Steve Keen, Professor of Economics and Head of the School of Economics, Politics and History at Kingston University London, one of the most recognized critic of the neoclassical economics, gave a lecture at the conference “Taking steps with Economics”, organized by the MNB Department of the Corvinus University of Budapest in November 2019. His presentation focused on the role of debt, disequilibrium dynamics and the shortcomings of the mainstream economics. He also gave an interview to Kristóf Lehmann, the head of the MNB Department and director at the Magyar Nemzeti Bank (Central Bank of Hungary).
Kristóf Lehmann (KL): You have framed strong criticism about the pre-crisis mainstream economics in your successful book, Debunking Economics. What kind of reactions did you get from mainstream and non-mainstream economists and do you see univocal signs of the needed mental change?
Steve Keen (SK): Mainstream economists were almost universally dismissive of each and every critique in the book. A Professor of Mathematics responded to one dismissive remark on Twitter by challenging the critics to find one mathematical error in the book. The fact that a mathematician felt that way about the book is, to me, more significant than the fact that he didn’t receive a reply.
So unfortunately, I see no signs of the needed mental change. In part, this is always how adherents to a scientific paradigm behave, as Max Planck pointed out in relation to the reception of quantum mechanics by his peers. He wrote that “A new scientific truth does not triumph by convincing its opponents and making them see the light, but rather because its opponents eventually die, and a new generation grows up that is familiar with it”.
Unfortunately, that doesn’t seem to work with Neoclassical economics: it revives despite anomaly after anomaly turning up in the real world, from the Great Depression till today.
The truly ideological nature of theories about human society is one reason why, but I think another important reason is that Neoclassical economic theory is like a Swiss watch: it describes a perfect economic mechanism in which the economy works “like clockwork”, with everyone receiving what they should (the marginal productivity theory of income distribution), properly priced assets (the Efficient Markets Hypothesis), and the economy returning to equilibrium after any exogenous shocks (DSGE models). And just like a watch, if you remove even one gear, the mechanism fails. So they defend every aspect of the theory because, with one aspect removed (income distribution based on class rather than merit, markets behaving chaotically, far-from-equilibrium dynamics rather than equilibrium), the whole edifice collapses.
In the end, I didn’t write Debunking Economics to persuade existing adherents to abandon the theory. I wrote it so that people, especially young students, who questioned what they were being taught would know that they weren’t mad or stupid, the theory they were being taught was. It’s become very influential in the Rethinking Economics movement, and I’m very proud of that.
KL: News coming up daily saying that a slump or a recession could occur again soon. How do you currently see the global economy’s state? Are there real dangers that could cause serious economic problems soon?
SK: I argued in the first edition Debunking Economics that, by letting private debt grow far too quickly, “America could well join Japan on the list of the global economy’s ‘walking wounded’ – mired in a debt-induced recession, with static or falling prices and a seemingly intractable burden of private debt” (Keen 2001, p. 254). This is in fact what has happened: the USA, UK, and much of Europe (especially Spain and Portugal) rode a private debt financed boom that crashed in 2007-09, in the aftermath of which, private debt is still too high, and therefore credit based demand is very low.
This has meant low growth – an average for the USA of 1.9% p.a. since the crisis versus 3.3% before it – but it also removes one of the preconditions for a big crisis: a big crisis requires a very high level of credit-based demand, which then turns from positive to negative when the crisis hits.
So I don’t expect a global economic and financial crisis like 2007-09, though I do think that Central Bank policies like QE have made occasional financial disturbances like the recent Repo crisis more likely. Given the impact of QE on boosting stock market prices – most notably in the USA, where valuations have more than trebled since QE began – any attempt by Central Banks to normalize their assets by reversing QE is likely to cause a stock market crash and lead to a reversal of the policy. The same applies to attempts to “normalize” interest rates, which will motivate the private sector to return to deleverage, thus reducing credit-based demand even further and triggering a much sharper slowdown in economic activity than expected. So I now see these countries as locked into a Central-Bank-driven economic cycle, rather than a credit-driven one. This again replicates the experience of Japan.
However, I do expect regional economic crises, which I’ll discuss in answer to your next question.
