Steve Keen’s critique of Krugman attempting to learn from Minsky is a verbal attack parallel to a trap sprung by a waiting spider when the clueless fly lands on her web. Steve Keen has developed his web over many years using Minsky as his inspiration and teacher. His main point is that Krugman ignores all prior Minsky scholarship that accurately predicted the crisis. Good point that. He has only one good thing to say about Krugman’s paper in the first sentence excerpted here.
…One thing I can compliment Krugman for is honestly about the state of neoclassical macroeconomic modeling before the Great Recession. His paper opens with the observation that:
“If there is a single word that appears most frequently in discussions of the economic problems now afflicting both the United States and Europe, that word is surely “debt”” (Eggertsson and Krugman 2010, p. 1)
He then admits that private debt played no role in neoclassical macroeconomic models before 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. (p. 2; emphasis added)
However, from this mea culpa, it’s all downhill, because Krugman makes no fundamental shift from a neoclassical approach; all he does is modify his base “New Keynesian” model to incorporate debt as he perceives it. On this front, he falls into the neoclassical trap of being incapable of conceiving that aggregate debt can have a macroeconomic impact:
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. (p. 3)
This one sentence establishes that Krugman has failed to comprehend Minsky, who realized—as did Schumpeter and Marx before him—that growing debt in boosts aggregate demand. Minsky put it this way:
If income is to grow, the financial markets… must generate an aggregate demand that, aside from brief intervals, is ever rising. For real aggregate demand to be increasing… it is necessary that current spending plans, summed over all sectors, be greater than current received income … It follows that over a period during which economic growth takes place, at least some sectors finance a part of their spending by emitting debt or selling assets. (Minsky 1982, p. 6)
Schumpeter made the same case in a more systematic way, by focusing upon the role of entrepreneurs in capitalism. He made the point that an entrepreneur is someone with an idea but not necessarily the finance needed to put that idea into motion. The entrepreneur therefore must borrow money to be able to purchase the goods and labor needed to turn her idea into a final product. This money, borrowed from a bank, adds to the demand for existing goods and services generated by the sale of those existing goods and services:
THE fundamental notion that the essence of economic development consists in a different employment of existing services of labor and land leads us to the statement that the carrying out of new combinations takes place through the withdrawal of services of labor and land from their previous employments… this again leads us to two heresies: first to the heresy that money, and then to the second heresy that also other means of payment, perform an essential function, hence that processes in terms of means of payment are not merely reflexes of processes in terms of goods. In every possible strain, with rare unanimity, even with impatience and moral and intellectual indignation, a very long line of theorists have assured us of the opposite…
From this it follows, therefore, that in real life total credit must be greater than it could be if there were only fully covered credit. The credit structure projects not only beyond the existing gold basis, but also beyond the existing commodity basis. (Schumpeter 1934, pp. 95, 101; emphasis added)
This argument is a pivotal part of my analysis, in which I define aggregate demand as the sum of income plus the change in debt—as regular readers of this blog would know.
Krugman also has no understanding of the endogeneity of credit money—that banks create an increase in spending power by simultaneously creating money and debt. Lacking any appreciation of how money is created in a credit-based economy, Krugman sees lending as simply a transfer of spending power from one agent to another, and neither banks nor money exist in the model he builds.
