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Dude, Where’s my recovery?

June 13, 2011

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Occasionally I forget that Paul Krugman doesn’t know what he’s talking about, nor does Robert Reich, nor does Rachel Maddow, nor a host of other heart-in-the-right-place progressive personalities. Not that they are completely at sea, but that they have mischaracterized the cause and so the solution of the current depression. And to be fair, they are drifting toward the proper understanding.

Today we’ll review the situation by way of a recent post from Australian economist Steve Keen. Now Keen plainly does know what he’s talking about. He is first recipient of the Revere Prize for the economist who most aptly predicted the coming of the Great Financial Crisis, author of the soon-to- be updated “Debunking Economics”, founding member of the World Economics Association (which you should look up and join too), and directly in line in terms of financial Keynesianism from the great Hyman Minsky.

While Keen does not take his analysis to its conclusion in the death of the consumer economy that we do at Demand Side, all the elements are there, and we are happy to draw the line to the final dot. More importantly, the first steps are there.

In a recent post under the title, Dude, Where’s my recovery? Keen describes the predicament facing Barack Obama. As he came into the White House, outgoing chief economist Edward Lazear promised him and the rest of the nation, quote “the deeper the downturn, the stronger the recovery”. On the basis of a regression analysis so beloved by the quasi-economists, (reproduced online) Obama was almost certainly told that real growth would probably exceed 5 per cent per annum.

“To give an idea of how wrong this guidance was,” Keen says, “the peak to trough decline in the Great Recession—the x-axis in Lazear’s Chart—was over 6 percent. His regression equation therefore predicted that GDP growth in the 2 years after the recession ended would have been over 12 percent. If this equation had born fruit, US Real GDP would be $14.37 trillion in June 2011, roughly in line with trend. Instead of recovering to the trend broken, we have recovered barely to the level of 2008 in terms of GDP, and are of course, millions of jobs below that level in terms of employment.

“So why has the conventional wisdom been so wrong?” asks Keen. “Largely because it has ignored the role of private debt.”

Neoclassical economists typically ignore the level of private debt, on the basis of the argument that “one man’s liability is another man’s asset”, so that the aggregate level of debt has no macroeconomic impact. They reason that the increase in the debtor’s spending power is offset by the fall in the lender’s spending power, and there is therefore no change to aggregate demand.

Keen quotes Ben Bernanke from the latter’s Essays on the Great Depression. Economics doesn’t need to take Irving Fisher nor his debt deflation theory of depressions, says Bernanke, quote “ 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… (Ben S. Bernanke, 2000, p. 24)

Similarly, the estimable Paul Krugman parrots the error in his most recent draft academic paper on the crisis:


Given both the prominence of debt in popular discussion of our current economic difficulties and the long tradition of invoking debt as a key factor in major economic contractions, one might have expected debt to be at the heart of most mainstream macroeconomic models—especially the analysis of monetary and fiscal policy. Perhaps somewhat surprisingly, however, it is quite common to abstract altogether from this feature of the economy. Even economists trying to analyze the problems of monetary and fiscal policy at the zero lower bound—and yes, that includes the authors—have often adopted representative-agent models in which everyone is alike, and in which the shock that pushes the economy into a situation in which even a zero interest rate isn’t low enough takes the form of a shift in everyone’s preferences

Ignoring the foreign component, or looking at the world as a whole, the overall level of debt makes no difference to aggregate net worth — one person’s liability is another person’s asset.

(Paul Krugman and Gauti B. Eggertsson, 2010, pp. 2-3; emphasis added)

Keen points out that they “are profoundly wrong on this point because neoclassical economists do not understand how money is created by the private banking system—despite decades of empirical research to the contrary, they continue to cling to the textbook vision of banks as mere intermediaries between savers and borrowers.

This is bizarre, since as long as 4 decades ago, the actual situation was put very simply by the then Senior Vice President, Federal Reserve Bank of New York, Alan Holmes. Holmes explained why the then faddish Monetarist policy of controlling inflation by controlling the growth of Base Money had failed, saying that it suffered from “a naive assumption” that:

the banking system only expands loans after the [Federal Reserve] System (or market factors) have put reserves in the banking system. In the real world, banks extend credit, creating deposits in the process, and look for the reserves later. The question then becomes one of whether and how the Federal Reserve will accommodate the demand for reserves. In the very short run, the Federal Reserve has little or no choice about accommodating that demand; over time, its influence can obviously be felt. (Alan R. Holmes, 1969, p. 73; emphasis added)

The empirical fact that “loans create deposits” means that the change in the level of private debt is matched by a change in the level of money, which boosts aggregate demand. The level of private debt therefore cannot be ignored—and the fact that neoclassical economists did ignore it (and, with the likes of Greenspan running the Fed, actively promoted its growth) is why this is no “garden variety” downturn.
Look for links, citations, charts, the transcript all online at Demandsideeconomics dot net.

On Wednesday’s forecast we’ll get into more of Keen’s work, including a look at his credit accelerator, the main factor in the recent brief recovery and also implicated in the upcoming dreaded double dip. .

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