Debt-financed demand percent of aggregate demand
25
20
15
Percent
10
5
0
0
5
Great Depression
including Government
Great Recession
including Government
 10
 15
 20
 25
0
1
2
3
4
5
6
7
8
9
10
11
12
Years since peak rate of growth of debt (mid-1928 & Dec. 2007 resp.)
Finance Education “After” the Crisis
Steve Keen
University of Western Sydney
Debunking Economics
www.debtdeflation.com/blogs
www.debunkingeconomics.com
13
Finance: the Humpty Dumpty of Academia
• “I don’t know what you mean by ‘glory,’ ” Alice said.
• Humpty Dumpty smiled contemptuously. “Of course
you don’t—till I tell you.
• I meant ‘there’s a nice knock-down argument for you!’”
• “But ‘glory’ doesn’t mean ‘a nice knock-down
argument’,” Alice objected.
• “When I use a word,” Humpty Dumpty said, in rather a scornful tone,
• “it means just what I choose it to mean—neither more nor less.”
• “The question is,” said Alice, “whether you can make words mean so
many different things.”
• “The question is,” said Humpty Dumpty, “which is to be master—that’s
all.”
• Alice was too much puzzled to say anything, so after a minute Humpty
Dumpty began again. “They’ve a temper, some of them—particularly
verbs, they’re the proudest—adjectives you can do anything with, but
not verbs—however, I can manage the whole lot!
• Impenetrability! That’s what I say!”
Humpty Dumpty’s Dictionary
• “Efficient Market”: Noun
– System capable of accurate prophesy
• Prophesy—see “Rational”
– System in which all agents can predict the future
– System where any agent can borrow infinite amount at
risk-free rate
– E.g. (1): “In order to derive conditions for equilibrium
in the capital market we invoke two assumptions.
• First, we assume a common pure rate of interest,
with all investors able to borrow or lend funds on
equal terms.
• Second, we assume homogeneity of investor
expectations…
• Needless to say, these are highly restrictive and
undoubtedly unrealistic assumptions….” (Sharpe ‘64)
Humpty Dumpty’s Dictionary
• E.g. (2):
– “Sharpe (1964) and Lintner (1965) add two key
assumptions to the Markowitz model to identify a
portfolio that must be mean-variance-efficient.
– The first assumption is complete agreement: given
market clearing asset prices at t-1, investors agree on
the joint distribution of asset returns from t-1 to t.
– And this distribution is the true one—that is, it is
the distribution from which the returns we use to test
the model are drawn.” (Fama and French 2004, p. 26)
Humpty Dumpty’s Dictionary
• “Expected Value (E.V.)”: Noun
– What you won’t get in a one-off gamble
– What your lecturer says the gamble is worth
– Correct answer in multiple choice question
• Rational
– Able to predict future course of complex system
• See Prophetic, (Nostradamus, as in)
• E.g., Lucas 1972 (p. 54) “one is led simply to adding the
assumption that [the gap between actual and expected
inflation] is zero as an additional axiom… or to assume
that expectations are rational in the sense of Muth.”
• “Risk, capital markets, in”: Noun
– Standard deviation of return around expected return…
Humpty Dumpty’s Dictionary
– E.g.: “investors are assumed to agree on the prospects
of various investments—the expected values, standard
deviations and correlation coefficients…” (Sharpe
1964)
• “Uncertainty”: Noun
– Certainty with risk
• See Expected Value; OR
– Certainty without risk (Debreu 1959)
• “… A contract … now specifies… an event on the
occurrence of which the transfer is conditional… a
theory of uncertainty free from any probability
concept and formally identical with the theory of
certainty developed in the preceding chapters.”
• Is it any wonder that Humpty didn’t see The Fall coming?
