Keen on financial crises ahead

I was listening to Steve on the radio yesterday. Here a short video of the Bloomberg Surveillance. 

The World Health Organization warns of outbreak of virulent new ‘Economic Reality’ virus

New paper by Steve Keen. After Paul Romer accused mainstream colleagues of using phlogiston to explain phenomena they don't understand, now we have a better working hypothesis about what is happening with the mainstream. From the abstract:

A new virus, known as ‘Reality’, has started to afflict Mainstream Economists, causing them to reject the ‘as if’ arguments they used to use to justify their models. There is no known cure for the virus, and complete avoidance of ‘Reality’ is the only effective strategy to prevent infection.

Read full paper here.

A debate on Endogenous Money and Effective Demand: Keen, Fiebiger, Lavoie and Palley

The last issue of the Review of Keynesian Economics (ROKE) has a debate between Steve Keen with Brett Fiebiger, Marc Lavoie and Tom Palley. Two papers are available for download (Keen and Lavoie's). Tom's paper is available as a working paper here.

The basis for Steve's defense of endogenous money is based on the works of Schumpeter, as developed by the latter's student Hyman Minsky. In his words:

"The proposition that effective demand exceeds income is not a new one: it can be found in both Schumpeter and Minsky (and arguably in Keynes's writings after The General Theory, though not in as definitive a form – see Keynes 1937*, p. 247). A difference between income and expenditure, with the gap filled by the endogenous creation of money, was a foundation of Schumpeter's vision of the entrepreneurial role in capitalism. Minsky's attempt to reconcile endogenous money and sectoral balances is the closest antecedent to the argument I make, but I will start in chronological order with Schumpeter's analysis."

I have noted before that the idea of endogenous money is NOT central for heterodox approaches, since Wicksell and the whole modern New Keynesian consensus adopts it. And perfectly conventional authors like Irving Fisher had introduced debt in their models too. I also noted that Schumpeter is essentially a Real Business Cycle (innovations are nothing but exogenous productivity shocks) author, which thought that both short-run output and employment and long-run growth were determined by supply-side factors. So in general I'm not a great fan of having Schumpeter as a staring point, or the notion that to introduce debt and endogenous money is per se a critique of the mainstream.

In that respect, I tend to agree with Tom's point that it is the way in which endogenous money and debt are introduced in the model that matters. Keen's use of a variation of Fisher's equation of exchange, as pointed out by Tom, is troublesome. In Tom's words:

"The Fisher equation constitutes the monetarist framework for macroeconomics. Income-expenditure accounting constitutes the Keynesian framework and it offers an alternative approach to understanding the AD, credit, endogenous money nexus."

In fact, in the equation of exchange framework the presumption is that demand would adjust (in Steve's approach with endogenous money) up to the point that it meets supply at the optimal level (also something that would be perfectly in line with  Schumpeter). The whole point of the income-expenditure framework is that it puts demand in charge of the level of activity.

At any rate, a good debate that it's worth checking out. Enjoy!

* J.M. Keynes (1937), "Alternative Theories of the Rate of Interest," 47, Economic Journal, pp. 241-252. Available here (subscription required).

Steve Keen on why Krugman needs a new school of thought

Professor Steve Keen on Krugman's brush-off of heterodox economics. 

In his latest blog, Paul Krugman slings off at non-mainstream economists -- and the students at Manchester University campaigning for change to the economics curriculum -- for wanting fundamental change in economics. The status quo is fine, he reckons: move along folks, nothing to see here. Says Krugman in his latest post, Frustrations of the Heterodox:

“Here’s the story they tell themselves: the failure of economists to predict the global economic crisis (and the poor policy response thereto), plus the surge in inequality, show the failure of conventional economic analysis. So it’s time to dethrone the whole thing -- basically, the whole edifice dating back to Samuelson’s 1948 textbook -- and give other schools of thought equal time.

“Unfortunately for the heterodox (and arguably for the world), this gets the story of what actually happened almost completely wrong.