I do believe that we face a serious crisis within the next 20 years: a climate crisis. Again, Neoclassical economists have played a major role in lulling the public and policymakers, to quote a critical science paper, “into a false sense of security by smooth projections of global change” (Lenton, Held et al. 2008, p. 1792). If these projections, by Neoclassical economists like William Nordhaus using his DICE model, that “damages [from Global Warming] are estimated to be 2 percent of output at a 3°C global warming and 8 percent of output with 6°C warming” (Nordhaus 2019, p. 2000), have been used by actuaries and stock market professionals to value companies in the energy sector, then when it becomes obvious that damages are going to be far greater than this, stock market valuations of these companies (and potentially many others) will plunge.
A serious financial crisis will thus accompany realisation of how severe the dangers of climate change really are. Central Banks need to be ready for this, both to take action to stop the financial system from collapsing, and to provide finance now to enable the long overdue action needed to attenuate climate change.
KL: Where, in which regions do you see the biggest macroeconomic risks?
SK: Countries that avoided a crisis in 2008 by continuing private debt bubbles are the ones who are likely to have a crisis in the near future. For some of these, the risk is attenuated by either very strong government financing of economic activity (China), or very large current account surpluses which attenuate the impact of credit crunches (the Nordic countries and some northern EU countries, perhaps Korea).
But countries that don’t have either backstop (in particular, Australia and Canada) face either a crisis (if credit is high at the time that credit growth turns negative) or a drawn-out period of economic stagnation worse than that suffered by the 2008 crisis countries.
This is doubly so for Canada and Australia, since they have specialized even more since the crisis on resource-extractive industries, so that their industrial structures are simply not prepared for a world in which resource exports plunge (and perhaps are even banned, as may happen with coal).
KL: The economic policy’s ammunition for the stimulation of the economy in the regular framework runs low in developed countries (even in some emerging economies). Excluding the Fed, major central banks are at zero or negative interest rate. In most countries, especially within the EU politicians avoid increasing public debt and using fiscal policy actively. In this situation there is a heavy debate on Modern Monetary Theory (MMT), which sends the message of fiscal policy’s more active use, maintain of full employment and healthy state of sectoral balances. How do you see the state of the economic policy and do you see useful points in the MMT in contrast to the usual mainstream approach?
SK: Mainstream economics has failed triply, first by failing to anticipate the crisis – whereas several non-mainstream economists like myself did (Bezemer 2009; Bezemer 2010; Bezemer 2011), and a crisis was widely expected within both Post Keynesian and Austrian economic circles – secondly, by not being able to explain the decline in growth since the crisis, and thirdly, by recommending “unconventional monetary policies” which, while they have stimulated the economy to some degree, have come at the expense of widening the wealth inequality gap caused by the boom before the crisis itself.
Much of this failure emanates from their flawed model of banking, which ignores the roles of private debt in economic stability and credit in aggregate demand. But it is also because their approach to government policy is also fatally flawed, and MMT has done a tremendous service for pointing this out.
The hardcore mainstream position was put by Robert Barro in the papers that gave us the concept of “Ricardian Equivalence” (Barro 1989; Barro 1996), which assume that “for a given path of government spending, a deficit-financed cut in current taxes leads to higher future taxes that have the same present value as the initial cut” (Barro 1989, P. 38) and that “households capitalize the entire array of expected future taxes, and thereby plan effectively with an infinite horizon” (Barro 1989, p. 40). MMT establishes that the former is a false assumption – a government with its own currency (that is not constrained by a current account deficit, a point I return to below) can finance and service its budget deficits indefinitely – and the latter is simply a fantasy which should have been rejected by referees on sight.
We now have enough empirical data to categorically reject Barro’s first assumption. The US government surplus since 1900 has averaged minus 2.45%: in other words, it has run a deficit of about 2.5% of GDP for 120 years. If you omit the deficit during the two World Wars, the deficit averages about 2.2% of GDP.
I hope that even a Neoclassical economist will concede that 120 years is a reasonable proxy for the “long run”. Barro’s assumption is that in the long-run this must be zero: it clearly has not been, and in fact comes close to a rule of thumb of mine – that the government deficit should be roughly the rate of nominal economic growth divided by the velocity of money.
So MMT puts the correct perspective that the government deficit is not a constraint in itself, but via in its impact on the performance of the economy – most obviously on the potential for inflation at high employment levels, but also in terms of its impact upon other economic factors such as the current account deficit.