Humpty Dumpty had a great fall…
CPI-Deflated DJIA Since 2000
110
Index Jan 2000=100
100
90
80
70
60
50
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
www.debtdeflation.com/blogs
• “Unfortunately, the empirical record of the model is
poor—poor enough to invalidate the way it is used in
applications…
• the failure of the CAPM in empirical tests implies that
most applications of the model are invalid.” (Fama and
French 2004, p. 25)
Reform: Integrated economics & finance
• Neoclassical macro and neoclassical finance have to go
• Neoclassical Finance/Economics divide
– Money neutrality, no role for debt in macro
• Barter model of capitalism
– Debt financing no impact on firm value in finance
• Equilibrium analysis of finance
• Both nonsense in credit-based dynamic economy
• Integrated economics & finance instead
• Plus uncertainty-aware finance subjects
• Almost all of neoclassical economics & finance false
– But above all else, abandon fetishes of equilibrium &
strong reductionism (Anderson 1972)
• Especially in mathematical modeling…
Integrated financial economics
• Walras’ Law false in a credit driven economy
– Barter economy
• Sum of all excess demands is zero
• Aggregate demand is aggregate supply
• Savings create loans
– Aggregate debt has no macro impact
– Credit economy
• Sum of all excess demands equals change in debt
• Aggregate demand = Aggregate supply + Ddebt
• Loans create Deposits
– Money supply endogenous
– Change in debt drives growth & asset bubbles
Neoclassical macro naïve about money & debt
• “The idea of debt-deflation goes back to Irving Fisher…
• Fisher's idea was less influential in academic circles,
though, because of the counterargument that debtdeflation 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)
Neoclassical macro naïve about money & debt
• Krugman: Good start after the crisis…
– “Given both the prominence of debt in popular
discussion of our current economic difficulties …, one
might have expected debt to be at the heart of most
mainstream macroeconomic models…
– Perhaps somewhat surprisingly, however, it is quite
common to abstract altogether from this…” (p. 2)
• But returns to same old a priori nonsense:
– “the overall level of debt makes no difference to
aggregate net worth—one person's liability is another
person's asset…
– we begin by setting out a flexible-price endowment
model in which “impatient” agents borrow from
“patient” agents.” (Krugman & Eggertsson, 2010, p. 3)
Naïve “savings creates loans” model
• Patient lends to Impatient
•
•
•
•
Patient’s spending power goes down
Impatient’s spending power goes up
No change in aggregate demand
Banks merely intermediaries & ignored in analysis
Actual credit money creation process
• 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)
• New loan puts additional spending power into circulation
• Adds to aggregate demand
Empirical dynamics of Credit
• In credit-driven economy, aggregate demand spent on both
goods & services (GDP) and existing assets
– AD = Income + DDebt = GDP + Net Asset Sales (NAS)
• NAS = PA * fraction sold * QA= PA.sA.QA
– D AD = D GDP + DDDebt = DGDP + D(PA.sA.QA)
• Acceleration of debt ignored by neoclassical economists
• Neoclassicals wrong
• Finance & economics entwined by dynamics of debt
– Credit Accelerator correlated
• With Change in output;
• With Change in employment; and
• With Change in asset prices
Empirical dynamics of Credit
• Private debt bubbles caused “Roaring Twenties” &
“Noughty Nineties”
US Private Debt to GDP
300
275
250
Percent of GDP
225
200
175
150
• Bursting of
bubbles
caused Great
Depression &
Great
Recession
125
100
75
50
25
0
1920 1930 1940 1950 1960 1970 1980 1990 2000 2010 2020
Empirical dynamics of Credit
• Change in Private Debt drives both booms and busts
0
14
0
12
10
8
2
4
6
12
10
8
2
4
6
6
4
8
10
6
4
8
10
2
0
12
0 14
2
0
12
0 14
2
16
2
16
4
6
18
20
4
6
18
20
8
22
Change in Debt
 10
24
Unemployment
 12
26
 14
1920 1922 1924 1926 1928 1930 1932 1934 1936 1938 1940 1942
Year; Source Census, BLS, BEA
Percent change in debt p.a.