“It is true that economists failed to predict the 2008 crisis (and so did almost everyone). But this wasn’t because economics lacked the tools to understand such things -- we’ve long had a pretty good understanding of the logic of banking crises. What happened instead was a failure of real-world observation -- failure to notice the rising importance of shadow banking.

“Economists looked at conventional banks, saw that they were protected by deposit insurance, and failed to realise that more than half the de facto banking system didn’t look like that anymore. This was a case of myopia -- but it wasn’t a deep conceptual failure. And as soon as people did recognize the importance of shadow banking, the whole thing instantly fell into place: we were looking at a classic financial crisis…

“Events have also reflected very badly on the style of economics that prizes 'microfoundations' based on ultra-rational behavior over evidence, and rules any kind of ad hockery out of bounds. But the heterodox want more than that; they want to interpret recent events as a refutation of the kind of economics Simon Wren-Lewis, or Janet Yellen, or Larry Summers (as economist, not public official), or yours truly does. And that interpretation just doesn’t work. By all means, advance heterodox ideas if you believe they’re right. But don’t claim vindication from events that didn’t actually follow the script you wish they did.”

Thus does Krugman trash what he accurately sees as “an upwelling of frustration on the part of heterodox economists” like Tom Palley, and students at the University of Manchester (A post-crash manifesto to rebuild economics) about the failure of economics to change after the financial crisis. No need for change, boys and girls: mainstream economics has everything under control. We missed the crisis just because we failed to observe the shenanigans in the shadow banking system. Once we realised our observational errors, we had all the necessary tools and knew what to do. (Oh, and what the rebels said would happen didn't anyway, so there!)

Read the rest here.

Palley's Keynesian critique of Keen and an alternative theoretical framework

New Paper by Tom Palley titled: "Effective demand, endogenous money, and debt: a Keynesian critique of Keen and an alternative theoretical framework."From the abstract:

This paper presents a Keynesian critique of Steve Keen’s treatment of the endogenous money – credit – aggregate demand (AD) nexus. It argues his analytic intuition is correct but is developed in the wrong direction. Keen’s fundamental relation describing determination of AD in an endogenous credit money economy suffers from two flaws. First, it neglects the core Keynesian problematic of leakages from and injections into the circular flow of income. Second, it falls into the theoretical morass regarding the black box of velocity of money via its adoption of a form of Fisher equation to determine AD. The paper contrasts Keen’s treatment with a Keynesian structural framework. 

Read it here.

Minsky's crises

Last week I taught a couple of classes on financial crises, including Minsky's ideas. Lance Taylor's paper (with Stephen O'Connell; subscription required) is probably one of the few discussions of Minsky in a mainstream journal (in the Quarterly Journal of Economics, the working paper series of Harvard and MIT), and one of the last heterodox papers published on any topic, by the way. Lance's paper, as he admits leaves out a lot of the institutional richness of Minsky's ideas.

In Lance's model the crisis is fundamentally based on expectations about future profits, and the determination of economic growth is demand determined, but based on a Cambridge equation model in which profits determine investment. It's fundamentally a profit-led regime (for a critique of these kind of closures see here). In this view, the crisis is brought by a sudden decline in confidence (although a hike in the rate of interest would work too), which leads to a contraction of growth, and even lower expectations of future profits. Eventually, if the central bank continues to 'lean against the wind,' in this simple version by expanding money supply, the expected profits would pick up and the economy would recover.

The paper lacks the Minskian notion of firms and individuals getting increasingly indebted, with ever higher leverage ratios, as a result of competition, or worsening income distribution. Note that Godley's framework [Godley arrived at the Levy Institute, if I'm not wrong, right before Minsky passed away, so for a while they were both there] suggests that private debt accumulation was one, and the crucial, unsustainable process in the US economy. Keen provides a more recent formalization of Minsky's ideas worth looking, suggesting that is essential for understanding the Great Recession. Palley, on the other hand, suggests that while important Minsky's model does not provide the whole picture.

