Video: Steve Keen on modelling and the Krugman debate

I think this video is worth watching because Keen gets to the heart of the issues with the standard approach to economics. He says that banks, money and debt are front and center in reality as we now see after the crisis. Consequently, they should also be integral in economic models. I have made exactly the same criticisms in the past. See my piece on the origins of the next crisis which is holding up well in the two years since I wrote it.

For me, the bottom line here is that the crisis is really not over. We need authoritative people like Blinder telling us we’ve got it wrong if we are to have a reasonable chance of getting out of this unscathed. I lobe that kind of stuff – more please! My fear is that the debt and banking problems re-assert themselves in the next downturn to cause significant economic damage. And since I am predicting this is what is likely to occur, it’s not just a worry, it’s something more than that.

Steve Keen video below

P.S. – I did read the comments on the Krugman post Lauren and Steve discuss in the video and the comments are as negative toward Paul Krugman as they suggest. My hope is that we see some more engaged and thoughtful follow up.

  1. BT says

    This video summarises Keen’s position quite clearly. Keen wants to include money and banks very explicitly in his economic models. This is why a clear view of monetary operations (‘tactics’) matters. He also wants his models to be dynamic and dis-equilibrium, like the models of systems engineering.

    This is different from the DSGE New Keynesian models, which lack banks and are equilibrium or quasi-equilibrium models.

    Krugman’s defence is that his Krug-Egg model (DSGE with patient & impatient people) captures some of the key effects of deleveraging/balance sheet recessions. Krugman also says that IS-LM – while an oversimplification – does include money (loanable funds) and gives you the liquidity trap, which is also a good *approximation* of the deleveraging/balance sheet recession.

    So Krugman’s work is very good in the context of DSGE and IS-LM models and gets the policy recommendations right.

    But Keen is saying economics can do even better by embracing some of the approaches of systems engineering, which first requires an accurate understanding of monetary operations.

    Alan Blinder seems to be on the side of accurately describing money (i.e.: getting the direction of causation correct in the money multiplier).

    Cullen Roche strongly agrees with Scott Fulwiler (and others) that the money multiplier is an obsolete gold-standard notion that does not apply to bank credit in a floating exchange rate system.

    But only Keen is really pushing the systems dynamics approach to modelling booms and busts.

    It’s a pity the debate didn’t last.

    1. BT says

      Update: Mark Thoma agrees that, although DSGE models are valuable, economists could benefit from models that include financial intermediation.

    2. Edward Harrison says

      Thanks for the Thoma link. BT, I think this discussion has legs – at least I hope so. It has been going on for a week now and maybe the Keen talk at INET will spur some serious analysis as well.

  2. Dave Holden says

    I really hope this tentative dialog between the silos of thought continues – it’s very much needed!

    1. Edward Harrison says

      I hope so too, Dave. This debate is at least for now causing a bit of a stir. Let’s hope it continues.

  3. David Lazarus says

    My thoughts are that banks need to be included in any economic model because they can fail and when debts become too big they no longer become assets, they become liabilities, which is something that Krugman appears to miss. As for economic equilibrium, I doubt that actually exists in reality. It would be like saying that balance a pencil on its nib is stable. Which it clear is not. It can be momentarily stable but that is not its normal state. I do agree with Krugman’s sticky prices. Look at the housing market for lots of examples of sticky prices especially downward. Though housing is not as competitive as it needs to be to be sticky upwards.

    Edward I agree with you that the financial problems are not over. Too much debt exists, but still risky trading is the issue. I am coming to the conclusion that as austerity destroys Europe slowly it will eventually mean big European banks collapsing and this will totally disprove risk models that interbank lending is risk free. So bank losses and then derivative liabilities will eventually wipe out the big US banks. The problem will then be will US politicians actually bail out the banks again and destroy the US middle class in the process.

  4. Bernd says

    Hi Ed, I thought this link might be interesting for you:

    A member of the german council of economic advisors, Peter Bofinger( ), essentially siding with Keen and calling Krugmans approach a “Mickey-Mouse” model [of banking], in the german version of the FT.