14
8
Change in Debt
Unemployment
Unemployment (U6)
22
 10
24
 12
26
 14
1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012
Year; Source Census, BLS, BEA
• Differences Now vs Then
– 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
Percent unemployment (inverted)
Change in Private Debt and Unemployment
Percent unemployment (inverted)
Percent change in debt p.a.
Change in Private Debt and Unemployment
Empirical dynamics of the Credit Accelerator
• Great Depression & Great Recession both commenced
with collapse in Credit Accelerator
200
20
200
15
150
15
150
10
100
10
100
5
50
5
50
00
0
5
 50
 10
 100
 15
 20
1920
Credit Accelerator
Unemployment Change
1922
1924
1926
1928
1930
 150
1932
1934
1936
1938
 200
1940
Unemployment Change
20
00
0
5
 50
 10
 100
 15
Credit Accelerator
Unemployment Change
 150
 20
 200
1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012
www.debdeflation.com/blogs
www.debdeflation.com/blogs
• Recent apparent recovery in US economy largely due to
slowdown in rate of decline of private debt—a positive
Credit Accelerator (CA)
• Same true for sharemarket…
Unemployment Change
Credit Accelerator & Change in Unemployment
Credit Accelerator
Credit Accelerator
Credit Accelerator & Change in Unemployment
Empirical dynamics of the Credit Accelerator
• Credit Accelerator affects sharemarket performance…
Credit Impulse and Change in Real Share Prices
Credit Impulse and Change in Real Share Prices
30
120
30
120
24
96
24
96
18
72
18
72
12
48
12
48
6
24
6
24
00
0
00
0
6
 24  6
 24
 12
 48  12
 48
 18
 24
Credit Impulse (Left Hand Scale)
Change in DJIA (Right Hand)
 72  18
 96  24
Credit Impulse (Left Hand Scale)
Change in DJIA (Right Hand)
 72
 96
 120
 30
 120 30
1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012
1920 1922 1924 1926 1928 1930 1932 1934 1936 1938 1940 1942
Year; Source Census, BLS, BEA
Year; Source Census, BLS, BEA
• Complex, unstable lead/lag relationships between Credit
acceleration, asset prices, economic growth…
– Combined monetary economics/finance theory needed
to understand it
Monetary Circuit Theory (MCT)
• Neglected “Classical” economists the right foundation for
the future
– Marx, Keynes, Schumpeter, Keynes, Minsky
• + European “Circuitists” (Graziani)
• + Complexity theory (Goodwin & many others)
– Monetary, dynamic integrated finance/macro model
• Starting point:
– All demand monetary
– Money creation via bank double-entry bookkeeping
• Enter financial flows into “Godley Table”
• Generate dynamic model of money creation
– Coupled to nonlinear non-equilibrium production model
(Goodwin)
Modeling monetary dynamics
• Input basic financial flows in table:
Assets
Reserve
BR
Lend
Liabilities
Loan
FL
-A
A
Interest
B
Pay Interest
WD
BE
B
-B
Wages
Consumption
F
-C
C
D+E
-D
-E
-F
-F
New Money
Record
FD
-B
Record
Record
Firm Deposit Worker Deposit Bank Equity
A
Record Loan
Repay Loan
Equity
G
G
• System of dynamic equations derived automatically:
Modeling monetary dynamics
• Prior to substitutions…• Simple linear model
d
BR   A  F
dt
d
FF  A  F  G
dt
d
FD  A  B  C  D  E  F  G
dt
d
WD  C  D
dt
d
BE  B  E
dt
A
BR
V
B  rL  FL
B
F
d
BR   R  L
dt
V  L
FD
B
F F
d
FF  R  L  D
dt
V  L  M
D
WD
B
F W
B
F F
d
FD  R  rL  FL  D  D  E  L  D
dt
V
 F W  B  L  M
E
BE
F W
d
WD  D  D
dt
 F W
FL
B
d
BE  rL  FL  E
dt
B
C
F
G
F
W
B
L
FD
M
• Implemented in easy to use GUI program
– Prototype “QED”: www.debtdeflation.com/blogs/QED
– Professional version “Minsky” under development
Modeling monetary dynamics
• With nonlinear functions + cyclical production model:
Academic finance: A more limited role
• No longer separate discipline from economics