Keen on Krugman and the endangered heterodoxy

Steve Keen replies to Krugman (who was commenting on a post by Noah Smith), again, on whether neoclassical economics has done a good job during the crisis. Krugman's point is that we should evaluate models, and how well they can manage to explain the crisis, and not individuals, or how well they have predicted the crisis. Arguably there is a correlation between the two. Individuals using more sensible models should do better, but obviously good luck, or a certain personal ability that transcends the particular model (and underlying theory being used) might also have a significant impact on predicting outcomes.

Mind you, the broader point that Paul makes is that the mainstream model (an ISLM with a natural rate is what he has in mind, and a few imperfections) has done pretty well. I have dealt with Paul's claims in more than a few posts (see here) and will not deal with that. What I think is relevant that was raised by Steve is that there is no evidence, in spite of the great expectations that several heterodox groups harbored, for an improvement in the profession, and changes in what they teach and use for policy advice.

Steve says:

"Even though the crisis has led the public to be more sceptical (sic) of economics in general, the dominance of neoclassical economics has if anything increased in academic institutions, while the Post Keynesian approach – to which I belong – is even more endangered than it was before the crisis began."

That seems about right. And I'm more skeptical about changes in the IMF and other key institutions than Steve. In part, the survival of austerity, and the respectability that the Reinhart-Rogoff bogus 90% debt result had are proof of that. Krugman's attachment to his conventional model is part of the problem.

PS: This post is a bit old, but, given the importance of the Journal of Economic Literature as a source for  reviews, my comments on Gorton and Metrick and what the mainstream learnt from the crisis is still pretty relevant, and apropos for this post. By the way, the problems with the two bubbles (dot.com and housing) were more evident for heterodox authors, since they did play a role in their theories, and overall heterodox authors were able to foresee the effects better than mainstream authors.

What is really neoclassical economics?

So Noah Smith thinks that I, Lars Syll and Steve Keen, and other heterodox bloggers (in which he adds Austrians; you see why they should teach History of Thought?* For a discussion of the meaning of heterodox economics, including why Austrians are not so, go here) use the term neoclassical economics as a pejorative term. In fact, in the post he links to, in which I do criticize his views on Graber's work, I do say this on neoclassical economics: "mainstream (neoclassical) notions about debt are really problematic." So nothing derogatory or abusive is suggested. What is said there is that certain views of that particular school of thought are not necessarily free of problems. So no, neoclassical is not a slur.

But before I get back to what I think Noah is trying to get to, we need to address the actual meaning of neoclassical economics. For starters neoclassical is a bit of a misnomer. Veblen invented the term to suggest continuity between the old classical school and the new marginalist school of his time, fundamentally based on Laissez Faire providing an intellectual link between both groups. But the continuity between classical authors and marginalists is not defensible, once one goes beyond certain policy stances and concentrates on the main theoretical propositions of both schools [in this respect the book by Krishna Bharadwaj is still worth reading]. But we are to some extent stuck with the name. So be it.

The core propositions in neoclassical economics are associated to what Garegnani referred to as the data of the system, that is, the variables that are taken as exogenous and allow explaining the functioning of the system, namely: the endowments of factors of production, the preferences of the economic agents, and technology. On the basis of these variables the supply and demand functions of all goods, including the so-called factors of production (capital, labor and land), can be determined, and as a result the relative prices of all goods and the efficient allocation of resources is established. Central to the approach is that supply and demand for labor and capital determine the remuneration of these factors of production, and as a result, and in contrast to classical political economy and Marx, income distribution is endogenously determined [there are insurmountable problems with this theory, as Paul Samuelson accepted, subscription required; for more go here]. And there are differences between the old version of neoclassical models based on the notion of a long term equilibrium (which is what is still taught in undergrad courses) and the intertemporal version, but for our purposes we can just omit the differences.

