{"id":25613,"date":"2011-11-28T09:51:09","date_gmt":"2011-11-28T14:51:09","guid":{"rendered":"http:\/\/countingpips.com\/fx\/2011\/11\/28\/debunking-economics\/"},"modified":"2011-11-28T09:51:09","modified_gmt":"2011-11-28T14:51:09","slug":"debunking-economics","status":"publish","type":"post","link":"https:\/\/www.investmacro.com\/fx\/2011\/11\/28\/debunking-economics\/","title":{"rendered":"Debunking Economics"},"content":{"rendered":"

By The Sizemore Letter<\/a><\/p>\n

\"\"<\/a>\"\"
\nIn the new 2011 edition of his magnum opus Debunking Economics: The Naked Emperor Dethroned<\/em><\/a><\/strong>, Australian economics professor Steve Keen comes out guns blazing, blasting the \u201cPanglossian view\u201d of neoclassical economics that did so much to get us into the credit boom and bust that we are still struggling to recover from.<\/p>\n

Keen, unlike most of his peers, understands the role of debt in the economy, both as fuel for a boom and as an enormous anchor that prevents recovery during a bust. He also clearly shows how private financial institutions create most of the debt in the economy, not the government or central banks. \u00a0Mainstream economists did not see the 2008 crisis coming because, frankly, the tools they use have no way to take the role of private debt into account.\u00a0 It\u2019s not that mainstream economists are stupid; far from it.\u00a0 Most are highly intelligent.\u00a0 There just happens to be a rather large hole in their body of research that Professor Keen has sought to fill.<\/p>\n

In the preface, he writes that \u201cas a means to understand the behavior of a complex market economy, the so-called science of economics is a m\u00e9lange of myths that make the ancient Ptolemaic earth-centric view of the solar system look positively sophisticated in comparison,\u201d adding also that \u201ceconomics is too important to be left to the economists.\u201d<\/strong><\/em><\/p>\n

Well said, Professor.<\/p>\n

In this age of popular angst in which our reigning politico-economic system\u2014and the Federal Reserve in particular\u2014is under attack from both the Tea Party on the right and Occupy Wall Street<\/a> on the left, it is easy to dismiss Professor Keen as just another fringe, anti-establishment doom monger.\u00a0 \u00a0But Professor Keen is no Johnny-come-lately, and I advise readers to take his words very seriously.\u00a0\u00a0 While his fiery rhetoric has made him a bit of a black sheep among his peers in the profession, he can rightly call \u201cscoreboard.\u201d\u00a0 He was one of the few professional economists to predict the 2008 meltdown, correctly pointing out the risks of the private-sector debt explosion and sounding the alarms of the disaster to come as early as December 2005.\u00a0 For his efforts, he received the Revere Award from the Real World Economic Review for the being economist \u201cwho most cogently warned of the crisis, and whose work is most likely to prevent future crises.\u201d\u00a0\u00a0 Keen is a man we would all be wise to listen to.<\/p>\n

He\u2019s also highly<\/em> likely to make you uncomfortable, which is a cross that all contrarians bear.\u00a0 As a race, humans crave certainty, and\u2014like a proverbial ostrich with its head buried in the sand\u2014they tend to hide from any evidence that might call that certainty into question.<\/p>\n

Economists are no better than the rest of us on this count and might even be worse.\u00a0 Economists (and political scientists too, for that matter) tend to be dogmatic in their views.\u00a0<\/strong> Like a die-hard Marxist who insists that communism could work \u201cif only it were implemented correctly,\u201d it seems that no amount of evidence to the contrary can convince a neoclassical economist that the market is not always<\/em> efficient and that instant liquidity is not the solution to every problem.<\/p>\n

As Keen writes of his peers,<\/p>\n

\n

I came to the conclusion that the reason [economists] displayed such anti-intellectual, apparently socially destructive, and apparently ideological behavior lay deeper than any superficial pathologies.\u00a0 Instead, the way in which they had been educated had given them the behavioral traits of zealots rather than of dispassionate intellectuals.<\/p>\n

As anyone who has tried to banter with an advocate of some esoteric religion knows, there is no point in trying to debate fundamental beliefs with a zealot.<\/p>\n<\/blockquote>\n

On a personal note, I\u2019ve had the same frustrations in speaking to gold bugs and Austrian economists who, knowingly or not, speak of gold in mystical terms usually reserved for religions and extreme political movements.\u00a0 That gold is the \u201cone true currency,\u201d sounds remarkably similar to the Islamic tenet that Islam is the \u201cone true religion\u201d or that the Catholic Church is the one, true \u201cuniversal church.\u201d\u00a0 Gold may or may not be a good investment or a suitable asset to base an international monetary system on; this is a subject for intelligent debate.\u00a0 But you can\u2019t have<\/em> an intelligent debate with an ideologue.<\/p>\n

