Gary Karz, CFA
Host of InvestorHome

In the wake of the Global Financial Crisis (GFC), economists worldwide have been reassessing their opinions and theories about how the economy works, what caused the crisis, and how to fix it. In fact, many have blamed the profession of economics (and specific economists) for contributing to the crisis.

A chief critic of mainstream economics that has been drawing increasing attention in recent years is Australian Professor Steve Keen. While there are (I believe) more than 50 prominent individuals that warned in advance of the crisis, thousands of economists at Real-World Economics Review overwhelmingly voted Keen the winner of the Revere Award (the criteria being those that "first and most clearly anticipated and gave public warning of the Global Financial Collapse and whose work is most likely to prevent another GFC in the future"). The result is particularly impressive given that Keen outpolled the other prominent nominees including Nouriel Roubini (who placed second and is widely acknowledged by the press for predicting the crisis), Robert Shiller, George Soros, as well as Nobel laureates Joseph Stiglitz and Paul Krugman.

Keen originally published the first edition of his book Debunking Economics in 2001 and he expanded and updated the 2nd Edition, which was released near the end of 2011. Keen argues that virtually every aspect of conventional neo-classical economics' thinking is intellectually unsound and that "neoclassical economics is not bad because it is mathematical per se, but because it is bad mathematics." Keen discusses many of the modern world's most well-known economists and economic theories and critiques the principle concepts, theories, and methodologies of economics in the book. He is particularly critical of many of the commonly used economics textbooks and Keen states "the critiques in this book are not based on politics, but on logic. No political position - left, right or middle - should be based on foundations which can easily be shown to be illogical. Yet much of economic theory is illogical."

As the GFC evolved there were many that gravitated toward the work of the late economist Hyman Minsky. Keen's PhD thesis was on modeling Minsky's financial instability hypothesis and Keen argues that some of those that have jumped on the Minsky bandwagon misinterpret or display ignorance of Minsky's work. For instance, Keen writes that some prominent economists seem "incapable of conceiving that aggregate debt can have a macroeconomic impact . . . While Krugman reached some policy conclusions with which I concur - such as arguing against government austerity programs during a debt-deflation crisis - his analysis is proof for the prosecution that even cutting edge' neoclassical economics, by continuing to ignore the role of aggregate debt in macroeconomic dynamics, is part of the problem of the Great Recession, not part of the solution." I'm sure there is more to the story, but I did see this Krugman blog post (11/29/2011) "looking at the long-term debt history of the United States" showing nonfinancial private-sector debt as percentage of GDP. He concluded "for now, I think the data are really interesting."

One interesting detail Keen notes in the book is that Minsky himself identified 1966 as the time at which America made the transition from a productive to a Ponzi economy. I always try to look at (and link to) the various sides of an argument/theory and there are others that have not joined the Minsky bandwagon, one prominent one being Richard Roll. See the The Possible Misdiagnosis of a Crisis (March/April 2011) and his response to a comment referencing Minsky in the May/June 2011 issue of the Financial Analysts Journal.

While the news regularly cites unemployment numbers (the definition of which was changed in 1994), Keen argues the correct comparison to the Great Depression is an "alternative measure for the US measure that includes long-term discouraged workers." (See Shadowstats). Keen points out that "one in six Americans are out of work today, versus a peak rate of one in four during the Great Depression. The current crisis, though it is called the Great Recession, is therefore really a depression too." A sample chapter that Keen has made available is Misunderstanding the Great Depression and the Great Recession. In the book, Keen makes "the empirical case that a collapse in debt-financed demand was the cause of both the Great Depression and the Great Recession. Bernanke's neoclassical goggles rendered him incapable of comprehending the best explanations of the Great Depression and let him to ignore the one data set that overwhelmingly explained the fall in aggregate demand and the collapse in employment." See also Down and Out: Measuring Long-Term Hardship in the Labor Market (January 2012) and Unemployment Is Down Because People Have Given Up Looking for Work (24 January 2012) from The Center for Economic and Policy Research.