Note that Noah says that neoclassical economics is: "Assumption of individual rationality, utility maximization, and supply/demand." But this is at best incomplete, and at worst simply incorrect. Yes they assume individual rationality, but that was also true of classical authors like Smith, Ricardo and Marx, who wouldn't assume that capitalists did not rationally pursue profits. And a more relevant discussion would be about types of rationality, substantive or bounded (like in Simon, but I'll leave that for another post). And also, social utility, not personal individual subjective utility, was essential for classical authors, since nothing that didn't have use value (utility) would be produced. Finally, market prices, but not long term natural or production prices, were determined by supply and demand, and disequilibrium played a role in gravitation towards normal prices. So the three characteristics are not enough to distinguish Ricardo and Marx from Marshall or Noah Smith. The essential thing is that supply and demand determine the long term normal prices of everything including factors of production (endogenous distribution).

Noah then points out that papers that deal with the issues in the core are almost not published. He says that publication of papers that deal with the theoretical core fell "from over half of top-journal econ papers in 1963 to less than 28% in 2011." As it should be, in particular with a core that has been revealed to be so full of problems since the capital debates. And yes, most developments like the Acemoglu et al. paper (discusses here in various places by Cesaratto and I, also here) are orthogonal to the core. But these are developments outside the core, but still within the so-called protective belt of the neoclassical paradigm or research program (for protective belts and paradigms go here and here). The problem is that they still presume that the neoclassical theory in the core holds. Note that they suggest that a minimal government that protects private property rights is enough for development, something that goes hand in hand with the neoclassical core. So a lot of the time what seems to be the use of neoclassical economics as an insult is just frustration about the inconsistencies that appear between the empirical research in the protective belt and the incoherence in the core.

Mind you, as students and newly minted PhDs like Noah have never heard or read on the capital debates, and have not been exposed to the authors of the surplus approach and Marx (besides reading less in other disciplines in the social sciences) it is not surprising that the term neoclassical is seen as an insult hurled at them by crazy and older heterodox economists. But it's not. Don't get me wrong, the core of neoclassical economics is not good or bad in itself, but it is logically flawed.

* By the way, it should be required at both the graduate and undergraduate level, since many graduate students come from other disciplines. A discipline that does not understand its own history is bound to move blindly rediscovering old truths, accepting already discarded myths, and forgetting useful ideas. And you might have, also, the paradoxical situation of a neoclassical economist that does not know what neoclassical economics is (like Dave Chappelle's black white supremacist).

PS: Note that Noah is not responsible for the definition of neoclassical economics he uses, which was lifted from Wikipedia. And yes Wikipedia is not the best source.

Macroeconomics and the financial cycle

Claudio Borio from the BIS has written a widely cited paper. The Economist has linked to it and suggested that so far his advice for including the financial cycle into macroeconomics has only been followed by a few. Besides Borio, Minsky, Godley and Lavoie and Keene are also cited by The Economist. The paper by Borio (he only cites Minsky), which has been a very influential voice suggesting that capital flows were pro-cyclical and more regulation was needed before the financial crisis, is somewhat underwhelming though.

For starters the definition of the financial cycle is based on individual perceptions. In his view, financial cycles result from "self-reinforcing interactions between perceptions of value and risk, attitudes towards risk and financing constraints, which translate into booms followed by busts." Then there is the question of the theoretical features for modeling the financial cycle according to Borio. There are three that are essential according to him. First, that financial cycles have endogenous causes, second, that debt must be present, and last but not least a different measure of the output gap. The last one is really the central theoretical modification in his scheme [note that heterodox models, like Kaldor's 1940 cycle model were endogenous, and Keynes had debt in the General Theory, in chapter 19 it is central, in fact].

The new output gap measure would include financial variables. He correctly notes that output gap measures take into consideration only inflation, when ascertaining whether the economy is above the potential or not, and that "it is quite possible for inflation to remain stable while output is on an unsustainable path" [and you can have inflation without being at full employment too, I would add]. His measure of the output gap would include information about asset price inflation too (property prices and measures of credit booms) and is shown for the US and Spain as the red line below.

