Steve Keen, an associate professor at the University of Western Sydney, is well known for his attempts to highlight the failings of classical economics, as evidenced in, say, modern portfolio theory (MPT) and the Capital Assets Pricing Model (CAPM). His arguments are many, subtle and various, and also quite often blindingly straightforward. He takes issue with Milton Friedman’s well known axiom, known as instrumentalism, that it does not matter if an economic theory’s underlying assumptions are unrealistic provided its results are realistic. (It’s a complicated world and the economic model has to start somewhere…)
To many readers this might sound like Keen is engaged in yet another internecine battle between economists (yawn), of which the world has seen many, and few of which have ultimately proved to be of much lasting interest to anyone outside the rarified atmosphere of university economics departments. That would, I humbly submit, be a wrong judgement to make. We live in very interesting times and the turmoil in the global economy in general, and the US economy in particular, has given a senior economist like Ben Bernanke a Heaven-sent chance to experiment in a real world laboratory on a scale that academic economists can only wonder at.
So far, Bernanke’s experiments, though undertaken on a grand scale and at a cost in magnifying US debt that have many clutching their heads, have not had the effects he was seeking. Keen explains his take on why Bernanke is meeting with such little success in his recent blog, “What Bernanke doesn’t understand about deflation”. It is a hugely worthy piece and is already being widely read and quoted.
What Bernanke—and other neoclassical economists—are blind to, Keen argues, is private sector deleveraging, which is now taking place on a massive scale in the US and in Europe. They are blind to it because, in their economic model of how the world works, it is axiomatic that when money moves from a creditor to a debtor it adds nothing to the overall equation. There’s still the same amount of money in the system. So the neoclassical economist looks at the fact that people took on too much debt and are now getting themselves out of debt as fast as they can, any way they can, notes it as a phenomenon, and then looks past it to something else. For Keen, there is now something else:
“Debt reduction is now the real story of the American economy, just as real story behind the apparent free lunch of the last two decades was rising debt. The secret that has completely eluded Bernanke is that aggregate demand is the sum of GDP plus the change in debt. So when debt is rising demand exceeds what it could be on the basis of earned incomes alone, and when debt is falling the opposite happens.”
Keen redefines aggregate demand in a way that conflates commodity markets and asset markets, an act that would make a neoclassical economist stare blankly into the distance. For him, aggregate demand…
“…is the sum of expenditure on goods and services, PLUS the net amount of money spent buying assets (shares and property) on the secondary markets. This expenditure is financed by the sum of what we earn from productive activities (largely wages and profits) PLUS the change in our debt levels. So total demand in the economy is the sum of GDP plus the change in debt.”
The nub of Keen’s redefinition is that Bernanke is using billions of dollars to fight trillions of dollars going in what, for him, is the wrong direction. When a billion going in one direction meets a trillion going in the opposite direction it just gets washed away like it wasn’t there. As Keen notes:
“In the years from 1987, when Greenspan first rescued the financial system from its own follies, till 2009 when the US hit Peak Debt, the US private sector added $34 trillion in debt. Over the same period, the USA’s nominal GDP grew by a mere $9 trillion.
Ignoring this growth in debt—championing it even in the belief that the financial sector was being clever when in fact it was running a disguised Ponzi Scheme—was the greatest failing of the Federal Reserve and its many counterparts around the world.
Though this might beggar belief, there is nothing sinister in Bernanke’s failure to realize this: it’s a failing that he shares in common with the vast majority of economists. His problem is the theory he learnt in high school and university that he thought was simply “economics”—as if it was the only way one could think about how the economy operated. In reality, it was “Neoclassical economics”, which is just one of the many schools of thought within economics.”
So, here’s $34 trillion coming at ya, Ben… Contrary to Bernanke’s belief, private debt does matter and when there is so much of it to “deleverage” the only thing to do is to recognise that you just do not have the resources available to put up as a countervailing force. The US economy has to contract and trying to reflate it and pretend that the US is not headed for, and indeed, actually, already in, a Depression (with a capital “D”) is simply exacerbating the problem.
Despite this alleged “blindness” Bernanke and Keen are at one, unsurprisingly, on the view that it would be incredibly jolly if the US consumer were to jump out of bed tomorrow and say, “By Jingo, I feel like spending again! Stuff this deleveraging lark…”
Here’s an excerpt from Bernanke’s “Jackson Hole” speech which Keen was reacting to in his blog:
“At best, though, fiscal impetus and the inventory cycle can drive recovery only temporarily. For a sustained expansion to take hold, growth in private final demand–notably, consumer spending and business fixed investment–must ultimately take the lead. On the whole, in the United States, that critical handoff appears to be under way”
Does it indeed? If Bernanke is right then this will be one of the greatest Houdini tricks in history and he will doubtless retire showered with honours, neoclassical economist or not. I wouldn’t celebrate just yet though…
Further information on the US debt debacle and neoclassical economists
- Why Printing Money Sometimes Works for Central Banks, by Paul Kasriel
- Mixflation, by Giles Keating
- Bernanke’s testimony—A lesson in the perils of forecasting gloom, by Anthony Harrington [blog post]
- Bernanke’s land grab falls flat, by Ian Fraser [blog post]
Tags: Ben Bernanke , Federal Reserve , fiscal stimulus , Milton Friedman , private debt , quantitative easing , sovereign debt , Steve Keen , US