Steve Keen is an Associate Professor in economics and finance at the University of Western Sydney. The second expanded edition of his popular book Debunking Economics is available now.
Interview conducted by Philip Pilkington, a journalist and writer based in Dublin, Ireland.
Philip Pilkington: One cannot help but be struck by the reaction of the economics profession to the recent financial crisis. In the first edition of your book, Debunking Economics, you warned that a crash was probably coming – and in this you weren’t the only one. And yet now, post-crash, neoclassical economists have simply buried their heads in the sand and pretended that rational criticism of their theories simply doesn’t exist. The crash discredits almost all these theories and yet they continue to insist that they remain valid.
They remind me of Christian fundamentalists rabidly arguing against evolution in face of what appears to be insurmountable evidence against their assertions. Could you talk a little about this? How can these people be so deluded? Why won’t they listen to reason?
Steve Keen: That’s a pretty accurate characterisation of their behavior. I cite a couple of glaring instances of this in the second edition. Olivier Blanchard, founding editor of the American Economic Review: Macroeconomics, and Chief Economist of the IMF, published a paper one year after the crisis began in which he opined that “the state of macro [economic theory] is good” – despite its complete failure to anticipate the biggest economic event of the last 70 years. One year later, rather than admitting that the state of macro might not be so good after all, he instead warned that just because neoclassical economics had failed this crucial empirical test:
It is important to start by stating the obvious, namely, that the baby [neoclassical macroeconomics] should not be thrown out with the bathwater…
The only two neoclassicals that I could locate who attempted to model the crisis using the DSGE framework – that is, the overarching macroeconomic framework used by mainstream economists to explain large-scale economic shifts – actually did so by arguing that large unanticipated shocks hit the economy, and these explained the crisis entirely! One of these (P.N Ireland, ‘A New Keynesian Perspective on the Great Recession’, 2011) toyed with abandoning the model…
Indeed, the Great Recession’s extreme severity makes it tempting to argue that new theories are required to fully explain it.”(Ireland 2011, p. 31)
…but he rejected this course largely because he thought there was no other analytic way to consider the crisis apart from neoclassical economics. In so doing he argued that it was effectively impossible to do what I do, which is develop causal mathematical models of the relationships between economic variables, especially private debt, that anticipated this crisis:
Attempts to explain movements in one set of endogenous variables, like GDP and employment, by direct appeal to movements in another, like asset market valuations or interest rates, sometimes make for decent journalism but rarely produce satisfactory economic insights.(p. 32)
Instead he explained the crisis by varying unpredictable shocks:
…the Great Recession began in late 2007 and early 2008 with a series of adverse preference and technology shocks in roughly the same mix and of roughly the same magnitude as those that hit the United States at the onset of the previous two recessions… The string of adverse preference and technology shocks continued, however, throughout 2008 and into 2009. Moreover, these shocks grew larger in magnitude, adding substantially not just to the length but also to the severity of the great recession…(Ireland 2011)
The problem with this argument is that shocks, if that’s what really caused the crisis, should ultimately stop – and in fact unexpected good ones should start to arrive to keep the mean shock at zero. But the economy continues to tank, because it wasn’t an exogenous shock that caused it at all, but the endogenous dynamics of credit that neoclassicals completely ignore.
The reason they continue with this delusion is for the same reason that astronomers stuck with the Ptolemaic version of the solar system long after anomalies were discovered between the theory’s predictions and observation: it’s all they know, and their whole world view is organised around it.
Secondly, though neoclassical economists like to intimidate critics with mathematics, frankly most of them lack training in the areas of mathematics needed to analyse dynamic systems – which explains Ireland’s ignorant remark cited above.
They’ll only start to listen to reason when reality has continued to defy their predictions well past the initial crisis of 2007. We’re now into the 4th year of this crisis, and only now as the effects of the fiscal stimuli of 2007-09 wear off (policies their underlying economics opposed, by the way, which they adopted only in a state of sheer panic when the crisis hit) and the economy still hasn’t recovered, are some of them starting to realise that their paradigm simply doesn’t fit reality.
However most will go to their graves still believing in the neoclassical paradigm and they’ll blame some exogenous factor – probably some unspecified government policy or even, laughably, unions –for causing the crisis. In this they’re just like any other set of committed believers in a falsified paradigm. Max Planck, the person who discovered quantum mechanics, gave up on convincing his contemporaries of the new approach, as most of them stuck to the Maxwellian model despite its empirical failures and the success of quantum mechanics, once quipped that “science advances one funeral at a time”, and the same will be even more true of this pseudo-science of economics.
PP: It’s nice to draw analogies to physics, but economics seems to me to be a whole different enterprise. To admit that Planck’s theories may have something to them merely required that a person renege on certain aspects of their scientific worldview. But to see capitalism as being inherently flawed raises all sorts of political and moral questions. Unlike Planck’s theories, I get the impression that new economic perspectives actually offend economists – and, for that matter, policymakers – at an almost spiritual level.
