predict. The conversation includes discussion of climate, peak oil, and an economy in which even big energy producers like Chesapeake Energy are more focused on financial speculation than on industrial activity.

 

Music by AllFlaws.

 

Join KMO at the 3rd Full Circle Series Event for a talk by Michael Goodwin, author of Economix: How Our Economy Works (And Doesn’t Work) In Words and Pictures on December 14th, 2012.

  • robert

    Hey KMO,

    Really interesting discussion in this episode, but I confess myself a little disappointed that there was little critical analysis here. You made hay of the fact that Neo-Classical economics doesn’t include banks, et al in it’s models but did you ever consider why? Every model by it’s very nature excludes some things and it’s important to understand why. What for instance does Keen’s model exclude? Would someone like Krugman shake his head similarly toward those exclusions? I think that in the main I agree with Keen’s analysis but without any sort of critical analysis or honest presentation of the different views to just accept it would be little more then an appeal to authority.

    So I read the like you post above and it seems to me that it explains why banks are excluded from Neo-Classical models. This explanation makes it a lot less of a laugh line IMO and to not present it seems disingenuous. In essence this sums it up:

    “While banks and their debt may be important in the greater scheme of things, it matters not what they do or how they lend because a disciplined Fed will always have control of the monetary base.”

    Now again I’m not enough of an expert here to say who’s right in this argument (and again I lean toward Keen) but to just snort derisively that the N-C model doesn’t even include MONEY for gods sake seems a serious disservice. And then what about Keen’s preferred system? I’d like to have heard a lot more about that. The linked article here, which thought Krugman came off to the worst in the Fed v. Debt issue is a lot less charitable toward what they see as Keen’s solution:

    “The debate becomes not “do banks expand the money supply or not?” but “who is really in charge here?” Keen says the banks, Krugman says the Fed/Treasury.

    Keen is wedded to the idea that banks control the monetary base, and thus Fed interference will never be enough to control credit.

    But his very proposals to fix the system essentially endorse an idea that Keen himself opposes: He expects that regulators and laws will prevent the follies that cause financial crises. If we just re-invent the wheel, he argues, we’ll get rid of the “positive feedback loop between rising debt and asset prices” in order to tame the financial system.

    Further, all the evidence points to the idea that the Federal Reserve does indeed control credit conditions in the economy, falling short of preventing credit crises simply because it is an imperfect regulator. That said, the Fed’s actions in the recovery suggest that it has probably mitigated the worst of the recession’s effects”

    • http://c-realm.com KMO

      Hi Robert,

      Thanks for the great comment and feedback. True, I did not challenge Steve Keen at all. I don’t know if you’ve ever seen one of his presentations, but they’re very math-intensive, involve dynamic modelling, and lots of visual reference. When I record a conversation with him, my main objective is to get him to present his ideas in a way that somone without access to his visual presentation can make sense of some of his claims. Most people have no training or experience with economics. I, myself, have no formal training, and most of my understanding comes from reading the books and articles of people whom I interview for this podcast. In short, my goal was to help Steve Keen present communicate his point of view to people who wouldn’t otherwise have been in a position to take it in and integrate it into their existing mental models.

      What do Steve Keen’s models leave out? First, let me say that I don’t claim to understand the math that goes into his simulations. And, like you say, a model by its very nature must leave out most aspects of the world and include only the elements the modeler deems crucial to creating a representation of the world that has explanatory and predictive utility. Neoclassical models do not include banks, money, interest or energy. Steve Keen’s models, as far as I know, also leave out energy, but they do include banks, money and interest.

      Economic models that do not include banks, money, or interest could not have predicted the housing bubble and the economic crisis it precipitated. Banks, looking for a way to generate income from speculating in the capital appreciation of something that everybody needs to live, in this case shelter, started aggressively soliciting home loans to people who would be unlikely to repay the loans. Their plan was bundle the mortgages and then sell shares in the intangible product comprised by those bundled mortgages. The banks said to investors, “All these mortgages represent an income stream from ‘homeowners’ to us the bank. We’d like to sell you a share of that income stream with the respected ratings agencies have certified as AAA reliablle. Because we lent money to the ‘homeowners’ at very high interest rates, they are going to be paying back a much larger amount than we lent to them. This bundle of promises of future repayment constitutes an aseet which will increase in value over time. If you buy a peice of it now, it will be worth more in the future and you will be using your money to make more money.”

