Saturday, April 21, 2012

Paul Krugman, Steve Keen and the mysticism of Keynesian economics

by Michael Roberts

As promised, let me return to the debate within Keynesianism between Paul Krugman, Nobel prize winner and guru of orthodox Keynesianism and Steve Keen, the upstart radical ‘Minsky-Keynesian’, over what are the key processes of modern capitalism and the cause of the Great Recession.
Steve Keen has recently revised and expanded his excellent book, Debunking Economics ( and his attacks on mainstream economics, the nature of capitalist crisis and what to do about it provoked the great columnist of the New York Times and scourge of the Republicans, Paul Krugman, to respond.  Krugman wasted no time in dismissing Keen’s ideas in his daily blog as “mysticism”(  Keen responded sharply and then a long debate ensued with loads of other economists with their blogs entering the fray. You can follow the twists and turns in the debate at

So I suppose it’s my turn.  But first is this debate important and interesting? Well, I think it is, because the differences expressed help to show the struggle that mainstream economics has in trying to explain the slump that world capitalism has just been through and why the recovery is so weak.  This particular debate is not between Keynesians and the Austerians (see my recent post, The debate on austerity, 14 April 2012) for that).  It is between what I call orthodox Keynesianism and a more radical variety that considers most Keynesians still locked in many neoclassical theorems that do not allow them to understand modern finance capital and the banking system. If the orthodox Keynesians did understand, say the unorthodox, then they would see more clearly why capitalism gets into crisis and what to do about it.  Steve Keen leans on the ideas of these radical Keynesians, as a follower of Hyman Minsky and Modern Monetary Theory (MMT), which tries to explain the key role of banking in capitalism as the major cause of economic crises.

So what are the issues at debate?  Well, after perusing thousands of thousand of words from participants in the debate, I think there are three issues.  The first is whether, in a modern capitalist economy, money is created endogenously i.e. demand for money drives its supply, rather than exogenously, namely by the printing or absorption of money by a central bank.  The second is whether the expansion of debt, particularly private credit, adds to demand in an economy, such that it can get way out of sync with the expansion of the production of things and services; and whether this is key to the capitalist crisis.  And third, whether it is the inherent instability of the financial system that is the kernel of crisis and not just the lack of ‘effective demand’ as orthodox Keynesians argue.

Let’s start with the first issue: endogenous money; namely, the need to borrow by corporations, households, financial institutions and government drives bank lending, not vice versa.  The MMT says that banks lend first and that generates deposits, a simple double bookkeeping process.  So banks can create money out of nothing.  Banks do not wait for deposits from customers and central bank cash before lending.  Orthodox Keynesians like Krugman fail to recognise this, says the MMT guys (and Keen).  Banks may drive loan quantity, or create money by lending, but they are restricted in how much by three factors: interest rates (the cost of their own borrowing, partly set by the central bank), required reserves of cash they must hold (as enforced by a central bank regulation) and the amount of equity capital they must hold (again a matter of regulation).  But these restrictions on lending affect the profitability of loans for the banks, not the quantity they can make.

The issue in the debate here is whether central banks have any real control over the money supply and credit in an economy.  In effect, the MMT guys suggest that it is little and the orthodox Keynesians are kidding themselves that the capitalist economy can be controlled by central banks by trying to manipulate the money supply exogenously or even by changing interest rates.  The MMT guys are stating the authorities cannot control the ‘business cycle’,  the cycle of boom and slump, by monetary policy because money is created endogenously.  The orthodox Keynesians like to think that they can and so their policy of lowering interest rates or squeezing bank reserves will work in regulating capitalism.

What does Marx say about this?  Although Marx did not spell out his theory of money and credit clearly in one book (as usual!), it is clear from his writings that he reckoned that money supply is endogenous to the capitalist system and that the banks can create credit as demanded by capitalist production without waiting for some exogenous agent to provide it.  As he put it: “The credit given by a banker may assume various forms, such as bills of exchange on other banks, cheques on them, credit accounts of the same kind, and finally, if the bank is entitled to issue notes – bank-notes of the bank itself. A bank-note is nothing but a draft upon the banker, payable at any time to the bearer, and given by the banker in place of private drafts. This last form of credit appears particular important and striking to the layman, first because this form of credit-money breaks out of the confines of mere commercial circulation into general circulation, and serves there as money; and because in most countries the principal banks issuing notes, being a particular mixture of national and private banks, actually have the national credit to back them, and their notes are more or less legal tender; because it is apparent here that the banker deals in credit itself, a bank-note being merely a circulating token of credit. (Marx, 1894, pp.403-404).  What drives bank lending is not the supply of money but the demands of capitalist production: “The quantity of circulation notes is regulated by the turnover requirements (of capital accumulation – MR)), and every superfluous note wends its way back immediately to the issuer.” (Marx, 1894, p. 524).  Credit creates deposits.