Note that the new output gap shows the economy growing way beyond its potential in both the US and Spain before the crisis, more than in the alternative measures using a Hodrick-Prescott filter (green) and a conventional production function (blue). He concludes that: "potential output and growth tend to be overestimated" by conventional methods. Further, his point when arguing that the cycle is endogenous is that excessive booms are the cause of the collapse, so what is needed is to smooth out the boom. The prescription is to grow less and avoid to surpass the potential level, which is supply determined and exogenous presumably (since no word on this is uttered).*

He wants then to constrain booms, and macroprudential policies should be used for that aim. Further, while noting that in balance sheet recessions (following Koo) it is important to deal with agents losses head on, he suggests that "fiscal policy is less effective than in normal recessions" and that as a result of excessive monetary expansion after the bust "the central bank’s autonomy and, eventually, credibility may come under threat." So one really needs to kill booms, since nothing much beyond re-writing debt down and acting as lender of last resort with moderation can be done after.

I have several problems with these views, even if there are some good things, beyond good intentions, in Borio's paper. In fact, I think that there is significant evidence for the notion that potential output varies with demand expansion (Kaldor-Verdoorn Law), so that if a revision of the way potential output is measured it would be in the opposite direction. Mind you, if you check the chart above it means that Spain now is close to its potential level. I guess the natural rate of unemployment in Spain is around 20% or so (slightly below the current level). Note, also, that in Latin America we have been smoothing the boom with the consequence that our crises are not milder than Asia, but we end up growing less (see the paper by Pérez and Pineda linked here).

However, in my view the biggest flaw in the approach to financial cycles proposed by Borio is the absence of any discussion of how debt-deflation (the balance sheet recessions) affect and are affected by income distribution. There is no understanding of how wage stagnation in the center was as instrumental as financial de-regulation for the collapse, as noted by Barba and Pivetti (link here) or Jamie Galbraith's last book, not by chance called Inequality and Instability. This is again something that heterodox economists have known for a while and that the mainstream still has to learn.

* The reasons for the excess in the boom are associated to excessive finance [which he calls excess elasticity of the system], as in Shin's (2011) global banking glut, and not excessive savings, since he correctly points out that "expenditures require financing, not saving."

Another Cambridge debate: Keen vs. Rendhal

Steve Keen and Pontus Rendahl did a very rare thing. they had an open debate between an heterodox and a mainstream economist. Worth checking it out. Keen linked to the audio here. Rendahl calls it a debate between Keenonomics and Metrodox Equilibrium (see here), whatever that is. If you ask me Rendahl shows the same confusion that most younger -- by which I mean educated post capital debates, and once the new notion of equilibrium (intertemporal short term equilibrium, without a uniform rate of profit) became dominant -- mainstream economists seem to be stuck with (see my previous post too).

Heterodox economics under attack

The University of Western Sydney, where Steve Keen teaches, is proposing to shut down its economics program. For an explanation of what is going on go here.

Not so fast, the premature recovery problem

There is a certain brouhaha about the speed of the recovery. John Taylor says financial crises do not lead to slow recoveries (also Michael Bordo here). On the other hand, Krugman (and also Reinhart and Rogoff here) say that slow recoveries from financial crises are the norm. At stake, obviously, whether Romney is right and Obama is at fault for the slow recovery. Don't get me wrong, I would tend to agree that recoveries are relatively slow after a financial crisis, since deleveraging is a slow process.

Yet, that is not the main issue about this debate. The point is that ALL involved agree that the system has a natural (automatic) tendency to move back to the trend. Bordo refers nicely to Friedman's 'plucking' model. He reminds us, how it works:

"Friedman imagined the U.S. economy as a string attached to an upward sloping board, with the board representing the underlying long-run growth rate. A recession, in this view, was a downward pluck on the string; the recovery was when the string snapped back. The greater the pluck, the faster the bounce back to trend."

