Debt-financed demand percent of aggregate demand
25
20
15
P ercent
10
5
0
0
 5
Great Depression
 10
 15
including Government
Great Recession
 20
including Government
 25
0
1
2
3
4
5
6
7
8
9
10
Years since peak rate of growth of debt (mid-1928 & Dec. 2007 resp.)
Economics Education “After” the Crisis
Steve Keen
University of Western Sydney
Debunking Economics
www.debtdeflation.com/blogs
www.debunkingeconomics.com
11
12
13
Before the Crisis
• Oliver Blanchard, 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, pp.214-215)
“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;
emphasis added)
• Wrong: this baby should never have been conceived
– DSGE models logically flawed
– Deep neoclassical research proved cannot reduce
macro to applied micro before DSGE models developed
• Why don’t neoclassical economists know this?
A paradoxical but transcendental truth…
• Learn theory from textbooks: Mankiw, Varian, Mas-Colell
– Ignore fundamental research in good faith
• Should be able to trust textbooks to truthfully
summarize fundamental research
– But textbooks teach sanitized “as if” version of theory
• Macro “as if” can model whole economy as one agent
– Fundamental research: “as if” conditions false
• Consequently:
– Neoclassical economists don’t understand
neoclassical economics; and
– Neoclassical models violate neoclassical theory
• Illustration: DSGE models, SMD conditions, & Solow
Solow rejects DSGE
• Solow (2001 p. 19; emphases added)
– “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 the only universal empirical aggregative
implications of general equilibrium theory are that excess
demand functions should be continuous and homogeneous
of degree zero in prices, and should satisfy Walras' Law.
• Anyone is free to impose further restrictions on a macro
model, but they have to be justified for their own sweet
sake, not as being required by the principles of economic
theory.…” (Solow 2008, p. 244; emphasis added)
Sonnenschein-Mantel-Debreu Conditions
• “Law of Demand” applies to individual Hicksiancompensated demand curve
– Reduce price, demand necessarily rises
• Does it apply to a market demand curve? No!:
• “we prove that every polynomial … is an excess demand
function for a specified commodity in some n commodity
economy… (Sonnenschein 1972 , pp. 549-550)
– That is, a demand curve for a single market can have
any (polynomial) shape at all
• Even study of a single market demand curve can’t
be reduced to study of a demand curve derived
from a single utility-maximizing agent
• Yet Neoclassical DSGE macro models the whole
economy as a single utility/profit-maximizing agent
SMD: “Anything goes” for market demand curves
• SMD Conditions (Sonnenschein 1973; Shafer &
Sonnenschein 1993;):
– Market demand curves do not obey the "Law of Demand"
– Even if summing "well behaved" individual demand curves
P
Crusoe
P
Friday
q
P
q
Market
Q
• An accidental "Proof by contradiction":
– Assume market demand curves do obey Law of Demand
– Derive conditions under which this is true
– These contradict initial assumptions
• Therefore market demand curves don‘t obey the
"Law" of Demand
Logic: Price changes alter income distribution
•
Z
X
Coconuts
B
(1) Can vary Price
without altering
income
• Pivot point does
not move
Y
q1
q2
q3
II
I
III
Bananas
Price of Bananas
• Logic:
– “Law of Demand”
derived from Hicksian
compensated demand
curve procedure
– Take individual with
well-behaved utility
function
– Vary price of one
commodity while
keeping others
constant and consumer
income constant
• Key assumptions:
p1
p2
p3
q1
q2
q3
Bananas
W
Individual demand curve derivation
X
Coconuts
• (2) Can change income and
perfectly compensate for income
effect of lower price (Hicksiancompensation)
• Outcome: Hicksian-compensated
individual demand curve
necessarily slopes down: the
“Law of Demand”
Price of Bananas
• Motivation behind SMD
research: Does this result
survive aggregation to market
demand?