But the Marxist theory of money makes an important distinction from the MMT guys.  Capitalism is a monetary economy.  Capitalists start with money capital to invest in production and commodity capital, which in turn, through the expending of labor power, eventually delivers new value that is realised in more money capital.  Thus the demand for money capital drives the demand for credit.  Banks create money or credit as part of this process of capitalist accumulation, not as something that makes finance capital separate from capitalist production.

But both Marx and the MMT guys agree that the so-called quantity theory of money as expounded in the past by Chicago economist Milton Friedman and others, which dominated the policy of governments in the early 1980s, is wrong.  Governments and central banks cannot ameliorate the booms and slumps in capitalism by trying to control the money supply.   The dismal record of the current quantitative easing (QE) programmes adopted by major central banks to try and boost the economy confirms that.   Central bank balance sheets have rocketed since the crisis in 2008, but bank credit growth has not.

And over the same period, the so-called money multiplier (ratio of broad money in the economy to central bank money), upon which quantity theorists rely to judge whether the quantity of money is right, has just dived (M3/M1).  In other words, central banks have tried to boost the money supply by ‘printing’ money, but it has had minimal or no effect on the real economy because the demand for borrowing has dropped away.

The orthodox Keynesians like Krugman would say that the collapse of the money multiplier proves the phenomenon of the ‘liquidity trap’.  This is when aggregate demand in an economy is so weak that people hoard their money and banks stop lending, so even if interest rates are lowered to zero (as they more or less are now), it does not spark an economic recovery. Then we need exogenous policies to kick-start it.  The MMT guys would say because money creation is endogenous, purely monetary policies like quantitative easing will never work.  Marxists would agree, as long as it is recognised that while banks may be able to create money out thin air, they won’t do so if capital accumulation has slumped.  Credit growth depends on capital accumulation, even if it is never in line (so money is never neutral).

That brings me to the second issue: excessive credit or debt.  One of the key arguments of the Austrian school of economics is that credit can become excessive because it is artificially driven up by central banks.  If there were no central banks, then the ‘free market’ would eventually bring credit into line with production through a move to an equilibrium rate of interest.  Money would have a neutral effect on production and there could be no monetary crises, if it were not for central bank interference.

Steve Keen also argues that the key to crises under capitalism is excessive credit or private debt. But it is not the Austrian explanation.  Instead, he leans on the ideas of Hyman Minsky, the radical Keynesian of the 1980s.  Keen-Minsky argues that the modern financial system is inherently trying to expand credit to gain higher returns.  This leads to a Minsky-type of financial speculation (for more detail on Minsky’s speculation view of banking, see my paper, The causes of the Great Recession).  Private credit rockets as banks speculate in ever riskier forms of assets (stocks, bonds, property).  This creates extra demand in an economy that cannot eventually be satisfied. Increasingly, borrowing is raised just to cover previous borrowing in a Ponzi-like scheme.  Eventually, the whole pack of cards collapses in a ‘Minsky moment’ and capitalism has a slump.

Keen says the best way to look at Keynesian-style ‘aggregate demand’ in a modern capitalist economy is to add to national income the amount of private debt or borrowing.  If you amend Keynes like this, you get a better indicator of when a crisis is coming.  Keen won the Real Economics Review prize for forecasting the credit crunch. He says that this came to him as a revelation because he suddenly realised how the rise in US private debt was preparing a crisis.  Keen said the graphic on US private debt to GDP looked like the ‘hockey stick’ graphic for global warming.

The orthodox Keynesians did not consider this and Krugman dismisses the idea in his debate with Keen.  For them, the crisis, namely a collapse in aggregate or ‘effective demand’, is due to the ending of what Keynes called ‘animal spirits’, a loss of business confidence that feeds through to a collapse in investment and a willingness to spend.  It is not due to excessive private debt.  A slump ensues and can stay for a long time if the economy is locked into a liquidity trap.  It needs government intervention to break out.

What does Marx say?  Marxist theory agrees with Keen that private credit can become excessive.  Indeed, this flows from the Marxist view that money is not neutral in the capitalist economy but central to it.  Credit can and will get out of line with the capitalist production.  Credit is really fictitious capital i.e. money capital advanced for the titles of ownership of productive and unproductive capital i.e. shares, bonds, derivatives etc.  The prices of such assets anticipate future returns on investment in real and financial assets.  But the realisation of these returns ultimately depends on the creation of new value and surplus value in the productive capitalist sector.  So much of this money capital can easily turn out to be fictitious.