You go into great detail in the book about how economists are actually trained and I found this to be very interesting and relevant. As they advance through academia they have their worldviews gradually narrowed and hollowed out until they cannot really conceive of the economic, political and social world in any way that doesn’t fall into line with what they refer to – in high Scholastic fashion, I might add – as their ‘axioms’. They seem to be brought through an indoctrination program that ensures that these ‘axioms’ remain fixed in their minds at such a base level that they cannot be moved – not unlike a Scientologist or some other cult member.
Surely there is some difference here between how neoclassical economics is taught and, say, how physics was taught in Planck’s day? And surely this has consequences for, shall we say, the rather long half-life that neoclassical economics seems to possess relative to other disciplines? In short, given the way economics is transmitted through the generations can we really expect the neoclassical research program to die before there is some fundamental shift in the way we organise our societies?
SK: Yes, that’s true. The general principle is the same, and this is what led to Kuhn’s analysis that science proceeds by the development of paradigms in what he calls ‘normal science’, followed by periods of volatility when the old paradigm strikes a series of anomalies it can’t resolve, leading to a scientific revolution in which a new paradigm is formed that can account for the anomalies.
But this process requires a degree of dispassionate separation between the empirical data and the theories. If a theory makes a prediction, and an anomalous result occurs–like the Michelson-Morley experiment that implied that there was no ‘aether’ through which light waves passed (since the speed of light was the same when measured in any direction). This and other anomalies were confronted by the pre-quantum physicists of the day within their paradigm in an attempt to resolve them – unsuccessfully. Hence the ultimate development of quantum mechanics
But in economics, anomalies abound but simply aren’t even acknowledged, so attempts to resolve them simply don’t occur: the neoclassical paradigm just sails on oblivious to them.
My favourite here is the conflict between the neoclassical theory of the firm, which requires rising marginal costs, and the more than a hundred studies that have contradicted this –the most recent being Alan Blinder’s ‘Asking About Prices’. Rather than confronting this ‘anomaly’, neoclassical economists continue teaching and building models that assume rising marginal costs, and in fact the most (in)famous paper in methodology – Friedman’s ‘assumptions don’t matter’ paper – was written specifically to advise economists NOT to even read the empirical literature. When he argued that ‘assumptions don’t matter’, the assumption he was defending most strenuously was the counter-factual assumption that marginal costs rise as output rises:
The lengthy discussion on marginal analysis in the American Economic Review some years ago is an even clearer, though much less important, example. The articles on both sides of the controversy largely neglect what seems to me clearly the main issue — the conformity to experience of the implications of the marginal analysis — and concentrate on the largely irrelevant question whether businessmen do or do not in fact reach their decisions by consulting schedules, or curves, or multivariable functions showing marginal cost and marginal revenue…
The reason they simply refuse to even countenance anomalies – including now, not merely that marginal cost curves don’t rise but the inherent stability of capitalism given the economic and financial crisis – is, as you note, that this offends their world view. They perceive capitalism as inherently stable, and even what Australians call the ‘GFC’ (Global Financial Crisis) hasn’t been enough to shake that faith.
Though neoclassical economists would deny that they are political, the vision of the economy as inherently stable has become embedded in their politics and that of the populace as well. The fundamental difference between Republicans and Democrats really boils down to this, a difference in belief over whether the market system is really stable (Republican) or ever so slightly unstable (Democrat).
That’s where the organisation of society, as you put it, buts in. It has to cease being a political stance for an academic to say ‘capitalism is unstable’. One of the first economists to say that, by the way, was Joseph Schumpeter, and he was no raving radical: he actually saw the instability of capitalism as one of its strengths.
But while ever that’s how the political debate is shaped – and it was itself shaped by economic theory over the last two centuries – then developing a dispassionate understanding of how capitalism actually works will be almost impossible. In that situation, neoclassical economics becomes fundamentally ideological: its role is to defend capitalism against not merely attacks, but even dispassionate analysis.
The ultimate outcome of all this, however, is crises like the one we’re now in. If you use an ideology to guide how you design a society, then ultimately you will end up with social failure, whether that society is socialist (the Soviet Union before the Fall of the Wall), capitalist (America now), or religious (Iran etc).
I doubt that we can ever learn to be apolitical about our economy however. Maybe what we need instead is an ideology which is generally consistent with what its strengths are, while still cognizant of its weaknesses. That’s one reason I push a Schumpeter-Minsky vision of capitalism. Schumpeter emphasises the creative instabilities of capitalism – making instability to some degree a good thing. Minsky points the finger at financial instability – where those same creative energies are misplaced into Ponzi schemes that ultimately fail, leading to a private debt crises like the one we’re now in. If the Republicans and Democrats then effectively embraced the Schumpeterian core of capitalism, but differed over how one limits the Ponzi cancer that the financial sector can cause, we might get both a more realistic economics and a better class of politics.