For those with only a cursory knowledge of the popular schools of economic thought, let this serve as a crash course:<\/p>\n

Neoclassical School:<\/strong>\u00a0 The vast<\/em> majority of economists, including Fed Chairman Ben Bernanke and most policy wonks for both the Republicans and the Democrats, can be loosely classified as \u201cNeoclassical\u201d economists.\u00a0 The Neoclassical School is what you would think of as \u201cmainstream economics.\u201d\u00a0 There is a general belief in the efficiency of markets with a sprinkling of Keynesian ideas about the role of government spending during recessions and Monetarist ideas about the role of the central bank and official interest rates.\u00a0 Where neoclassical economics differ with one another\u2014such as on the proper size of the state, the size of social safety nets, the level of regulation and taxation needed, etc.\u2014they tend to argue at the margins.\u00a0 There is general consensus that, all else equal, markets and trade should be as free as possible, though regulation and fiscal and monetary policy have their respective places.\u00a0 While I consider myself a “free market” guy, I do think it is only prudent to look at the other side of the coin.<\/p>\n

Neoclassical economics hinges on a few assumptions that any non-ideologue would immediately know where untrue (and which Keen relentlessly<\/em> critiques throughout the book):<\/p>\n

    \n
  1. People act independently and on the basis of full information. (Under this assumption, irrational bubbles would be impossible; how anyone believes this given the recurrence of bubbles in history is a mystery.)<\/li>\n
  2. People have rational preferences that can be quantified (Again, this point is dubious at best.\u00a0 We are humans, not Vulcans<\/a>.)<\/li>\n
  3. Markets are rational and tend towards equilibrium (which implies that booms and busts are the exception and not the rule.)<\/li>\n
  4. What is true of the individual is true of the group.\u00a0 (Keynes attacked this as the Fallacy of Composition; more on that later.)<\/li>\n<\/ol>\n

    While the Neoclassical School\u2019s emphasis on the benefits of trade and free markets is generally spot on, the school clearly has its limitations.\u00a0\u00a0 Its dogmatic belief in the efficiency of markets is, frankly, ridiculous and flies in the face experience.\u00a0 And again, it suffers from the Fallacy of Composition<\/strong>, which we will discuss shortly.<\/p>\n

    \"\"<\/a>\"\"
    \nAustrian School: <\/strong>Formerly the domain of gold bugs and various stripes of libertarians, the Austrian School of economics has recently risen to prominence with the popularity of Congressman and perennial presidential candidate Ron Paul.\u00a0 Representative Michele Bachmann also describes herself as an Austrian and claims to read the works of von Mises on her beach vacations.\u00a0\u00a0 For the literary enthusiasts out there, Ayn Rand, author of The Fountainhead<\/em> and Atlas Shrugged<\/em> could be loosely lumped in with the Austrians, though she was not an economist and had her own school of thought known as Objectivism.<\/p>\n

    Friedrich von Hayek\u2014who taught for years at my alma mater, the London School of Economics\u2014and Ludwig von Mises were the main proponents for the movement in its early days, which rose in response to the creeping statism that grew out of the Keynesian movement in the years after World War II.\u00a0 The Austrian School objects to the hyper-precision quantification of most modern economic methods, insisting that economics is too complex and too subject to fickle human tastes to be accurately measured.\u00a0 On this count, I would have to agree. \u00a0\u00a0Unfortunately, they also tend to have a near obsession with the Federal Reserve and the effects of managed interest rates which Austrians believe inevitably lead to inefficient \u201cmal-investment.\u201d\u00a0\u00a0\u00a0 \u00a0For some of the more puritanical Austrians, the Federal Reserve is not simply an inefficient institution; it\u2019s a source of societal moral rot.<\/strong>\u00a0 (The Austrians seem to ignore that, even under a gold standard, irrational booms and busts were still a fact of life.\u00a0 It appears that the human emotions of greed and fear were concocted in the conference room of the New York Fed by a cabal of sinister bankers.) \u00a0\u00a0On balance, the Austrians have an emphasis on limited government and personal freedom which is refreshing and admirable, but they tend to be a little too radical to fully take seriously.<\/p>\n

    Hard-core Austrians would have been content to let every bank in America fail, even if it meant 50 percent unemployment and conditions worse than the Great Depression, because it would have struck them as being \u201cjust.\u201d\u00a0 It\u2019s easy to be a radical when you know there is no possibility that what you advocate will come to pass and that you\u2019ll never have to live with the consequences.<\/p>\n