– Ancillary role for discussion of
• Structure of finance markets/institutions
• Investment decision-making under uncertainty
– History of financial crises
• If we forget again, we will relive again…
Australia's Private Debt to GDP Ratio
175
150
US Private Debt to GDP
300
275 larger than they should
Finance sector (& profits) 4-6 times
be
Actual
Actual
250
225
Percent of GDP
125
200
175
100
150
75
125
Desirable
100
50
25
Desirable
0
1860 1870 1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010 2020
www.debtdeflation.com/blogs
75
50
25
0
1920
1930
1940
1950
1960
1970
1980
1990
www.debtdeflation.com/blogs
2000
2010
2020
Academic finance: A more limited role
• Behavioural Finance? Some role, but as usual, based on
misreading (or not reading) original literature
– Standard practice: Subjective probability
– v.s. von Neumann: “Probability has often been
visualized as a subjective concept more or less in the
nature of an estimation.
• Since we propose to use it in constructing an
individual, numerical estimation of utility, the above
view of probability would not serve our purpose.
• The simplest procedure is, therefore, to insist upon
the alternative, perfectly well founded
interpretation of probability as frequency in long
runs.” (Von Neumann and Morgenstern 1953 p. 19)
• All “paradoxes of behavioural economics”—Ellsberg,
Allais, etc.—disappear with objective probability
Academic finance: A more limited role
• Bounded rationality
– Sensible, but unlikely foundation for new economics
• Better “top down” logic than bottom up, given
emergent properties of macro & finance
– See “More is different”, Anderson 1972
• Multi-agent modelling as adjunct to system dynamics
– NetLogo, etc.
• Complexity, chaos theory & econophysics
– Far more important—complex systemic behaviour as
explanation for “can’t beat the market” “efficiency”
• Peters (2003), Lux (2001), McCauley (2004)…
– www.unifr.ch.econophysics
• Technically, teach the mathematics of dynamics—
differential equations, systems—not equilibrium
Academic finance: A more limited role
• Consider investment under uncertainty
– As in Blatt 1979, 1982
• “Sophisticated” NPV ignores uncertainty
• “Unsophisticated” Payback period considers uncertainty
bafg zCatf e
end
NPV C t 
start

 r t
Payback  C  t     C  t   e
dt  II
2
1
t
Investment
 2
 r t
2T
Time
 eHorizondt  II
o
• Yet another reason why finance has economic effects
– “Payback period” pro-cyclical: extends during booms,
contracts during slumps
• A new economics & finance needed…
Some resources
• Debunking Economics II: almost all
the economics you didn’t learn from
the textbooks…
• Available September 2011
• My blog www.debtdeflation.com/blogs
– Minskian explanation of the crisis
• Free software program “Minsky”
– “Monetary Macro-dynamics for dummies”
• Being develeoped using INET grant
– Mathematica version in development (Mike
Honeychurch mike.honeychurch@gmail.com)
– Prototype available on my blog:
www.debtdeflation.com/blogs/QED
• Lectures on history of economic thought, nonneoclassical monetary macroeconomics:
http://www.debtdeflation.com/blogs/lectures
References
•
•
•
•
•
•
•
•
•
•
•
•
•
•
•
•
•
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Bernanke, B. S. (2000). Essays on the Great Depression. Princeton, Princeton University Press.
Bezemer, D. J. (2009). “No One Saw This Coming”: Understanding Financial Crisis Through Accounting Models.
Groningen, The Netherlands, Faculty of Economics University of Groningen.
Bezemer, D. J. (2011). "The Credit Crisis and Recession as a Paradigm Test." Journal of Economic Issues 45: 1-18.
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