So the deeper the recession was, the faster would the recovery be. In other words, for the GOP economists (Taylor in this case) Obama is aborting holding back the economy and precluding what should be a premature or fast recovery. However, the point the critics make is that debt deleveraging makes the recovery slow, but it is more or less automatic anyway. Government is necessary to speed up something that markets, if they weren't imperfect, would do.

Krugman ideas are based on a recent paper on what he called the Fisher-Minsky-Koo model. Steve Keen has provided a full critique of a previous version here (h/t Lord Keynes who also provides an invaluable bibliography on debt deflations here). The essential point that generates an imperfection in the case of Krugman's model is that an external shock (a Wile E. Coyote moment in his terms, since agents finally notice the floor is gone) brings down the natural rate of interest, which becomes negative for a while (see my discussion on Krugman and the natural rate here). In that case, monetary stimulus is not capable of getting the economy naturally back on track, since the interest rate cannot fall below zero, and as a result agents cannot increase consumption enough to bring full employment automatically.

Hence, in the New Keynesian model of debt-deflation the change from more conventional neoclassical models is that they allow for a sudden (and exogenous) reduction in the debt limit that agents can borrow to reduce the natural rate. It's a financial shock (not a real one) that makes the rate of interest that would equilibrate investment with full employment savings (the inverse of consumption) negative. Agents suddenly understand that they would need a negative interest rate to satisfy their intertemporal consumption plans. From a post-Keynesian (I prefer classical-Keynesian but who cares), the problems are not related at all with the natural rate (yes the capital debates have shown that this makes no sense, where did I read that before?). So deleveraging has a direct effect on the ability of consumers to spend, and there would be no automatic bounce back if the equilibrium rate was not negative.

You may think it is a minor issue, and from a policy point of view it certainly the differences are minor. However, note that the New Keynesian version of the recovery suggests that markets are fundamentally, in the long run, efficient (again against logic and evidence) which is an essential totemic myth that they need to preserve.* And that has policy implications. Recoveries from financial crises are slow, as Krugman says, but not because the natural rate is negative. It is a political problem that involves class conflict. It is because agents that cannot consume out of wages (which have stagnated) cannot borrow themselves out of the crisis, and the federal government, the only one that can, will not do it for political reasons (to keep workers demands in line). That's why heterodox economists are not just for expansionary fiscal policy (and don't think that if the Fed signals more inflation investment confidence will pick up), but argue for higher wages, stronger unions, and debt relief.

* Let alone the funny thing that both sides in this dispute are basically arguing that the economy gravitates around a trend that is exogenous and attracts the actual economy (in a stronger or weaker way), and the way they actually measure the gravitational center (the natural trend) is by averaging the actual rates.

PS: And no, it's not a joke, they do actually sell that T-shirt!

Heterodox and Mainstream Economics: The Great Confusion

Simon Wren-Lewis has a post on heterodox versus mainstream macroeconomics in which he seems surprised by what he calls the Great Divide between the two groups. He claims to be sympathetic to the heterodox project, at least along the lines of Steve Keen, but argues that the "rejectionist strategy is of course unlikely to win friends within the mainstream."

Wren-Lewis also suggests that a Minsky model developed by Keen (which according to Keen was rejected by several mainstream journals) is very similar to his ideas, but he fails to note that the Keen's model, as well as Minsky's theory, does not include a crucial characteristic of mainstream models, New Keynesian (NK), New Classical (NC), Real Business Cycle (RBC) and New Neoclassical Synthesis (NNS) alike, namely: Friedman's natural rate hypothesis.*

If you accept that cycles are just a shock (monetary or real) to an optimal trend and that the only thing that prevents the return of the economy to its optimal level is some sort of rigidity, then the obvious solution, at least in the long run, is to eliminate the rigidities. By the way, that is the reason why the NKs and NNSs authors end up believing in a confidence fairy, very much like NCs and RBCs authors. The NK and NNS fairy being about higher inflation expectations allowing for more investment demand, rather than directly about the less uncertainty allowing for more investment.