    Keynesian School \/ Post-Keynesian School:<\/strong>\u00a0 Keen would count himself among the Post-Keynesians.\u00a0 For our purposes here, Keynesians and Post-Keynesians are close enough to be lumped together as one.\u00a0 Keynesianism can be defined more by what it is not<\/em> than what it is.\u00a0 It is not<\/em> a dogmatic grand unifying theory.\u00a0 It is more of a hodgepodge of pragmatic adjustments to what Keynes considered shortcomings of a pure market economy.<\/p>\n

    John Maynard Keynes cobbled together what we now call \u201cKeynesian economics\u201d from what he saw as shortcomings of mainstream economics during the Great Depression.\u00a0\u00a0 Delving into the arcane, Keynes believed that \u201cSay\u2019s Law,\u201d<\/strong> a tenet of classical economics that claims that supply creates its own demand, was a half-truth at best.\u00a0 Sometimes supply didn\u2019t<\/em> create its own demand.\u00a0 Sometimes you have overcapacity, falling prices, and weak aggregate demand.\u00a0 Sometimes an economy can settle at an equilibrium far below full capacity.\u00a0 Because of \u201csticky wages\u201d<\/strong> and \u201csticky prices,\u201d<\/strong> sometime the unemployment rate can stay uncomfortably high.\u00a0 Sometimes\u2014just sometimes\u2014the real world doesn\u2019t look like an economics text book, and waiting for things to work out in the long-run is not always a viable option.\u00a0 In the long run, we\u2019re all dead.<\/strong><\/em><\/p>\n

    To smooth over some of the rougher edges of a free-market economy, Keynes argued that the state could be a stabilizing force.\u00a0 One of the more controversial elements of his work was his advocacy for \u201ccountercyclical measures.\u201d\u00a0 Keynes argued that governments should run deficits during recessions to spur demand with the understanding that the debts racked up during the hard times would be paid back with surpluses during the good times.\u00a0 Alas, while this sounds great in theory, the always-pragmatic Keynes seemed to have a complete misunderstanding of how real-world politics works.\u00a0 Borrowing money is easy for a politician.\u00a0 Paying back proves to be remarkably hard.\u00a0 (Note: Though he is a \u201cPost-Keynesian\u201d economist, Keen makes it clear that that countercyclical Keynesian deficit spending is not going to fix an economic plagued by debt deflation.\u00a0 More on that to come.)<\/p>\n

    Governments on both sides of the Atlantic used Keynes work to justify the massive expansion of the state after World War II, and the stagnation that followed led to Keynesian economics falling into disrepute by the late 1970s.<\/p>\n

    Where Keynes\u2019s work would appear to justify socialism, I find it outright dangerous.\u00a0 But much of Keynes\u2019 work is politically neutral, and his insights into markets were largely spot on.<\/p>\n

    In particular, Keynes tore apart the notion that what is good for the individual is automatically good for the group.\u00a0 This is the Fallacy of Composition<\/strong> and is perhaps best illustrated by Keynes\u2019s Paradox of Thrift<\/strong>.\u00a0 While it is considered responsible behavior for an individual to spend less and save more, if everyone did it at the same time the economy would collapse.\u00a0 Keynes\u2019 disciples, including Steve Keen, have taken this notion further.\u00a0 In Debunking Economics<\/em>, Keen writes:<\/p>\n

    \n

    One of the great difficulties in convincing believers that neoclassical economics fundamentally misunderstands capitalism is that, at a superficial level and individual level, it seems to make so much sense.\u00a0 This is one reason for the success of the plethora of books like The Undercover Economist<\/em><\/a> and Freakonomics<\/em><\/a> that apply economic thinking to everyday and individual issues: at an individual level, the basic concepts of utility maximizing and profit-maximizing behavior seems sound.<\/p>\n

    As I explain later, there are flaws with these ideas even at the individual level, but by and large, they have more than a grain of wisdom at this level.\u00a0 Since they seem to make sense of the personal dilemmas we face, it is fairly easy to believe that they make sense at the level of society as well.<\/p>\n

    This reason this does not follow is that most economic phenomena at the social level\u2014the level of markets and whole economies rather than individual consumers and producers\u2014are \u201cemergent phenomena\u201d: they occur because of our interactions with each other\u2014which neoclassical economics cannot describe\u2014rather than because of our individual natures, which neoclassical economics seems to describe rather well.\u00a0 <\/strong><\/p>\n<\/blockquote>\n

    Keynesians, better than neoclassicals, \u201cget\u201d that economics is a social science.\u00a0 It\u2019s a lot<\/em> closer to psychology than it is to physics.\u00a0 (In this respect, Austrian Economics is also closer to the truth than Neoclassical.)<\/p>\n

    Neoclassical Economics (and Marxist Economics too, for that matter) focuses almost exclusively on the supply side of the equation.\u00a0 Demand is almost an afterthought, some that just kind of \u201chappens\u201d and doesn\u2019t need to be explained.\u00a0 I consider that a shortcoming and consider Keynes’ workin this respect to be insightful.<\/p>\n