Instead, in place of the usual neoclassical trick of modeling the entire economy as a single representative agent, he models it as two agents, one of whom is impatient while the other is patient. Debt is simply a transfer of spending power from the patient agent to the impatient one, and therefore the debt itself has no macroeconomic impact—it simply transfers spending power from the patient agent to the impatient one. The only way this can have a macroeconomic impact is if the “impatient” agent is somehow constrained in ways that the patient agent is not, and that’s exactly how Krugman concocts a macroeconomic story out of this neoclassical microeconomic fantasy:
In what follows, we begin by setting out a flexible-price endowment model in which “impatient” agents borrow from “patient” agents [where what is borrowed is not money, but “”risk-free bonds denominated in the consumption good” (p. 5)], but are subject to a debt limit. If this debt limit is, for some reason, suddenly reduced, the impatient agents are forced to cut spending; if the required deleveraging is large enough, the result can easily be to push the economy up against the zero lower bound. If debt takes the form of nominal obligations, Fisherian debt deflation magnifies the effect of the initial shock. (Eggertsson and Krugman 2010, p. 3)
He then generalizes this with “a sticky-price model in which the deleveraging shock affects output instead of, or as well as, prices” (p. 3), brings in nominal prices without money by imagining “that there is a nominal government debt traded in zero supply… We need not explicitly introduce the money supply” (p. 9), models production under imperfect competition (p. 11)—yes, the preceding analysis was of a no-production economy in which agents simply trade existing “endowments” of goods distributed like Manna from heaven—dds a Central Bank that sets the interest rate (in an economy without money) by following a Taylor Rule, and on it goes.
The mathematics is complicated, and real brain power was exerted to develop the argument—just as, obviously, it takes real brain power for a poodle to learn how to walk on its hind legs. But it is the wrong mathematics because the analysis compares two equilibria separated by time rather than being truly dynamic by analyzing change over time regardless of whether equilibrium applies or not, and wasted brain power because the initial premise—that aggregate debt has no macroeconomic effects—was false.
Krugman at least acknowledges the former problem—that the dynamics are crude:
The major limitation of this analysis, as we see it, is its reliance on strategically crude dynamics. To simplify the analysis, we think of all the action as taking place within a single, aggregated short run, with debt paid down to sustainable levels and prices returned to full ex ante flexibility by the time the next period begins. (p. 23)
But even here, I doubt that he would consider genuine dynamic modeling without the clumsy neoclassical device of assuming that all economic processes involve movements from one equilibrium to another. Certainly this paper remains true to the perspective he gave in 1996 when speaking to the European Association for Evolutionary Political Economy:
I like to think that I am more open-minded about alternative approaches to economics than most, but I am basically a maximization-and-equilibrium kind of guy. Indeed, I am quite fanatical about defending the relevance of standard economic models in many situations…
He described himself as an “evolution groupie” to this audience, but then made the telling observation that:
Most economists who try to apply evolutionary concepts start from some deep dissatisfaction with economics as it is. I won’t say that I am entirely happy with the state of economics. But let us be honest: I have done very well within the world of conventional economics. I have pushed the envelope, but not broken it, and have received very widespread acceptance for my ideas. What this means is that I may have more sympathy for standard economics than most of you. My criticisms are those of someone who loves the field and has seen that affection repaid.
Krugman’s observations on methodology in this speech also highlight why he was incapable of truly comprehending Minsky—because he still starts from the premise that neoclassical economics itself has proven to be false, that macroeconomics must be based on individual behavior:
Economics is about what individuals do: not classes, not “correlations of forces”, but individual actors. This is not to deny the relevance of higher levels of analysis, but they must be grounded in individual behavior. Methodological individualism is of the essence. (Krugman 1996; emphases added)
No it’s not: methodological individualism is part of the problem, as the Sonnenschein-Mantel-Debreu conditions establish—a point that neoclassical economists have failed to comprehend, but whose import was realized by Alan Kirman:
If we are to progress further we may well be forced to theorise in terms of groups who have collectively coherent behaviour. Thus demand and expenditure functions if they are to be set against reality must be defined at some reasonably high level of aggregation. The idea that we should start at the level of the isolated individual is one which we may well have to abandon. (Kirman 1989, p. 138)
So while Krugman reaches some policy conclusions with which I concur—such as arguing against government austerity programs during a debt-deflationary crisis—his analysis is proof for the prosecution that even “cutting edge” neoclassical economics, by continuing to ignore the role of aggregate debt, is part of the problem of the Great Recession, not part of its solution.