Debt Matters       |       Money Matters       |       The Economy is a Dynamic System       |       Realistic Economics

Debt Matters

An economics that realizes the centrality of debt would devote its attention to resolving this problem, no matter the difficulty. Instead, orthodox economics largely -- believe it or not -- ignores debt unless it is on the public balance sheets. It is the enormous private debt that created the crisis and continues to burden it. That debt is not shrinking, but growing. Absent a direct confrontation with this debt, there is no recovery. Obstructing the way are interests of an enormously powerful financial sector protecting huge and fragile banks.

Debt as the central burden, the primary cause of stagnation across the globe and the deepening crises in many countries, is still ignored by the orthodoxy. American households and European population suffer from the madness of austerity delivered by TINA (there is no alternative), the fairy godmother of the financial sector, ratified by the pronouncements of orthodox economists. 

The fundamental cause of the economic and financial crisis that began in late 2007 was lending by the finance sector that primarily financed speculation rather than investment. The private debt bubble this caused is unprecedented, probably in human history and certainly in the last century (see Figure 1). Its unwinding is the primary cause of the sustained slump in economic growth. The recent growth in sovereign debt is a symptom of this underlying crisis, not the cause, and the current political obsession with reducing sovereign debt will exacerbate the root problem of private sector deleveraging.

US private debt clearly rose faster than GDP from the end of World War II (when the debt to GDP ratio was 43%) until 2009 (when it peaked at nearly 200%), but there is no intrinsic reason why it (or the public sector debt to GDP ratio) has to rise over time.

The red line is U.S. private debt, the blue is government debt. Clearly private debt was the proximate cause of the 2008 crisis, and government debt has risen in response to that crisis.

The red line is U.S. private debt, the blue is government debt. Clearly private debt was the proximate cause of the 2008 crisis, and government debt has risen in response to that crisis.

The debt and asset price bubbles were ignored by conventional "Neoclassical" economists on the basis of a set of a priori beliefs about the nature of a market economy that are spurious, but deeply entrenched. Understanding how this crisis came about will require a new, dynamic, monetary approach to economic theory that contradicts the neat, plausible and false Neoclassical model that currently dominates academic economics and popular political debate.

Escaping from the debt trap we are now in will require either a "Lost Generation", or policies that run counter to conventional economic thought and the short-term interests of the financial sector.

Preventing a future crisis will require a redefinition of financial claims upon the real economy which eliminates the appeal of leveraged speculation.

An economics that acknowledges that money is created through the credit process is not forever waiting for baffled central bankers to make a difference. We would not be stuck in neutral with our foot on the accelerator, creating enormous action in financial markets, but going nowhere in the real economy, where real people and businesses are struggling.

The idea that money matters is not difficult unless you have had an education in economics from an institution of higher learning. In modeling the real economy, the conventional treatment casts money as merely a means of exchange, which facilitates the movement of goods and services.

Real Business Cycle models are "real" only in the narrow economic sense, of being adjusted for inflation. In this view, money is a veil behind which the activity of the economy is essentially barter.

The conventional view is that money simply mechanically multiplies from central bank "printing." This is exogenous, from outside. This in spite of now five years of empirical data showing no such relationship.

"Endogenous" money is key to the correct understanding of economic events.  It is the fact that money does not mechanically multiply from central bank action, but arises from credit creation -- debt creation. Money occurs "out of thin air" when banks make loans. Relying on nothing other than the promise of repayment, the bank makes a deposit of money in the creditors account.

The principle of endogenous money gained confirmation from the Bank of England recently. 

‘Banks do not act simply as intermediaries, lending out deposits that savers place with them, and nor do they ‘multiply up’ central bank money to create new loans and deposits … Commercial banks create money, in the form of bank deposits, by making new loans.’

‘Money creation in the modern economy’ Bank of England Quarterly Bulletin, 2014 Q1 

As Ann Pettifor has said,*

Money creation must be understood within the context of the economy as a whole.... It is important to emphasize that the money for a loan is not in the bank when a firm or an individual applies for a loan. It is the application for a loan that results in the creation of deposits.... Without applications for loans, there would be no deposits.
In other words, while the banker or bank clerk plays a critical risk assessment role in the ‘creation of money out of thin air’, and while the state plays an equally critical role in transforming that private loan into public fiat money, it is the myriad numbers of ... borrowers who are the real spur for the creation of money. When entrepreneurs and other borrowers apply for loans, they help create money (deposits) ‘out of thin air’.
If entrepreneurs and other borrowers do not apply for loans [or if lenders do not extend credit] (because interest rates are too high, terms too tough, confidence low or business slack) the money supply shrinks... and deflation may ensue. If the demand for and supply of loans exceeds the economy’s real potential then the money supply expands and inflation (of assets as well as wages and prices) is an inevitable consequence.
In a well-managed monetary system, private bankers should be regulated by the central bank to ensure that applications for loans are carefully assessed as both affordable and repayable, and that loans are aimed at facilitating transactions between economic actors engaged in productive, income-generating activity. Lending or borrowing for gambling and speculation would be restrained or even prohibited. Speculation, after all, does not increase an economy’s productive capacity, but speculative fevers increase both the risk that borrowers will not make the capital gains needed to repay debts and wider systemic risk.
While a sound monetary system such as our own can, like the sanitation system, be used to promote the interests of society as a whole, the system can also be captured by what is often described as ‘the money interest’ or ‘money power’.
It is the fate of the ... economy presently to be in the grip of a small, wealthy elite who effectively wield ‘despotic power’ over society as a whole.
Wrenching that power away and ensuring the monetary system serves not only the private interests of the wealthy but all of society, including the public sector, is a vital challenge to our democracy. Ensuring that the financial system is the servant, not master, of the economy cannot be achieved on the basis of flawed monetary and economic theory.

Ann Pettifor, "Out of thin air - Why banks must be allowed to create money,25th June 2014, PRIME.

"While a sound monetary system such as our own can, like the sanitation system, be used to promote the interests of society as a whole, the system can also be captured by what is often described as ‘the money interest’ or ‘money power’.

"The study of money, above all other fields in economics, is one in which complexity is used to disguise truth or to evade truth, not to reveal it. The process by which banks create money is so simple the mind is repelled. With something so important, a deeper mystery seems only decent."

– John Kenneth Galbraith writing in 'Money: Whence it came, where it went' (1975).


Critique of the Quantity Theory of Money

An economics that realizes a return to normal is not guaranteed in a dynamic system like the economy, but is a hope based on faith in disproven theory and unrealistic assumptions, would rapidly be installing the alternative. Instead TINA rules. There is No Alternative.

In this work, the appropriate appeal is to the evidence as judge, not to political visions nor academic speculation. History and data are the test of explanations and predictions. If the explanations are valid, the predictions will be valid. If not, they need to be revised. It is the scientific method, and it needs to return to economics. IDEA intends to be a destination source for relevant data, as well as for valid assumptions.

The economy is modeled as a series of static states, with a handful of differential equations, by virtually all economists. Evidence and observation prove that it is instead a dynamic system, and needs dynamic modeling. Steve's Collected papers on dynamics of the projects on the horizon at IDEA. Below is some preliminary work in describing what dynamics means in non-math terms and how to enter the world of mathematical terms without being intimidated.

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 SraffaThe 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.

 (for more, see Debunking Economics: the naked emperor dethroned?;or buy the book: Amazon USAAmazon UKKindle USAKindle UKAbbey's Australia).

I also provide critiques of conventional economic theory in my lectures, which I make more broadly available via Youtube videos.

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.