Keen writes further that "The Great Depression remains the greatest economic crisis that capitalism has ever experienced, but on every debt metric, the forces that caused the Great Recession are bigger. Private debt rose 50% of the 1920s, from $106 Billion (yes, billion) in 1920 to $161 billion by 1930; it rose from $17 trillion between 1999 and 2009 - a 140 percent increase. The debt-to-GDP ratio was 175 percent when the Great Depression began; it is over 100 percent higher today and hit 298 percent before it began to reverse in 2009." Diagrams supporting the book are also available from his web site here (46 pages), with graphic 96 accompanying the preceding text. The book is over 429 pages without the diagrams. Incidentally, Krugman has also said we are in a depression (and still believes that to this day).

Keen's prescription for fixing our debt problems has been finding more support recently. "There is a simple, but confrontational, way to stop this process: a unilateral write-off of debt." See also Keen's response to my GFC Survey. While it would be fascinating to see Keen debate some of the prominent economists he comments on, he doesn't expect many would change their minds, because "there is no point trying to debate fundamental beliefs with a zealot."

My first exposure to Keen's writing was when I found his FCIC Report critique Sound and fury, signifying nothing in which he commented that he "wasted a perfectly good day reading the report." While it's generally difficult to make economics books interesting, I find Keen to be consistently interesting and quotable. For instance, Keen summarized that "Economics is not the emperor of the social sciences, but the Humpty Dumpty." Frank Fabozzi and Sergio Focardi comment in What Can We Really Know about Economics? where they summarize "The science of economics is in an uncomfortable position, somewhere between the physical sciences and the human sciences . . . One can say: In physics, we have lots of information corrupted by a little noise; in economics, we have lots of noise corrupted by a little information."

In economics and investing, noise is a major issue, causing misdiagnosis, too much trading, and way too much overconfidence on the part of both economists and investors. After reading Debunking Economics, one thing I can say is I'm sure glad that I didn't major in economics.

Despite it's issues, economics clearly plays a role in the investment business, which is one of the reasons I link to many prominent economists' web sites and blogs. As I noted above, I like to hear both sides of an argument, so it's somewhat intentional that I link to the blogs of Paul Krugman and Greg Mankiw next to each other on the InvestorHome home page, as well as to Robert Reich alongside Karl Rove (alphabetically organized). I've added Steve Keen's blog to those links, and I think he has earned the right to be heard on major economic issues. As the debates about how to improve the world's economy continue, I think many will be well served to consult the advice of Keen and others, rather than solely relying on those with similar opinions to their own and/or only those in traditional positions of influence. Keen is seeking sponsors for his continued efforts to develop "a realistic theory of economics, and public knowledge of both the flaws in neoclassical analysis and the existence of alternatives."

Debunking Economics also has interesting discussions on many other topics including monopolies and unions, as well as the efficient market hypothesis. The final chapter is one of the most interesting and in it Keen discusses alternative economic approaches and their strengths, weaknesses, and track records. My collection of other interesting quotes from Debunking Economics include the following (it was difficult to cull the list down to these).

