Of Bunk and Economics By Arnold Kling

I was sent a review copy of Debunking Economics, by Australian economics professor Steven Keen. I agree with his view that heterodox economists have something to offer, particularly in the area of macroeconomics. His discussion of a debt bubble and Minsky reminds me that PSST includes the word “sustainable” for a reason. Patterns of specialization and trade that depend on ever-increasing debt loads are not sustainable. I think that Keen would agree with that one. But I also think that patterns of trade that depend on the government spending money it does not have are equally unsustainable. I do not get the sense that Keen is on board with that one.

If I were a zero-tolerance reader, I would have put the book down at page 7:

neoclassical economics advocated reducing government intervention in the economy and letting markets–especially financial markets–decide economic outcomes unimpeded by politicians, bureaucrats, or regulations. Counter-cyclical government budget policy–running deficits during downturns and surpluses during booms–gave way to trying to run surpluses all the time, to reduce the size of the government sector.

On the second point, suffice to say that the size of the government sector has grown in recent decades, particularly under the two most recent administrations. Furthermore, both Administrations cut taxes and increased spending in response to recessions.

The first point is just as wrong. Suppose you could take an economist from Mars and show him the financial regulatory regime that existed in the United States in 1980 and the one that existed in 2000. Ask that economist which regime constituted turning the banks loose to do whatever they want. I am pretty sure that the answer would be that the 1980 regulatory regime was looser. Back then there were no formal capital requirements at all. In 2000, there were capital requirements that were “sophisticated” in the sense that they were risk-based. In 1980, there were fewer mechanisms in place for resolving failed banks. Deposit insurance prices were not linked to risk.

It is true that in 1980 there were more barriers to competition between various forms of financial institutions. There were certainly more controls on interest rates thirty or forty years ago. But from a safety and soundness perspective, the regulatory regime of 2000 was the more stringent. Keen and all the other chaps who blame the financial crisis on what is often called “the atmosphere of deregulation” are so beguiled by their righteous indignation that they do not seem to see any need to back up their rants with proof.

A few more excerpts below the fold.p. 22:

were it not for the extreme rescue efforts he initiated in 1987, the stock market crash of that year would have precipitated a serious recession, but one far milder than that we are now experiencing. Instead, that rescue and the many others in the crises that followed…encouraged the speculative excesses of Wall Street to continue.

I read this as an Austro-Minsky critique of the “Greenspan put.”

Keen is not just out to debunk macroeconomics. He is ready to toss the whole of neoclassical economics, right down to the laws of supply and demand. On p. 55:

market demand does not necessarily increase when price falls, even if individual demand does.

He makes an argument based on aggregation issues. Consider three propositions.

1. The conditions that are necessary in order to be able to interpret market demand in terms of a representative consumer are unrealistically stringent.

2. The conditions under which market demand absolutely must slope down if individual demand curves slope down are unrealistically stringent.

3. The conditions are under which market demand is likely to slope down if individual demand curves slope down are unrealistically stringent.

Propositions (1) and (2) are true and uninteresting. Proposition (3) would be interesting, but it is not true. Keen uses propositions (1) and (2) to dance a sort of intellectual strip tease that makes you think he is going to reveal a case for (3), but he never goes that far.

p. 101:

Unless perfect competition rules, there is no supply curve.

Keen laments that so many economists are too dense to grasp this insight. I am afraid that I fall into that group.

In spite of all these criticisms, the book made me stop and think about where I agree with mainstream economics and where I disagree. I think that the concept of equilibrium can be a useful fiction, at least with respect to partial equilibrium. That is, although the market intersection of supply curves and demand curves may not be something we can observe outside the context of an organized exchange, the concept is still very useful, particularly in analyzing single markets.

On the other hand, the concept of general equilibrium can often be a harmful fiction. Clearly, the economy is in disequilibrium most of the time. Conditions are always changing, and adjustment is far from complete. I think that disequilibrium dynamics are both difficult to analyze and very important for the economy. I suspect that macroeconomic phenomena, such as widespread unemployment, are a reflection of disequilibrium dynamics.