      We all know how this worked out, but Neoclassical economists, who do not include banks, debt, or money in their economic models could not even describe, much less predict, the failure mode of this scheme. Steve Keen DID include banks, debt, and money in his models, and he is on record as predicting and accurately describing the failure of this scheme.
      You fault me for not including anything from the article linked to in the show description via the “joust with Paul Krugman’ text link. I had not read that article when I recorded the interview or my opening and closing comments. It’s something I hunted up after the fact as I was writing the description of the finished episode. In fact, I still haven’t read more than the first couple of paragraphs. I just read enough to be confident that it was a relavant source of information for people who wanted to learn more.
      As to your later comments, without making any claim about the effectiveness of the Federal Reserves efforts to mitigate the harm done buy the bursting of this latest bursting of a grand network of speculative bubbles, I will just say that Steve Keen’s point seems very straightforward and obvious to me. Regardless of whether you think banks have the ability to increase the money supply, they do make loans. At times they make a lot of loans with very little scrutiny of the borrows (like before the housing bubble burst). At other times they are very cautious, to the point of denying loans to what look like very reliable borrowers. Here’s the crucial part, as I see it:
      People only borrow money when they need to spend money.
      Nobody borrows money at a high interest rate in order to park it in savings at a lower interest rate. They borrow money to spend immediately on things that they need in order to conduct their business and generate income and hopefully profit. By putting the brakes on lending, banks are putting the brakes on all manner of economic activity, purchases which are routine and necessary for the normal functioning of the economy. When banks switch from free and largely careless patterns of making loans to overly cautious lending practices, they reduce the amount of money moving through the economy, the prevent purchases that would otherwise have taken place and created income for businesses, their owners, investors and employees. In Steve Keen’s words, they destroy demand, and demand destruction means economic contraction.
      Again, I’m not interested in weighing in on the effectiveness of the Fed’s action in response to the collapse of this grand speculative bubble. Given that your final paragraph returns to that topic, I’m inferring that this is a topic of interest to you and one on which you have an opinion. My main interest is to help people understand some of Steve Keen’s arguments (specifically the ones that I think I understand fairly well.) We did not even touch on his proposed solution to the cirsis in this interview, so I’ll say nothing about that.

      • robert

        Hey KMO,

        Thanks for the thorough, well considered response. After posting I felt that I should have perhaps devoted a few more sentences on how much I really dug the episode and the C-Realm in general. In my defense I felt I’d rambled on long enough and tried to be more brief. So thanks for the great work and for taking my comment as I really did intend and not so much as it could have come across. With all the limitations of text it probably is aways worth it to put in the extra space to get across what one is really trying to say in a kind way.

        So I should say that while I am interested in all of this and do read a diverse array of things (I read Krugman when linked to but am not a regular follower, more outsider types also as they come up and of course I’ve gotten a ton of information from your show) economics is tough enough that one can only be so expert without devoting ones life to it. I do understand your style of letting the guests speak for themselves and appreciate how it spurs me on to do further research. I think in this case though that there was so much criticism of the N-C model but we didn’t have a full picture of it that I found it hard to just accept the criticism. I suppose as the dominate model we could be expected to be up on it, but again there’s that lack of expertise. But in my mind to understand a criticism you have to understand what it is that is being criticized. So in my post above I cited some items from the article that you linked that I thought explained some of those questions. I don’t necessarily agree with them, as I said I tend to agree with Keen’s take on all of it. The Fed clearly has pretty limited power and while it should be included in one’s model I think those aspects controlled directly by the banks should be as well.

        The final paragraphs, again quoted from the linked article, was that articles criticism of Keen. The thing about any economic model I wonder if they can correctly model the complexity. I appreciate that Keen mentioned the non-linearity, unstable nature of this as from my perspective that nature of the system. Which means that our understanding is going to be necessarily incomplete. We may understand the fundamentals, but the interactions of them will always be beyond our kin. I am always skeptical of anything that doesn’t embrace the inherent complexity of massive amounts of interacting components whether it be economics or political ideologies.

        As so often is the case with the ‘Realm I ended up doing plenty more research after listening a lot of this assuaged some of my concerns. This article I recommend for those who want to see the numbers, the graphs and the data that Keen uses but with a layman’s approach:

        http://www.peakprosperity.com/blog/straight-talk-steve-keen/47466

        And thanks again KMO; keep up the good work.

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