• Rather than being a 'Black Swan', the Great Recession was a 'White Swan' made invisible by neoclassical economists because their theory makes them ignore the key factors that caused it: debt, disequilibrium, and time.
• An economic theory that ignores the role of money and debt in a market economy cannot possibly make sense of the complex, monetary credit-card based economy in which we live.
• Confronted by a competitive disconnect between what they believed and what was happening, economists reacted in a very human way: they panicked. Suddenly, they threw their neoclassical policy rules out the window, and began to behave like 'Keynesian' economists on steroids.
• Neoclassical efforts to get out of such a crisis - once they've gotten over the shock of one actually happening, and revert to form after behaving like 'born-again Keynesians' when the crisis begins - invariably argue that wages have to fall to end the crisis, because high employment clearly indicates the wages are too high.
• To neoclassicals like Friedman and Bernanke, it was better to blame one of the nurses for incompetence, than to admit that capitalism is a manic-depressive social system that periodically attempts to take it's own life.
• the key to preventing depressions is to prevent an explosion in the ratio of private debt to GDP, so that debt-financed demand cannot reach a level from which its collapse will trigger a depression.
• As this book details, neoclassical economics is awash with examples of its internal contradictions being ignored by its believers, so in one sense their practice of pretending that the Money Multiplier determines the amount of money in the economy is just another example of neoclassical economists believing in something that does no exist.
• The global economy won't return to sustained growth until debt levels are substantially reduced. With debt at its current level, the general tendency of the private sector will be to delever, so that the change in credit will deduct from economic growth rather than contributing to it. Any short-term boost to demand from the Credit Impulse - such as occurring in early 2011 - will ultimately dissipate, since if it were sustained then ultimately debt levels would have to rise again. Since the household sector in particular is debt-saturated credit growth will hit a debt ceiling and give way to deleveraging again. The US economy in particular is likely to be trapped in a never-ending sequence of 'double dips,' just as Japan has been for the last two decades.
• Though deregulation of the financial sector was far from the sole cause of the financial crisis that began in 2007, removing the fetters from the financial sector resulted in a crisis that was more extreme than it would have been had the previous regulations been kept in place. The USA's 'shadow banking' sector could not have invented and sold so many 'weapons of financial mass destruction' as it did - to use Warren Buffett's evocative phrase - had Glass-Steagall not been abolished during Bill Clinton's term, for example.

For an entertaining diversion while debating economics, invest a few minutes to watch 10 Principles of Economics by Stand-Up Economist Yoram Bauman. Additional examples of changing perceptions of economics (called the dismal science by some) in the wake of the GFC include the following.

• 10/28/2008 - The Behavioral Revolution by David Brooks in the NYT

  My sense is that this financial crisis is going to amount to a coming-out party for behavioral economists and others who are bringing sophisticated psychology to the realm of public policy. At least these folks have plausible explanations for why so many people could have been so gigantically wrong about the risks they were taking.

• February 2009 - The Financial Crisis and the Systemic Failure of Academic Economics by Thomas Lux, David Colander, Michael Goldberg

  We trace the deeper roots of this failure to the profession’s insistence on constructing models that, by design, disregard the key elements driving outcomes in real-world markets. The economics profession has failed in communicating the limitations, weaknesses, and even dangers of its preferred models to the public.

• 4/16/2009 - What Good are Economists Anyway? by Peter Coy in Businessweek

  "this group say government needs to break downward spirals with the kinds of aggressive policies the U.S. is following now—cutting interest rates and raising government spending. The group includes Paul R. Krugman, the Princeton University economist and Nobel laureate; NYU's Nouriel Roubini, who was early in predicting a severe recession; and Yale University's Robert J. Shiller, who predicted the housing bust and the tech-stock bust. Other economists have more confidence that the economy is self-equilibrating. They believe low interest rates and heavy deficit spending will be ineffective while leaving the U.S. with a mountain of debt. Count Harvard's Robert Barro in this camp, along with Chicago's Robert E. Lucas Jr., Arizona State University's Edward C. Prescott, and the University of Minnesota's Patrick J. Kehoe and V. V. Chari. No surprise, the equilibrium school mainly leans Republican, and the interventionist school seems to be crawling with Democrats. On the right, John H. Cochrane of the University of Chicago dismisses those who advocate Keynesian stimulus, saying: "Professional economists, the guys I hang out with, are not reverting to ancient Keynesianism any more than physicists are going back to Aristotle when they can't understand how fast the universe is expanding." There are some middle-of-the-roaders, such as Columbia University's Michael Woodford, who argue that macroeconomists are converging on a methodology for asking questions. But even Woodford agrees that "recent debates don't particularly make the field look unified."