    Much of Steve Keen\u2019s work in Debunking Economics<\/em> and elsewhere is an expansion on the work of two prominent Post-Keynesians: Hyman Minsky and Irving Fisher.<\/p>\n

    Minsky\u2019s Financial Instability Hypothesi<\/strong>s is brilliant.\u00a0 While Neoclassical Economics insists that market economies naturally tend towards equilibrium, Minsky argues exactly the opposite.\u00a0 Stability begets instability,<\/strong><\/em> and vice versa.\u00a0 A long period of stability lulls market participants into a false sense of security and encourages them to take on excessive debts and excessive risks.\u00a0 This inevitably leads to instability and crisis\u2014as it did in 2008\u2014which in turn causes market participants to go too far in the opposite direction, becoming too<\/em> risk averse.\u00a0 Try to get a mortgage today at a major bank, and you\u2019ll see what I mean.\u00a0 The only way to moderate this never-ending oscillation is to avoid the massive accumulation of debts, which can only be done by strictly regulating the banking system.<\/p>\n

    The aftermath of excessive debt is, unfortunately, what Irving Fisher called \u201cDebt Deflation.\u201d<\/strong><\/p>\n

    Debt deflation is a nightmare.\u00a0<\/strong> It starts with a debt-fueled boom.\u00a0 When the boom turns to bust, prices fall, which makes the value of the outstanding debt rise in real terms.\u00a0 The more that consumers and businesses cut back their spending to pay back their debts, the more the economy sinks, the further prices fall, and the higher the value of the debt rises.\u00a0 It\u2019s a vicious cycle in which the harder you try to pay off the debts, the more burdensome they become.\u00a0 This is where Greece is today and where the rest of the developed world may soon be going.<\/p>\n

    Japan is a perfect example of Irving Fisher debt deflation in action, mixed with a fatal dose of bad demographics.\u00a0 The last time prices rose significantly in Japan, Bill Clinton was the Governor of Arkansas.\u00a0\u00a0 Private debts have inched lower over the past two decades, but government debt has exploded in an attempt to follow the standard Keynesian policy of using government debt to spur demand.\u00a0 Alas, this won\u2019t end well for Japan. (John Mauldin calls Japan “a bug in search of a windshield,”<\/a><\/strong> and it is an apt metaphor.)<\/p>\n

    Overall, Keen has written a comprehensive work that I would recommend for any reader with an interest in economics.\u00a0 Keen is a serious student of the profession, and the proof of his critique of mainstream economics is in the pudding.\u00a0 Keen saw the crisis coming.\u00a0 Neither Bernanke, nor Greenspan, nor any other Neoclassical economist did.\u00a0 That, more than anything I can say, is testament to the importance of Keen\u2019s work.<\/p>\n

    If you liked this article by Sizemore Insights<\/em>, you\u2019d probably enjoy The Sizemore Investment Letter<\/em>, our premium members-only newsletter. Click here<\/a><\/strong> for more information.<\/p>\n","protected":false},"excerpt":{"rendered":"

    By The Sizemore Letter In the new 2011 edition of his magnum opus Debunking Economics: The Naked Emperor Dethroned, Australian economics professor Steve Keen comes out guns blazing, blasting the \u201cPanglossian view\u201d of neoclassical economics that did so much to get us into the credit boom and bust that we are still struggling to recover … <\/p>\n

    Continue reading “Debunking Economics”<\/span><\/a><\/p>\n","protected":false},"author":1,"featured_media":0,"comment_status":"closed","ping_status":"closed","sticky":false,"template":"","format":"standard","meta":{"footnotes":""},"categories":[],"tags":[],"class_list":["post-25613","post","type-post","status-publish","format-standard","hentry"],"_links":{"self":[{"href":"https:\/\/www.investmacro.com\/fx\/wp-json\/wp\/v2\/posts\/25613","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/www.investmacro.com\/fx\/wp-json\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/www.investmacro.com\/fx\/wp-json\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/www.investmacro.com\/fx\/wp-json\/wp\/v2\/users\/1"}],"replies":[{"embeddable":true,"href":"https:\/\/www.investmacro.com\/fx\/wp-json\/wp\/v2\/comments?post=25613"}],"version-history":[{"count":0,"href":"https:\/\/www.investmacro.com\/fx\/wp-json\/wp\/v2\/posts\/25613\/revisions"}],"wp:attachment":[{"href":"https:\/\/www.investmacro.com\/fx\/wp-json\/wp\/v2\/media?parent=25613"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/www.investmacro.com\/fx\/wp-json\/wp\/v2\/categories?post=25613"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/www.investmacro.com\/fx\/wp-json\/wp\/v2\/tags?post=25613"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}