Here I differ from MMT in one respect: its attitude to current account deficits is the opposite of mine, since they argue that “Imports are a benefit, exports a cost” (Mosler 2010, p. 3), and that a trade deficit is beneficial because “A trade deficit, in fact, increases our real standard of living” (Mosler 2010, p. 59). Firstly, I believe that this argument contradicts the extremely sound logic that underwrites the MMT analysis of domestic money creation. Secondly, even if this attitude to trade were correct, this is a reason to establish an international body to restrain predatory trade deficits. Mosler makes this point inadvertently when discussing the domestic USA attitude to trade deficits:
“We are benefiting IMMENSELY from the trade deficit. The rest of the world has been sending us hundreds of billions of dollars worth of real goods and services in excess of what we send to them. They get to produce and export, and we get to import and consume. Is this an unsustainable imbalance that we need to fix? Why would we want to end it? As long as they want to send us goods and services without demanding any goods and services in return, why should we not be able to take them?” (Mosler 2010, p. 60)
If MMT is to be a guide to global as well as US economic policy, then clearly all countries cannot be advised to run trade deficits, since the sum of all trade deficits is zero. So to this extent MMT is US-centric, as some critics allege.
KL: When it comes to climate change, you are usually very critical to economists like Nordhaus, but also to post-keynesian colleagues. What do they all miss?
SK: The fundamental thing all economists have missed to date – or not properly incorporated into their economic models – is the role of energy in production. Both the Cobb-Douglas and the Leontief production functions (and the CES function) assume that output is produced by labor and capital alone. That is a fallacy: all production requires energy, and it cannot be reduced to a form of capital because capital is a man-made means of production, and by the First Law of Thermodynamics, energy can be neither created nor destroyed – only its form can be changed. Some theorists have suggested introducing energy as a third factor of production (Solow 1974; Stiglitz 1974; Kümmel, Ayres et al. 2010; Kümmel, Lindenberger et al. 2015), but this (a) implies that energy can be added to a production process independently of labor and capital, which is false, and (b) by a suitable choice of exponents, a Cobb-Douglas or CES model with energy can set the exponent for energy to zero and therefore predict non-zero output with zero energy input, which is false.
I have recently worked out how to properly incorporate energy into production models, using the simple insight that “labor without energy is a corpse, capital without energy is a sculpture”: energy has to be treated as an input to both labor and capital which enables them to perform useful work. The correct basic form for a model of production is therefore not Y=F(K,L) or Y=F(K,L,E) but Y=F(K(E),L(E)) (Keen, Ayres et al. 2019). Even this needs amendment, since energy is used to transform raw materials – which are also, like energy, things that “the earth produces as a free gift” (Turgot 1774, p. 16).
With this correct perspective on the role of energy in production, economics and ecology are intimately linked. There is necessarily a gap between the energy input to production and the useful work performed as a result, which we call GDP (also, of course, including the transformation of raw materials into more useful forms, and the necessary creation of waste matter). By the Second Law of Thermodynamics, this waste (increase in entropy) must exceed the energy equivalent of the product (decrease in entropy).
With this perspective, there is no debate over whether economics affects the environment adversely: to deny this is to deny the Second Law of Thermodynamics, which as Eddington said so eloquently, is something which cannot be denied: “if your theory is found to be against the second law of thermodynamics I can give you no hope; there is nothing for it but to collapse in deepest humiliation” (Eddington 1928, p. 37).
As it happens, Neoclassical work on climate change is appallingly bad. I have yet to publish an academic paper on this topic, but I have written numerous blog posts detailing just some of the incredible flaws in this approach – especially the approach of William Nordhaus.
Barro, R. (1996). Ricardo and Budget Deficits. Monetary economics in the 1990s: The Henry Thornton lectures, numbers 9-17. F. Capie and G. E. Wood. New York:, St. Martin’s Press;: 13-32.
Barro, R. J. (1989). “The Ricardian Approach to Budget Deficits.” Journal of Economic Perspectives 3(2): 37-54.
Bezemer, D. J. (2009). “No One Saw This Coming”: Understanding Financial Crisis Through Accounting Models. Groningen, The Netherlands, Faculty of Economics University of Groningen.
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Lenton, T. M., H. Held, et al. (2008). “Tipping elements in the Earth’s climate system.” Proceedings of the National Academy of Sciences 105(6): 1786-1793.
Mosler, W. (2010). The Seven Deadly Innocent Frauds, Valance Co., Inc.
Nordhaus, W. (2019). “Climate Change: The Ultimate Challenge for Economics.” American Economic Review 109(6): 1991–2014.
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Turgot, M. (1774). Reflections on the Formation and Distribution of Wealth. Spragg, London.
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