• 5/13/2009 - Why Economists Failed to Predict the Financial Crisis (Knowledge@Wharton)
• 7/18/2009 - What Went Wrong with Economics? in the Economist

  OF ALL the economic bubbles that have been pricked, few have burst more spectacularly than the reputation of economics itself. . . In the wake of the biggest economic calamity in 80 years that reputation has taken a beating. In the public mind an arrogant profession has been humbled . . . The profession itself is suffering from guilt and rancour. In a recent lecture, Paul Krugman, winner of the Nobel prize in economics in 2008, argued that much of the past 30 years of macroeconomics was “spectacularly useless at best, and positively harmful at worst.” Barry Eichengreen, a prominent American economic historian, says the crisis has “cast into doubt much of what we thought we knew about economics.”

• 9/2/2009 - How Did Economists Get It So Wrong? by Paul Krugman

  There was nothing in the prevailing models suggesting the possibility of the kind of collapse that happened last year.

• 1/10/2011 - IMF Performance in the Run-Up to the Financial and Economic Crisis: IMF Surveillance in 2004–07

  The IMF’s ability to correctly identify the mounting risks was hindered by a high degree of groupthink, intellectual capture, a general mindset that a major financial crisis in large advanced economies was unlikely, and inadequate analytical approaches.

• 5/20/2011 - Neo-Voodoo Economics by Jim Tankersley and Chicago Economics on Trial in the WSJ
• 11/20/2011 - Robin Wells: We Are Greg Mankiw… or Not?
• 12/16/2011 - It's time for economic theory to evolve by Kevin Kaiser in Fortune

  Last month, seventy freshmen at Harvard walked out of Gregory Mankiw's introductory Economics 10 lecture; they wrote to the well-known economist that his course "espouses a specific – and limited – view of economics that we believe perpetuates problematic and inefficient systems of economic inequality in our society today."
  
  German physicist Max Planck said that, "Science advances one funeral at a time." And Keen concurs: "You cannot persuade people who believe a mythical vision of reality and their whole lives are dedicated to believing that way."
  
  Keen aptly states, "If economics is to become less of a religion and more of a science, then the foundations of economics should be torn down and replaced." We are on the way.

• 12/22/2011 Philip Mirowski's The Seekers, or How Mainstream Economists Have Defended Their Discipline Since 2008 Part 1, Part 2, Part 3, Part 4 via NakedCapitalism
• 12/31/2011 - Marginal revolutionaries in the Economist

  The crisis and the blogosphere have opened mainstream economics up to new attack.

• 1/19/2012 - Economists: A Profession at Sea: How to keep economists from missing the next financial crisis from Time
• 1/26/2012 - What future for economics?

  orthodox economics had, in the years leading up to the crisis, become more a cult than a science, particularly with the assumption that what exists in competitive markets has to be the best possible outcome, since, if it were not, it could not exist. So, if crises are not predicted, it is because they cannot be: they are the result of unexpected shocks, by assumption.

• 2/6/2012 - How Economics Contributed to the Financial Crisis

Some other recent books discussing the state of economics.

• 4/8/2010 - How the Economy Works: Confidence, Crashes and Self-Fulfilling Prophecies by Roger E. A. Farmer

  "Of all the economic bubbles that have been pricked," the editors of The Economist recently observed, "few have burst more spectacularly than the reputation of economics itself." Indeed, the financial crisis that crested in 2008 destroyed the credibility of the economic thinking that had guided policymakers for a generation.

• 6/21/2010 - The Puzzle of Modern Economics: Science or Ideology? by Roger Backhouse

  Does economics hold the key to everything or does the recent financial crisis show that it has failed?

• 1/1/2011 - Maynard's Revenge: The Collapse of Free Market Macroeconomics by Lance Taylor

  It is now widely agreed that mainstream macroeconomics is irrelevant and that there is need for a more useful and realistic economic analysis that can provide a better understanding of the ongoing global financial and economic crisis. Lance Taylor’s book exposes the unrealistic assumptions of the rational expectations and real business cycle approaches and of mainstream finance theory.

• 7/13/2011 - What Went Wrong with Economics: The flawed assumptions that led economists astray by Michael Reiss

Please send suggestions and comments to Investor Home

Last update 2/7/2012. Copyright © 2012 Investor Home. All rights reserved. Disclaimer