    Here´s the key passage:

    “FTD Sie werfen Ihren Kollegen vor, dass es ihnen nicht gelingt umzudenken. Gibt es bei Ihnen auch Dinge, die Sie heute anders sehen?
    Bofinger Ja. Was ich vor der Krise völlig unterschätzt habe, ist, welche gefährliche Rolle die Finanzwirtschaft für die Realwirtschaft spielen kann. Banken bestimmen mit ihrer Kreditvergabe entscheidend darüber, wie hoch Investitionen sind und wo sie vorgenommen werden.
    FTD Kommt das in den Lehrbüchern gar nicht vor?
    Bofinger In den Modellen agieren die Banken als reine Vermittler, die Ersparnisse einsammeln und sie als Kredite wieder zurück in die Wirtschaft geben. Diese Mickymaus-Modelle sind völlig realitätsfern. Der Finanzsektor braucht keine Einlagen um Kredite zu vergeben, in den Jahren vor der Krise konnten Banken nahezu grenzenlos Kredite aus dem Nichts schaffen. Daran wäre das Finanzsystem fast zusammengebrochen. Diese aktive Rolle der Banken hat bis heute weder Eingang in die Lehrbücher noch in die geldpolitische Strategie der Europäischen Zentralbank gefunden.”

    1. Edward Harrison says

      Thank you for the link, Bernd. I will take a look at it. Personally, I am surprised at how much people are pushing back on the idea that debt and banks are not central to economic modelling. Clearly we have seen fantastic levels of debt build up in the economy. It’s mind boggling that, in the wake of a financial crisis, this debt build up is not seen as the major contributing cause of financial fragility. The point is that general debt panics have always led to major economic calamities as they exposed an overleveraged system to mass liquidation. We need to fully integrate these events and their causes into how we think about the economy.

      1. David Lazarus says

        True but the world of mainstream economics has not really adjusted to this fact that this was a debt induced crisis. When neo-classical models do not even take into consideration debt levels what can you expect from them?

        1. Obsvr-1 says

          I expect an open mind, objectivity and an acknowledgement that education is an ongoing process of investigation, analysis and fact finding.

          [It is ironic that folks like Krugman, who are academics, seem to divert from the educational process into entrenched self described views of the world].

          Steve Keen has done some amazing work, and the “economic establishment” should embrace and incorporate his line of thought. [ thinking being the operative word/concept]

      2. Bernd says

        Here´s my attempt at a translation, I know you speak German, but it may be interesting for others:

        FTD: Your reproach to your colleagues that they fail to adjust there thinking to the new reality[post financial crisis]. Are there any aspects that you[personally] see in a different light today?

        Bofinger:Yes. What I completely underestimated prior to the crisis is what a dangerous role the financial sector can play in terms of what the real economy is concerned. Banks, through the extention of loans, control how high the level of investment is and where[in which areas/sectors] investments takes place.

        FTD: Is that aspect not covered at all in the [economic] textbooks?

        Bofinger: In the models[covered in textbooks] banks act purely as intermediaries, they collect savings and then hand them back to the economy in the form of loans. These Mickey-Mouse models are far removed from reality{I´m not sure this translates well, the gist of “Mickymaus-Modelle” is: fantasy models}.
        The financial sector does not need deposits to extend loans, over the years prior to the crisis the banks where able to create loans out of nothing[/out of thin air]. Due to that the financial system almost broke down. The active role that banks play has neither been included in textbooks up to today, nor is it taken into account by the ECB when formulating monetary strategy[/policy]. ”

      3. DCF says

        The nub of the problem is that because the mainstream see loans as originating from existing deposits, private debt can never be a problem (by definition). In their world the role of the bank is simply to act as intermediaries to transfer e.g. $1000 from you to me. However in the real world this is not how it works. We have an expansion of credit, and a subsequent expansion of demand without any matching loss of demand from existing deposit holders — who still have their money should they wish to withdraw and spend on goods, services, and assets. result = bubbles.

        What I find surprising is that none of this should require theorizing — surely all the economics profession need to do is talk to bankers and accounts and learn the operational facts (knowable knowns). Save the theorizing for esoteric topics where the facts are known unknowns.

  5. Marko says

    If some economists , like Krugman , can’t accept the idea that banks “create money out of thin air” , they should be able to accept that banks “create asset values out of thin air” , as they did with bogus AAA MBS and such.

    Only by selling off the phony securities did their deposits (somewhat) keep pace with their lending. Once you accept that banks can either create money or create asset value , you then must accept that you have to account for them in your economic model.

    The fact that – in the long term – values will mean-revert is the lamest possible excuse for ignoring the issue that I can imagine. Serial bubble-blowing and bursting is no way to run an economy.

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