The key point for Marxists here is profit.  The huge rise in private debt (measured against GDP) is clearly a very good indicator that a credit bubble is developing.  But it alone is not good indicator of when it will burst.  Some economists in the Austrian school have tried to gauge when the tipping point might be by measuring the divergence between the growth in credit and GDP growth (see Borio and White, Asset prices, financial and monetary stability, BIS 2002).  But Marxist theory provides a much better guide.  It is when the rate of profit starts to to fall; then more immediately, when the mass of profits turns down.  Then the huge expansion of credit designed to keep profitability up can no longer deliver.

It is this model of crisis that I adopted back in 2006 for my book, The Great Recession.  It led me to predict a major slump for 2009-10 (I was wrong as it came a year earlier).  The evidence was there for the US, where  the global slump was triggered.  The US rate of profit peaked in 1997.  At the beginning of 2006, the mass of profits began to fall and the housing market turned down.  Within 18 months, the credit crunch happened and the rest is history.

One way of showing how the fall in the rate of profit combined with excessive debt to bring US capitalism down is to measure the rate of profit not just conventionally against tangible corporate assets but also against financial assets (fictitious capital), which had risen so much.  I have done this in several places (including my paper, The profit cycle and economic recession and various posts).  Here is the graph again to emphasise the point.

It shows that the US corporate rate of profit as measured against all assets, was lower in 2002 than it was in 1982, while it was higher against just physical assets. Once conventional profitability also turned down in 2006, the crisis began and the impact was much bigger because of the size of fictitious capital.  Now, everywhere capitalism continues to try and ‘deleverage’ to cleanse not just dead capital out of the ‘real’ economy, but also to get rid of fictitious capital.

That brings me to the final issue: the cause of crisis.  For the orthodox Keynesians, it is due to the collapse in aggregate or effective demand in the economy (as expressed in a fall of investment and consumption).  This fall in investment leads to a fall in employment and thus to less income.  Effective demand is the independent variable and incomes and employment are the dependent variables.  There is no mention of profit or profitability in this schema.  Investment creates profits not vice versa.  This is the view of Keynes: “Nothing obviously, can restore employment which does not first restore business profits. Yet nothing, in my judgement, can restore business profits that does not first restore the volume of investment.”  (Collected Writing Vol 13, p343.

As I have argued before (see my post, Double dips, deficits and debt, 24 August 2011), these schemas are ‘back to front’ in explaining the laws of motion of capitalism.  Marx’s schema is the opposite.  A change in profits produces a change in investment, which in turn, affects employment and incomes and thus effective demand.

But if investment is the independent variable, according to Keynes, Krugman and Minsky-Keen, what causes a fall in investment? It is an ending of ‘animal spirits’ among entrepreneurs or a ‘lack of confidence’.  As Minsky put it, investment is dependent on “the subjective nature of expectations about the future course of investment, as well as the subjective determination of bankers and their business clients of the appropriate liability structure for the financing of positions in different types of capital assets”.  So profits depend on expectations and crises are the result of changed expectations by financial speculators.   Investment and credit grow as long as there is confidence: what others have called ‘magic Tinkerbell fairy dust’, a belief that things will only get better.

This is the real mysticism of Keynesian economics.  For Keen and the Minsky followers, the orthodox Keynesian/Kalecki identities still apply (see my post, op cit).  Instability in finance and/or excessive credit leads to a collapse of investment or ‘effective demand’ and then onto employment and incomes/profits.  For Marxists, instability in the financial sector would not be enough to cause a major crisis if profitability is rising. The Keynes/Minsky approach is subjective, based on ‘expectations’.  The Marxist approach is objective and based on the law of value.

Depending on your view, the policies for economic recovery are also different.  Keen advocates controlling the level of private debt as the main solution. Krugman advocates regulation of finance and easy money. Failing that, he wants fiscal intervention to stimulate the private sector.  Marxists look to replace the profit system.

The Marxist explanation is the most comprehensive as it integrates money and credit into the capitalist mode of production, it recognises that money and credit are not neutral as the Austrians believe; and argues that money may be a key factor in instability and crisis, as the Keynesians believe, but also shows that it is not the decisive flaw in the capitalist mode of production and that sorting out finance is not enough.  Thus it can explain why the Keynesian solutions do not work either.

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