Should/Could economics have predicted the crisis?
Dr. Steve Keen
www.debtdeflation.com/blogs
https://sourceforge.net/p/minsky/
The crash of 2007/08
• An “unexpected” macroeconomic downturn…
– “the current economic situation is in many ways better than what we
have experienced in years” (OECD, June 2007)
A "Black Swan"?
OECD
OECD
4
1
3
12
3
9
0 0
6
0
2
1
1
3
3
0 0
0
2
1

2
3
3
4
4
6
15
Correlation coefficient
coefficient == 0.98
0.91
Correlation
GDP
Ch ange Change
Employment
GDP Change
Credit
Accelerat ion
6
3
9
6

9
 12
 12

 15
15
5
5

2005
2006
2006.5
20082006
2008.5
2010
1990 2005.5
1992 1994
1996
1998 2007
2000 2007.5
2002 2004
20082009
20102009.5
2012 2014
www.debt deflat ion.com /blogs
Percent
of GPD
GPD p.a.
p.a. p.a.
p.a.
Percent of
Inflation-adjusted
percentp.a.
change p.a.
Percent change
2
5
Debt-driven asset markets too
• Credit acceleration drives economy and asset markets…
M argin acceleration & SP500 Change
2.5
Percent of GDP p.a. p.a.
2
1.5
90
Margin accelerat ion
SP500 Change
Decelerating trend now
75
60
45
1
30
0.5
15
0 0
0
 0.5
 15
1
 30
 1.5
 45
2
 60
 2.5
 75
3
 90
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
www.debt deflat ion.com /blogs
Change p.a.
3
Hubris before the crisis…
• “The Marxian view is that capitalistic economies are inherently unstable
and that excessive accumulation of capital will lead to increasingly
severe economic crises.
• Growth theory, which has proved to be empirically successful, says this
is not true.
• The capitalistic economy is stable, and absent some change in
technology or the rules of the economic game, the economy converges
to a constant growth path with the standard of living doubling every 40
years.” (Prescott 1999, p. 4)
• “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. (Lucas 2003 , p. 1 ; emphasis added)
Turning Nelson’s Eye to what really matters
• “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, p. 24)
• “Hyman Minsky (1977) and Charles Kindleberger (1978) 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, p. 43)
• What Minsky actually did was develop a model in which Depressions
can occur—because they had done so in the past…
Minsky & economic realism
• “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. (Minsky 1982, p. xii)
• Upshot: a historical-causal model in which private debt has
macroeconomic significance
– Contra Neoclassical mainstream which ignores banks, debt & money
Financial Instability Hypothesis
• “The natural starting place for analyzing the relation between debt and
income is to take an economy with a cyclical past that is now doing
well.
• The inherited debt reflects the history of the economy, which includes a
period in the not too distant past in which the economy did not do well.
• Acceptable liability structures are based upon some margin of safety so
that expected cash flows, even in periods when the economy is not
doing well, will cover contractual debt payments.
• As the period over which the economy does well lengthens, two things
become evident in board rooms. Existing debts are easily validated and
units that were heavily in debt prospered; it paid to lever.” (65)
Financial Instability Hypothesis
• “After the event it becomes apparent that the margins of safety built
into debt structures were too great.
• As a result, over a period in which the economy does well, views about
acceptable debt structure change. In the dealmaking that goes on
between banks, investment bankers, and businessmen, the acceptable
amount of debt to use in financing various types of activity and positions
increases.
• This increase in the weight of debt financing raises the market price of
capital assets and increases investment. As this continues the economy
is transformed into a boom economy…” (65)
• This transforms a period of tranquil growth into a period of speculative
excess:
Financial Instability Hypothesis
• “Stable growth is inconsistent with the manner in which investment is
determined in an economy in which debt-financed ownership of capital
assets exists, and the extent to which such debt financing can be carried
is market determined.
• It follows that the fundamental instability of a capitalist economy is
upward.
• The tendency to transform doing well into a speculative investment
boom is the basic instability in a capitalist economy.” (65)
• My model of this (circa 1992) added debt financed investment to Goodwin
cyclical growth model. 3 system states:
– Employment rate
– Income distribution (Workers’ share of output)
– Debt to GDP ratio…
My 1992 Minsky model
• Apparent tranquility precedes breakdown • Cause is rising debt to GDP
• “The chaotic dynamics explored in
this paper should warn us against
accepting a period of relative
tranquility in a capitalist economy
as anything other than a lull before
the storm.” (Keen 1995, p. 634)
Percent of GDP
• “the overall level of debt makes no difference to aggregate net
worth—one person’s liability is another person’s asset.
• “It follows that the level of debt matters only if the distribution of net
worth matters, if highly indebted players face different constraints
US Private Debt
from players with low debt.”
225
35
Crisis
• So we can ignore this trend…
Level
200
30
Rate of Change
• Versus predictions that a
25
crisis would begin when the 175
rate of growth of private
150
20
debt declined…
125
15
• A realistic macroeconomics
must be monetary and
genuinely dynamic
• And transcend the myth of
“Loanable Funds”…
100
10
75
5
50 0
0
25
5
0
 10
1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015
www.debtdeflation.com/blogs
Percent of GDP p.a.
Why ignore banks, debt & money in macroeconomics?
Not foreseeing it: Ignorance about money & debt
• The conventional and false vision of banks: “Loanable Funds”
• The unconventional and accurate vision: “Endogenous Money”
• Simply acknowledging that bank loans appear on asset side of bank
ledger completely transforms vision of macroeconomics
– Loanable Funds: Banks, debt & money irrelevant
– Endogenous Money: Banks, debt & money crucial
Not foreseeing it: Ignorance about money & debt
• Loanable Funds: debt irrelevant
• Endogenous money: debt crucial
Debt-driven Crises
• Incorporating debt into economics—Minsky crises…
• Beginnings of a monetary dynamic macroeconomics
• Reformed education also needed for a realistic economics …
A mendacious approach to education
• Standard micro tuition—downward sloping market demand (Mankiw)
• “Unfortunately . . . The aggregate demand function will in general
possess no interesting properties . . . But…
• Suppose that all individual consumers’ indirect utility functions take the
Gorman form … This demand function can in fact be generated by a
representative consumer.” (Varian 1992, pp. 153-154)
• “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.”.
(Gorman 1953 , p. 64)
Versus what advanced research has concluded
• Sonnenschein-Mantel-Debreu Theorem:
– “Can an arbitrary continuous function … be an excess demand
function for some commodity in a general equilibrium economy?...
– we prove that every polynomial … is an excess demand function for
a specified commodity in some n commodity economy…
– every continuous real-valued function is approximately an excess
demand function.” (Sonnenschein 1972 , pp. 549-550)
• I.e., The “Law” of Demand does not survive aggregation even for
micro, let alone macro
• A sensible reaction to this general theorem:
– “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.” (Kirman 1989 , p. 138)