– Answer: No!
q1
q2
q3
Bananas
p1
p2
p3
q1
q2
q3
Bananas
With more than one consumer…
• Logic: “individual demand curve” model ignores impact of
price changes on income
– But price changes will change income distribution
• In 2 (or more) consumer model, each must have
– Different income sources; and
– Different tastes
• Otherwise, there’s only one consumer
– Tastes must change with income
• Otherwise, there’s only one commodity
• Consider 2-consumer, 2 commodity world
– Crusoe and Friday; Coconuts and Bananas
– Crusoe the Banana owner, Friday Coconut owner
– Coconuts necessity, Bananas luxury
– Friday higher preference for coconuts than Crusoe
Change in relative price alters incomes
• Start with arbitrary price ratio;
• Keep aggregate income constant;
• Consider lower price for bananas
– Crusoe’s (banana owner) income falls; Friday’s rises
Coconuts
Coconuts
Crusoe
Bananas
Friday
Bananas
• Market demand for bananas falls because of lower price
– Crusoe’s income fell
– Friday’s income rose
– But his preferences for bananas less than Crusoe’s
Income growth alters distribution if tastes differ
• Hicksian procedure
– Keep relative prices constant
– Increase income equally
– Banana demand (luxury) rises more than Coconut
– Crusoe’s income rises more than Friday’s
Coconuts
Coconuts
Crusoe
Bananas
Friday
Bananas
• Cannot “compensate” for income effect of price change:
– “Uniform” increase in income alters income
distribution, because varying consumption as income
rises favours luxury-producing agent over the other
Market demand curve any polynomial at all
• Outcome: market demand curve can have any (polynomial)
shape at all
– Need not obey “Law of Demand”
• Only way to avoid this:
– Assume all consumers have identical tastes
• So there is only one consumer!
– And 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 is this communicated to students?
Textbooks hide SMD results
• Samuelson and Nordhaus 2010 (p. 48)
– “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 (p. 268)
– “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!
– Believe “macroeconomics is applied microeconomics”
– But SMD conditions prove otherwise
• “macroeconomics cannot be applied microeconomics”
• Neoclassical theory commits the fallacy of “Strong
Reductionism”…
Fallacy of Strong Reductionism
• Common knowledge in real sciences
• Physics Nobel Laureate Anderson in “More is Different”,
Science (1972, Vol. 177, p. 393)
– “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”
X
Solid state or many-body physics
Chemistry
Molecular biology
Cell biology
…
Psychology
Social sciences
Y
Elementary particle physics
Many-body physics
Chemistry
Molecular biology
…
Physiology
Psychology
• 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.”
Neoclassical macro didn’t see “It” coming
• Strong reductionism blinded neoclassical macroeconomists:
• “The preferred model has a single representative
consumer optimizing over infinite time with perfect
foresight or rational expectations, in an environment that
realizes the resulting plans more or less flawlessly through
perfectly competitive forward-looking markets for goods
and labor, and perfectly flexible prices and wages.
• How could anyone expect a sensible short-to-medium-run
macroeconomics to come out of that set-up? …
• we want macroeconomics to account for the occasional
aggregative pathologies that beset modern capitalist
economies, like recessions, intervals of stagnation,
inflation, “stagflation”…
• A model that rules out pathologies by definition is
unlikely to help.” (Solow 2003, p. 1; emphases added)
Many other flaws in neoclassical doctrine
• Money is not neutral in a credit economy:
– “nothing is so unimportant as the [nominal] quantity of
money … let the number of dollars in existence be
multiplied by 100; that … will have no other essential
effect provided that all other nominal magnitudes
(prices of goods and services, and quantities of other
assets and liabilities that are expressed in nominal
terms) are also multiplied by 100.” Friedman 1969 (p. 1)
• Debts aren’t increased when prices rise
– hence money is not neutral in a credit economy
• Rational expectations = “capable of accurate prophesy”
– 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.”
• No wonder neoclassical macro couldn’t explain the crisis!
Neoclassical macro can’t explain “It” continuing…
• US Unemployment rising again after brief fall:
USA Unemployment Rate
12
Start
End
11
Percent of workforce
10
9
8
7
6
5
4
3
2
2004
2005
2006
2007
2008
2009
2010
2011
www.debtdeflation.com/blogs
• Non-neoclassical macro can
explain “It” and why “It” is
continuing…
• “We don't have a precise
read on why this slower
pace of growth is
persisting” (Bernanke,
June 23 2011)
• The Economist: “His
admission of ignorance
reflects genuine
puzzlement with the
economy’s failure to
2012
reach what he likes to
call escape velocity.”
Private debt crisis, just like the Great Depression
US Private Debt to GDP
275
12
10
8
2
4
6
6
4
2
0
8
10
12
0 14
2
4
6
16
18
20
200
175
150
125
100
75
50
8
22
Change in Debt
 10
24
Unemployment
 12
26
 14
1920 1922 1924 1926 1928 1930 1932 1934 1936 1938 1940 1942
25
Change in Private Debt and Unemployment
0
1920 1930 1940 1950 1960 1970 1980 1990 2000 2010 2020
P ercent c hange in debt p.a .
• Debt-focused analysis is why
“Bezemer 12” did see the
crisis coming:
– http://mpra.ub.unimuenchen.de/15892/
– Bezemer 2010, 2011
14
0
12
2
10
4
8
6
6
8
4
10
2
12
0
0 14
 2
16
 4
18
 6
20
22
 10
Change in Debt
Unemployment
 12
Unemployment (U6)
26
 8
 14
1990
1992
1994
1996
1998
24
2000
2002
2004
2006
2008
2010
2012
P ercent u nem ploym ent (in verted)
225
Percent unemployment (inverted)
0
Percent change in debt p.a.
14
250
Percent of GDP
Change in Private Debt and Unemployment
300
Dilemma for economics educators
• What do you do when all you know is that you don’t know?
• Continue teaching neoclassical economics
– But from the originals, not the textbooks
• Learn/teach your own school of thought properly
• Teach the theory “warts and all”
• Hire economists who know non-neoclassical economics
– Teach parallel classes in the real Classical Economists
– Attend those classes & learn some different questions
– Engage with part of the discipline you have ignored for
40 years
It ain’t Walras, Babe…
• Neoclassical macro direct descendant of Bentham, Say,
Walras, Marshall
– Equilibrium, methodological individualism, strong
reductionism, linearity
• Unrelated to Classical Economists Smith, Ricardo, Marx,
Keynes, Schumpeter, Fisher, Minsky, Goodwin
– Dynamics, social classes, emergent phenomena,
complexity & evolution
• Non-neoclassical economics underdeveloped compared to
neoclassical
• Doesn’t have all the answers…
– Many wrong ones—e.g., Labor Theory of Value in Marx
– Some correct—e.g., Financial Instability Hypothesis
It might be Marx, Schumpeter, Minsky…
• But many correct questions
– Focus on instability
– Uncertainty
– Crucial role of money
– Disequilibrium dynamics
• Better to ask the right questions than give accurate
answers to the wrong ones
–
–
–
–
Equilibrium fetish
Risk as proxy for uncertainty
Barter model of monetary economy
Equilibrium Dynamics
• an oxymoron in any real science
• Given manifest failure of neoclassical macro, students
must be exposed to non-neoclassical ideas
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”
• Recently received 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
•
•
•
•
•
•
•
•
•
•
•
•
•
Anderson, P. W. (1972). "More Is Different." Science 177(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. (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.
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 Economics 13(1): 1-14.
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 & Organization In Press, Corrected Proof.
Kirman, A. (1989). "The Intrinsic Limits of Modern Economic Theory: The Emperor Has No Clothes." Economic
Journal 99 (395): 126-139.
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.
References
•
•
•
•
•
•
•
•
•
•
•
•
•
Lucas, R. E., Jr. (2004). "Keynote Address to the 2003 HOPE Conference: My Keynesian Education." History of
Political Economy 36: 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.
Mas-Colell, A., M. D. Whinston, et al. (1995). Microeconomic theory. New York :, Oxford University Press.
Minsky, H. P. (1982). Can "it" happen again? : essays on instability and finance. Armonk, N.Y., M.E. Sharpe.
Solow, R. M. (2001). From Neoclassical Growth Theory to New Classical Macroeconomics. Advances in
Macroeconomic Theory. J. H. Drèze. New York, Palgrave.
Solow, R. M. (2003). Dumb and Dumber in Macroeconomics. Festschrift for Joe Stiglitz. Columbia University.
Solow, R. (2008). "The State of Macroeconomics." The Journal of Economic Perspectives 22(1): 243-246.
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.