A Realistic Economics
The unrealistic orthodoxy: Neoclassical Economics
The economic and financial crisis has been caused by unenlightened self-interest and fraudulent behaviour on an unprecedented scale. But this behaviour could not have grown so large were it not for the cover given to this behaviour by the dominant theory of economics, which is known as "Neoclassical Economics".
Though many commentators call this theory "Keynesian", one of Keynes's objectives in the 1930s was to overthrow this theory. Instead, as the memory of the Great Depression receded, academic economists gradually constructed an even more extreme version. (This began with Hicks's "IS-LM" model, which is still accepted as representing "Keynesian" economics today. It was in fact a Neoclassical model derived two years before the General Theory was published.}
As it grew more virulent, Neoclassical theory encouraged politicians to remove the barriers to fraud that were erected in the wake of the last great economic crisis, the Great Depression, in the naïve belief that a deregulated economy necessarily reaches a harmonious equilibrium. As Robert Lucas, one of the chief theoriests of the Neoclassicals, put it:
'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)'
Regulators in its thrall—such as Alan Greenspan and Ben Bernanke—rescued the financial sector from a series of crises, each one leading to another, until ultimately the Great Financial Crisis of 2008, from which no return to "business as usual" is possible. Neoclassical economics enabled and facilitated the collapse and continues to prolong the stagnation that has followed. It is time to succeed where Keynes failed, by eliminating this theory and replacing it with a realistic alternative.
Keynes was scathing about Neoclassical treatment of time, expectations, uncertainty and money, and the stability (or otherwise) of Capitalism:
I accuse the classical economic theory of being itself one of these pretty, polite techniques which tries to deal with the present by abstracting from the fact that we know very little about the future…. The orthodox theory assumes that we have a knowledge of the future of a kind quite different from that which we actually possess… The hypothesis of a calculable future leads to a wrong interpretation of the principles of behavior which the need for action compels us to adopt, and to an underestimation of the concealed factors of utter doubt, precariousness, hope and fear. (Keynes 1937, pp. 215-222)
Keynes's failed in his attempt to overthrow Neoclassical economics. It was reconstructed in an even more extreme form in "Rational Expectations" macroeconomics (led by Robert Lucas). Far from simply dealing with the present "by abstracting from the fact that we know very little about the future", Rational Expectations deals with it by assuming we can accurately predict the future!
Prof. Keen wrote Debunking Economics to help prevent a Neoclassical revival after our current crisis is over, with the advantage of time over Keynes: when he wrote The General Theory (1936). The flaws in Neoclassical economics were only vaguely specified—and Keynes himself retained some of the concepts (such as the marginal productivity theory of income distribution).
Since then, the flaws have been fully detailed, by critics like Pierro Sraffa. The intent of Debunking Economics was to make the many flaws in Neoclassical economics so well known that it would not survive should the economy ever experience another Great Depression.
Developing an alternative
The seeds of an alternative, realistic theory were developed by Hyman Minsky in the Financial Instability Hypothesis, which itself reflected the wisdom of the great non-neoclassical economists Marx, Veblen, Schumpeter, Fisher and Keynes, as well as the historical record of capitalism that had included periodic Depressions (as well as the dramatic technological transformation of production). Minsky argued that an economic theory could not claim to represent capitalism unless it could explain those periodic crises:
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. 5)
Minsky developed a coherent verbal model of his hypothesis, but his own attempt to develop a mathematical model in his PhD thesis was unsuccessful. Using insights from complexity theory, Prof. Keen developed models that captured the fundamental proposition of the Financial Instability Hypothesis--that a market economy can experience a debt-deflationafter a series of debt-financed cycles. These models generated a period of declining volatility in employment and wages with a rising ratio of debt to GDP, followed by rising volatility, and then a debt-induced breakdown.
From the perspective of economic theory and policy, this vision of a capitalist economy with finance requires us to go beyond that habit of mind which Keynes described so well, the excessive reliance on the (stable) recent past as a guide to the future. 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)
The empirical data and the implications of these models led him to expect and warn of an impending serious economic crisis at a time when Neoclassical economists such as Ben Bernanke and Larry Summers were waxing lyrical about "The Great Moderation."
The crisis itself emphatically makes the point that a new theory of economics is needed, in which capitalism is seen as a dynamic, monetary system with both creative and destructive instabilities, where those destructive instabilities emanate overwhelmingly from the financial sector.