Wren-Lewis' confusion is to assume that the proximity of heterodox Keynesian groups and NKs like him on policy issues implies that on a deeper theoretical level there must be agreement too, and that this does not happen because of the sectarian nature of the heterodoxy.

Krugman's views, by the way, are very similar, in the sense that he seems to not quite understand why he is not seen as Keynesian by some heterodox economists. In a recent post, he argues that:

"Some devotees of Keynes claim that people like me aren’t really Keynesians – and while there are some serious grounds for the charge, part of the reason is precisely that we’ve treated Keynes as an inspiration to be modified in the face of evidence rather than as holy writ."

The confusion is incredible. Keynes himself accepted some neoclassical ideas that made his argument limited and heterodox authors actually have discarded a lot of Keynesian concepts (I myself believe that both the marginal efficiency of capital and liquidity preference are highly problematic, but that is material for other posts). The problem with Krugman is that he maintains (yes you guessed) the natural rate (a concept that a least Keynes wanted to drop from his theory), and suggests that unemployment and the recession are caused by the downward rigidity of the interest rate (a liquidity trap), propositions for which there is little evidence. Krugman is the one that treats neoclassical principles (the idea that a natural rate exists) as holy writ!

Both Krugman and Wren-Lewis seem to believe that economics (and science) is about convincing the others on a political level and are puzzled by the fact that heterodox do not fall in line with the NKs. That is why a less rejectionist, to use Wren-Lewis term, strategy is suggested (a similar view by Colander is criticized here). The problem is that evidence and logic (for the logical critique of the natural rate you must get the capital debates) suggest that the natural rate does not exist. Don't get me wrong, on political issues most heterodox authors are with Krugman, Wren-Lewis and company, against austerity, but science implies (as Krugman himself notes) adherence to facts.

So why don't NKs just renounce to the idea of a natural rate once and for all. For one they would make lots of friends within the heterodox community, which is way ahead in understanding the crisis (and foreseeing it too), and also would make their models more realistic.

* I have my own troubles with the kind of model presented in that paper by Keen, which are related to his profit driven investment function, but that is better discussed in another post.

Not so Keen on Krugman

I have been critical of the theoretical positions held by Krugman for a while now, even if he and DeLong, and even Summers, have been useful for policy reasons. Now a lengthy debate between Krugman and Steve Keen, a very pragmatic and reasonable post-Keynesian (and I guess part of MMT tradition) that understands endogenous money has developed [a good summary with all the links here].

First, and foremost endogenous money implies that the rate of interest is exogenous and determined by monetary authorities. That per se is not necessarily in contradiction with a neoclassical/marginalist view according to which the rate of interest equilibrates investment to full employments savings, as Krugman clearly believes. Wicksell [see here] certainly did not think so either.

For Wicksell in a giro system, in which all transactions were recorded as debit/credit relations, credit could expand indefinitely, but in the real world, bank reserves would vanish and lending would eventually collapse if the bank rate remained below the natural rate for a long period. That is fundamentally the reason why Krugman does not understand the notion that banks can create reserves, and that loans cause deposits. In other words, what regulates the bank rate is, ultimately the natural rate of interest.

Further, the natural rate of interest is NOT a banking phenomenon in marginalist analysis, and, as a result, cannot be exogenous to the system. It results from the marginal productivity of capital and the intertemporal decisions of consumers. Krugman is in fact very clear that he supports the loanable funds theory of interest.

Hence, Peter Cooper is correct to point out that ultimately the debate with Keen must revolve around a notion of a long term normal rate of interest that is institutionally determined by the central bank independent of the marginalist notion of the natural rate. That can only be obtained with the proper critique of the neoclassical notion of capital.