PP: Interesting. What sort of responses did you get to your work from economists? I mean, I know that most of these criticisms have been around for a number of years, but now that you collected all the old ones in one place and added a few of your own what was the response from your colleagues? I don’t just mean ‘official’ correspondences and articles, but also ‘unofficially’, at meetings and the like? Surely they couldn’t hide from the fact of the financial crisis which you predicted in the first edition ten years ago and which must have at least softened their intellectual armour a little.
SK: You’d be amazed, there certainly have been some neoclassicals who have shifted a bit from blind faith, but generally they are unmoved. I recently gave a talk at a conference on lawyers on regulation of financial institutions, and at the end the organizer asked if there were any economists in the room who would like to respond. There was one – a chief economist for a major Australian regulatory authority. He looked very uncomfortable as he told me that what I had presented was a ‘straw man’ critique of neoclassical economics. I replied that my presentation had centred on the works of Krugman, Bernanke and Blanchard – so if I was guilty of attacking straw men, neoclassical economists were guilty of awarding straw men Nobel Prizes, top ranking government jobs and editorships of leading journals!
Two factors lie behind this I believe. The first is that they simply can’t conceive of any other way to analyse the economy than the one they’ve imbibed from their economic training.
The second is the zealotry component of the belief in neoclassical economics: their capacity to believe in this approach is as firm as the capacity of a Doomsday Cult to believe that the world will come to an end on a particular day. When each time the given day passes, a new one is constructed. The irony for neoclassical economics of course is that it’s the opposite of a Doomsday Cult: it preaches that nothing bad will ever happen (so long as governments are kept under a leash and unions are cowed). Then something really bad does happen given nearly unregulated markets. They can’t deny that it has happened, but already they’re starting to interpret it as the result of government policy!
I’m not joking, even though they played a huge role in encouraging the dismantling of so many regulatory structures from the time of the Great Depression – including the abolition of Glass-Steagall – they are now developing models that argue that what regulations there were led to the ‘moral hazard’ problem that caused the crisis in the first place. Take this comment from the most recently forged (I’m sorry, I meant minted…) Nobel Prize winner Thomas Sargent:
The main idea is that when a government is in the business of being a lender of last resort or a deposit insurer, depending on how it regulates banks, it affects the risk that banks take and the probability that the government is actually going to be required to exercise lender of last resort and bail out facilities. Neil and Jack call it the “moral hazard” problem, which is the idea that when you insure a bank, you alter its incentives to undertake risks.
So now they’re developing papers that argue that what caused the crisis was deposit insurance! Imagine how we’d be now if that remaining pillar from the post-Great Depression debacle had been removed prior to 2007. But instead they’re trying to pretend that the crisis would not have occurred if there hadn’t been deposit insurance! Instead, of course, the crisis still would have occurred and the aftermath would have been an instant Depression, rather than the more drawn-out one we’re actually experiencing.
PP: That’s absolutely shocking, but it seems a bit silly at the same time. Are they really suggesting that we get rid of deposit insurance to limit ‘moral hazard’? I can’t imagine that would go down well with their target audience – or anyone else, for that matter. Are statements like this indicative that neoclassical economists cannot actually talk about anything practical anymore? Are we seeing a shift to a sort of purely theoretical cult that just sits around debating inanities and broadly retreating from the policy arena?
SK: I think it’s the usual syndrome: since capitalism is perfect, any problems in capitalism have to be the result of government interventions into it (or nasty unions). So the best they can do when a crisis hits is to point to some government intervention and say that it was to blame – when in fact if it hadn’t been in place, a serious downturn would have become a catastrophic one: imagine Lehman times ten if suddenly the public’s deposits disappeared when the crisis hit.
Of course they claim that if there hadn’t been deposit insurance then depositors would have chosen safer banks and the crisis wouldn’t have happened in the first place. But there are countries that didn’t have formal deposit insurance where irresponsible lending still occurred.
Fundamentally, they’ve always been such a cult. Their one policy objective for the last four decades has been to reduce the level of government intervention in and regulation of the economy – so their policy objective has been less policy (the one they still approved of was the central bank setting interest rates, so long as they did so to limit inflation).
They could get away with that while the economy was booming, and even seem practical if the economy did well at the same time as their policy of less policy was implemented.
Their deregulatory zeal did help set off a boom, since it allowed the huge growth in private debt that funded the internet and the subprime bubbles. But this was an unsustainable process, and now when the economy’s been about as deregulated as one can manage, its true instabilities and Ponzi Schemes have overwhelmed their belief in equilibrium.
So now they can whimper all they like about how removing the tiny handful of regulations they didn’t manage to abolish would have made things better, but it’s whimpering rather than analysis. I hope they actually make this case loudly, because it’s so stupid that it will hopefully discredit them in the eyes of the politicians who still take them seriously.