Sat Mar 17th, 2012 at 11:30:48 PM EST
Economics without a blind spot on debt Steve Keen
Steve Keen is being interviewed in front of a live audience at the London School of Economics on April 3. The topic will be Banks vs. the Economy. The following was excerpted from a post he prepared for the LSE blog British Politics and Policy at LSE and which he reproduced on his blog Debtwatch.
The LSE and the BBC are to be applauded for this contribution to the discussion of what needs to be done to resolve the ongoing financial, social, political and economic crisis gripping the world.
As a car driver, you have surely had the experience of changing lanes and being beeped by a car with which you were about to collide--but which you didn't see before the lane change. It's because the car was clearly visible in your rear-view mirror, but that part of the image fell on your retina's blind-spot--so you didn't see it. Fortunately most of us learn that we have a blind spot, and so we check carefully to avoid being fooled by it again--and causing an avoidable accident.
If only economists could learn the same way, we might not now be in the accident of this never-ending economic crisis. "Neoclassical" economists (who dominate both academic economics and policy advice to governments) have a blind-spot about the role of private debt in macroeconomics, yet despite the economy crashing once before because of it during the Great Depression, they continue to argue that it's irrelevant now--during this latest crash.
First, let's establish that there was indeed a "car in the rear view mirror" in the 1930s and today. Data on long-term private debt levels is difficult to find, but I've located it for both the USA from 1920 till today, and for Australia from 1880 (see Figure 1). Clearly, there was a debt bubble before the Great Depression, and a plunge in debt levels during and after it (and Australian data also shows the same phenomenon during an earlier bubble and crash in the Depression of the 1890s; see Fisher and Kent 1999). The same process is clearly afoot again now.
Now for the blind-spot. Anyone not blessed--or rather cursed--by an economics education might think there was something in that coincidence of debt and Depressions. But it's nothing to worry about, leading Neoclassical economists assure us--thus confirming that either they know something profound that proves that the coincidence is irrelevant, or that they have a blind-spot which means that their judgment can't be trusted.
The profound insight they believe they have is that the level of debt doesn't matter, and that only the distribution of debt can be important. Ben Bernanke rejected Irving Fisher's "Debt Deflation" explanation for the Great Depression on this basis; after noting that Fisher did influence Roosevelt's policies, Bernanke added that:
`Fisher's idea was less influential in academic circles, though, because of the counterargument that debt-deflation 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)
One crisis later, leading Neoclassicals like Paul Krugman continue to argue that only the distribution of debt can matter:
People think of debt's role in the economy as if it were the same as what debt means for an individual: there's a lot of money you have to pay to someone else. But that's all wrong; the debt we create is basically money we owe to ourselves, and the burden it imposes does not involve a real transfer of resources.
That's not to say that high debt can't cause problems -- it certainly can. But these are problems of distribution and incentives, not the burden of debt as is commonly understood. (Krugman 2011)
For a clear presentation of the role of the change of debt and the rate of change of debt on the performance of the economy see Better Economic Theories
So can we ignore the level of private debt? No--because this "profound insight" is in fact a blind-spot about the role of banks and debt in a capitalist economy. Neoclassical economists treat banks as irrelevant to macroeconomics--which is why banks are not explicitly included in their models--and regard a loan as merely a transfer from a saver (or "patient agent") to a borrower (or "impatient agent"), as in Krugman's "New Keynesian" model of our current crisis:
In what follows, we begin by setting out a flexible-price endowment model in which "impatient" agents borrow from "patient" agents, but are subject to a debt limit. (Krugman and Eggertsson 2010, p. 3)
With that model of lending, a change in the level of debt has no inherent macroeconomic impact: the lender's spending power goes down, the borrower's goes up, and the two changes roughly cancel each other out.
However, in the real world, banks lend to non-bank agents, giving them spending power without reducing the spending power of other non-bank agents.
See Steve's blog post for the tabular figures 2 & 3 which clearly show the difference between the NCE analysis of the role of banks in the economy and the model used by, for instance, by economists at the FRBNY since the '70s. In their analysis and modeling NCE does not seem to really take account of the role of variation in bank created 'money' in the economy, which correlates well with the business cycle. Steve Keen does and shows the correlation between accelerated borrowing and declines in unemployment as well as decelerated borrowing, or 'deleveraging' and rises in unemployment.
As to Krugman's claim "flexible-price endowment model in which "impatient" agents borrow from "patient" agents, but are subject to a debt limit" - just where was that 'debt limit' from 2000 to 2008 - when we needed it? Please indicate on Steve Keen's figure 6 below: