Adventures in Cognitive Dissonance

Brad DeLong, May 25:

WHAT ARE THE CORE COMPETENCES OF HIGH FINANCE? 

The core competences of high finance are supposed to be (a) assessing risk, and (b) matching people with risks to be carried with people with the risk-bearing capacity to carry them. Robert Waldmann has a different view:

I think their core competencies are (a) finding fools for counterparties and (b) evading regulations/disguising gambling as hedging.

Regulatory arbitrage, and persuading those who do not understand risks that they should bear them--those are not socially-valuable activities.

Brad DeLong, yesterday:

NEXT YEAR'S EXPECTED EQUITY RETURN PREMIUM IS 9% 

If you have any risk-bearing capacity at all, now is the time to use it.

So I guess last week's doubts have been assuaged. Or did he really mean to write "If you have any capacity for being fooled into being a swindler's counterparty, now is the time to use it"?


EDIT: Oh and then, the post just after that one argued -- well, really, assumed -- that the current value of Facebook shares gives an unbiased estimate of future Facebook earnings, and therefore of the net wealth that Facebook has created. (I guess not a single dollar of FB revenue comes at the expense of other firms, which must be a first in the history of capitalism.) Is there some way of consistently believing both that current stock values give an unbiased estimate of the present value of future earnings, and that stock values a year from now will be much higher than they are today? I can't see one. But then I've never had the brain for theodicy.

UPDATE: Anyone reading this should immediately go and read rsj's much better take on the same DeLong post over at Windyanabasis. He explains exactly why DeLong is confused here.

Prices and the European Crisis, Continued

In comments to yesterday's post on exchange rates and European trade imbalances, paine (the e. e. cummings of the econosphere) says,

pk prolly buys your conclusion. notice his post basically disparaging forex adjustment solutions on grounds of short run impact. but long run adjustment requires forex changes.

I don't know. I suppose we all agree that exchange rate changes won't help in the short run (in fact, I'm not sure Krugman does agree), but I'm not convinced exchange rate changes will make much of a difference even in the long run; and anyway, it matters how long the long run is. When the storm is long past the ocean is flat again, and all that.

Anyway, what Krugman actually wrote was

We know that huge current account imbalances opened up when capital rushed to the European periphery after the euro was created, and reversing those imbalances must involve a large real devaluation.

We "know," it "must": not much wiggle room there.

So this is the question, and I think it's an important one. Are trade imbalances in Europe the result of overvalued exchange rates in the periphery, and undervalued exchange rates in the core, which in turn result from the financial flows from north to south after 1999? And are devaluations in Greece and the other crisis countries a necessary and sufficient condition to restore a sustainable balance of trade?

It's worth remembering that Keynes thought the answer to these kinds of questions was, in general, No. As Skidelsky puts it in the (wonderful) third volume of his Keynes biography, Keynes rejected the idea of floating exchange rates because

he did not believe that the Marshall-Lerner condition would, in general, be satisfied. This states that, for a change in the value of a country's currency to restore equilibrium in its balance of payments, the sum of the price elasticities for its exports and imports must be more than one. [1] As Keynes explained to Henry Clay: "A small country in particular may have to accept substantially worse terms for its exports in terms of its imports if it tries to force the former by means of exchange depreciation. If, therefore, we take account of the terms of trade effect there is an optimum level of exchange such that any movement either way would cause a deterioration of the country's merchandise balance." Keynes was convinced that for Britain exchange depreciation would be disastrous...

Keynes' "elasticity pessimism" is distinctly unfashionable today. It's an article of faith in open-economy macroeconomics that depreciations improve the trade balance, despite rather weak evidence. A recent mainstream survey of the empirical literature on trade elasticities concludes,

A typical finding in the empirical literature is that import and export demand elasticities are rather low, and that the Marshall-Lerner (ML) condition does not hold. However, despite the evidence against the ML condition, the consensus is that real devaluations do improve the balance of trade. 

Theory ahead of measurement in international trade!

(Paul Davidson has a good discussion of this on pages 138-144 of his book on Keynes.)

The alternative view is that the main relationship is between trade flows and growth rates. In models of balance-of-payments-constrained growth, countries' long-term growth rates depend on the ratio of export income-elasticity of demand and import income-elasticity of demand. More generally, while a strong short-run relationship between exchange rates and trade flows is clearly absent, and a long-run relationship is mostly speculative, the relationship between faster growth and higher imports (and vice versa) is unambiguous and immediate. [2]

So let's look at some Greek data, keeping in mind that Greece is not necessarily representative of the rest of the European periphery. The picture below shows Greece's merchandise and overall trade balance as percent of GDP (from the WTO; data on service trade is only available from 1980), the real exchange rate (from the BIS) and real growth rate (from the OECD; three-year moving averages). Is this a story of prices, or income?

The first thing we can say is that it is not true that Greek deficits are a product of the single currency.  Greece has been running substantial trade deficits for as far back as the numbers go. Second, it's hard to see a relationship between the exchange rate and trade flows. It's especially striking that the 20 percent real depreciation of the drachma from the late 1960s to the early 1970s -- quite a large movement as these things go -- had no discernible effect on Greek trade flows at all. The fall in income since the crisis, on the other hand, has produced a very dramatic improvement in the Greek current account, despite the fact that the real exchange rate has appreciated slightly over the period. It's very hard to look at the right side of the figure and feel any doubt about what drives Greek trade flows, at least in the short run.

Now, it is true that, prior to the crisis, the Euro era was associated with somewhat larger Greek trade deficits than in earlier years. (As I mentioned yesterday, this is entirely due to increased imports from outside the EU.) But was this due to the real appreciation Greece experienced under the Euro, or to the faster growth? It's hard to judge this just by looking at a figure. (That's why God gave us econometrics -- though to be honest I'm a bit skeptical about the possibility of getting a definite answer here.) But here's a suggestive point. Greece's real exchange rate appreciated by 25 percent between 1986 and 1996. This is even more than the appreciation after the Euro. Yet that earlier decade saw no growth of the Greek trade deficit at all. It was only when Greek growth accelerated in the early 2000s that the trade deficit swelled.

I think Yanis Varoufakis is right: It's hard to see exit and devaluation as solutions for Greece, in either the short term or the long term. There are good reasons why, historically, European countries have almost never let their exchange rates float against each other. And it's hard to see fixed exchange rates, in themselves, as an important cause of the crisis.


[1] Skidelsky gives the Marshall-Lerner condition in its standard form, but the reality is a bit more complicated. The simple condition applies only in cases where prices are set in the producing country and fully passed through to the destination country, and where trade is initially balanced. Also, it should really be the Marshall-Lerner-Robinson condition. Joan Robinson was robbed!

[2] Krugman wrote a very doctrinaire paper years ago rejecting the idea of balance of payments constraints on growth. I've quoted this here before, but it's worth repeating:

I am simply going to dismiss a priori the argument that income elasticities determine economic growth, rather than the other way around. It just seems fundamentally implausible that over stretches of decades balance of payments problems could be preventing long term growth... Furthermore, we all know that differences in growth rates among countries are primarily determined by differences in the rate of growth of total factor productivity, not by differences in the rate of growth of employment. ... Thus we are driven to supply-side explanations...

The Krugmans and DeLongs really have no one to blame but themselves for accepting that all the purest, most dogmatic orthodoxy was true in the long run, and then letting long-run growth take over the graduate macro curriculum.


UPDATE: I should add that as far as the trade balance is concerned, what matters is not just a country's growth, but its growth relative to its trade partners. This may be why rapid Greek growth in the 1970s was not associated with a worsening trade balance -- this was the trente glorieuse, when all the major European countries were experiencing similar income growth. Also, in comments, Random Lurker points to a paper suggesting that another factor in rising Greek imports was the removal of tariffs and other trade restrictions after accession to the EU. I haven't had time to read the paper properly yet, but I wouldn't be surprised if that is an important part of the story.

Also, I was discussing this at the bar the other night, and at the end of the conversation my very smart Brazilian friend said, "But devaluation has to work. It just has to." And she knows this stuff far better than I do, so, maybe.

Do Prices Matter? EU Edition

The Euro crisis. One thing sensible people agree on is that the crisis has little or nothing to do with fiscal deficits  (government borrowing), and everything to do with current account deficits (international borrowing, whether public or private.) And one thing sensible people do not agree on, is how much those current account deficits are due to relative costs, or competitiveness.

A thorough dissection of competitiveness in the European context is here; Merijn Knibbe has some good posts critiquing it at the Real World Economics Review. Krugman, on the other hand, defends the competitiveness story, suggesting that the alternative to believing that relative prices drive trade flows, is believing in the "doctrine of immaculate transfer." What he means is, the accounting identity that net capital flows equal net trade flows doesn't in itself provide the mechanism by which trade adjusts to financial flows. A country with an increasing net financial inflow must, in an accounting sense, experience an increasing current account deficit; but you still need a story about why people choose to buy more from, or are able to sell less to, abroad.

So far, one can't disagree; but the problem is, Krugman assumes the story has to be about relative prices. It's not the case, though, that relative prices are the only thing that drive trade flows. At the least, incomes do too. If German wages fall, German goods may become more cost-competitive; but in any case, German workers will buy less of everything, including vacations in Greece. Similarly, if Greek wages rise, Greek goods may be priced out of international markets; but in any case Greek workers will buy more of everything, including manufactured goods from Germany. Estimating the respective impacts of relative prices and incomes on trade flows, or the elasticities approach, is one of the lost treasures of the economics of 1978. Both income and price elasticities solve the immaculate transfer problem, since capital flows from northern to southern Europe were associated with faster growth of both income and prices in the south. But their implications for policy going forward are quite different. If the problem is relative prices, a devaluation will fix it; this is what Krugman believes. If the problem is income elasticities, on the other hand, then balanced trade within Europe will require some mix of structural reforms (easier said than done), permanently faster growth in the north than the south, or -- blasphemy! -- restrictions on trade.

Let's pose two alternatives, understanding that the truth, presumably, is somewhere in between. In the one case, EU current account imbalances are due entirely to countries' over- or undervalued currencies. In the other case, current account imbalances are due entirely to differences in growth rates. One thing we do know: In the short run -- a year or two -- the latter is approximately true. In the short run, the Marshall-Lerner-Robinson condition is almost certainly not satisfied, so a change in prices will have the "wrong" effect on foreign exchange earnings, or at best -- if the country's imports and exports are both priced in foreign currency -- have no effect. In the long run, it's less clear. Do prices or incomes matter more? Hard to say.

So what is the evidence one way or the other? One simple suggestive strand of evidence is the intra- and extra-European trade balances of various countries in the EU. To the extent that trade flows have been driven by price, the deficit countries should have seen larger deficits with other EU countries than with other countries, and the surplus countries similarly should have seen larger surpluses within the union than outside it. Those countries whose currencies would otherwise, presumably, have appreciated relative to other EU members should have shifted their net exports towards Europe; those countries whose currencies would otherwise have depreciated should have shifted their net exports away. Is that what we see?

As is often the case with empirical work, the answer is: Yes and no. From Eurostat, here are trade balances as percent of GDP, within and outside the currency union, for selected countries and selected years.

Intra-EU Trade Balance
	1999	2007-2008	2011
Germany	2.0%	4.8%	2.1%
Ireland	19.0%	7.4%	12.6%
Greece	-10.0%	-9.6%	-5.3%
Spain	-2.9%	-4.0%	-0.6%
France	-0.3%	-3.1%	-4.3%
Italy	0.5%	0.5%	-0.2%
Netherlands	14.8%	24.5%	27.9%
Austria	-3.9%	-3.0%	-5.0%
Extra-EU Trade Balance
	1999	2007-2008	2011
Germany	1.2%	2.8%	4.0%
Ireland	6.1%	7.8%	15.1%
Greece	-3.9%	-9.1%	-4.4%
Spain	-2.1%	-5.1%	-3.8%
France	1.0%	-0.1%	0.0%
Italy	0.8%	-1.2%	-1.4%
Netherlands	-11.8%	-17.5%	-20.5%
Austria	1.4%	2.7%	1.9%

What we see here is sort of consistent with the competitiveness story, and sort of not. Germany did increase its intra-EU net exports about twice as much as its extra-EU net exports over the pre-crisis decade, just as a story centered on relative prices would predict. And on the flipside, the fall in Irish net exports over the pre-crisis decade was entirely with other EU countries, again consistent with the Krugman story. 

But for the other countries, it's not so simple. The increase of the Euro-era Greek deficit, for instance, was entirely the result of increased imports from non-Euro countries. Euro-area trade, and non-Euro exports, were approximately constant in the ten years from 1999. This is more consistent with a story of rapid Greek income growth, than uncompetitively high Greek prices. Similarly, the movement toward current account deficit of Spain was mostly, and of Italy entirely, a matter of trade with non-EU countries. This is not consistent with the relative-price story, which predicts that intra-EU trade imbalances should have grown relative to extra-EU imbalances. Note also that today, Germany's net exports to the rest of the EU area are no higher than when the Euro was created, while Greece and Spain have substantially improved their intra-EU balances; but all three countries have moved further toward imbalance with extra-EU countries. This, again, is not consistent with a story in which trade imbalances are driven primarily by the relative price distortions created by the single currency.

Conclusion: Krugman is right that how much relative prices have contributed to intra-European current account imbalances, is a question on which reasonable people can disagree. But as a doctrinaire Keynesian, I remain an elasticity pessimist. It seems to me that we should at least seriously consider a story in which European current account imbalances are due to relatively rapid income growth in the periphery, and slow income growth in Germany, as opposed to changes in competitiveness. A story, in other words, in which a Greek exit from the Euro and devaluation will not do much good.

UPDATE: While I was writing this, Merijn Knibbe had more or less the same thought.

Their Way Won't Do

(Today was the last day of classes here. The final slide for my macro course was an abridged version of this Brecht poem, which captures the discomfort any reasonable person ought to feel when they first study economics. The students could relate.)


Years Ago When I

Years ago when I was studying the ways of the Chicago Wheat Exchange
I suddenly grasped how they managed the whole world's wheat there
And yet I did not grasp it either and lowered the book
I knew at once: you've run
Into bad trouble.

There was no feeling of enmity in me and it was not the injustice
Frightened me, only the thought that
Their way of going about it won't do
Filled me completely.

These people, I saw, lived by the harm
Which they did, not by the good.
This was a situation, I saw, that could only be maintained
By crime because too bad for most people.
In this way every
Achievement of reason, invention or discovery
Must lead only to still greater wretchedness.

Such and suchlike I thought at the moment
Far from anger or lamenting, as I lowered the book
With its description of the Chicago wheat market and exchange.

Much trouble and tribulation
Awaited me.

Only Ever Equilibrium?

Roger Farmer has a somewhat puzzling guest post up at Noah Smith's place, arguing that economics is right to limit discussion to equilibrium:

An economic equilibrium, in the sense of Nash, is a situation where a group of decision makers takes a sequence of actions that is best, (in a well defined sense), on the assumption that every other decision maker in the group is acting in a similar fashion. In the context of a competitive economy with a large number of players, Nash equilibrium collapses to the notion of perfect competition.  The genius of the rational expectations revolution, largely engineered by Bob Lucas, was to apply that concept to macroeconomics by successfully persuading the profession to base our economic models on Chapter 7 of Debreu's Theory of Value... In Debreu's vision, a commodity is indexed by geographical location, by date and by the state of nature.  Once one applies Debreu's vision of general equilibrium theory to macroeconomics, disequilibrium becomes a misleading and irrelevant distraction. 

The use of equilibrium theory in economics has received a bad name for two reasons. 

First, many equilibrium environments are ones where the two welfare theorems of competitive equilibrium theory are true, or at least approximately true. That makes it difficult to think of them as realistic models of a depression, or of a financial collapse... Second, those macroeconomic models that have been studied most intensively, classical and new-Keynesian models, are ones where there is a unique equilibrium. Equilibrium, in this sense, is a mapping from a narrowly defined set of fundamentals to an outcome, where  an outcome is an observed temporal sequence of unemployment rates, prices, interest rates etc. Models with a unique equilibrium do not leave room for non-fundamental variables to influence outcomes... 

Multiple equilibrium models do not share these shortcomings... [But] a model with multiple equilibria is an incomplete model. It must be closed by adding an equation that explains the behavior of an agent when placed in an indeterminate environment. In my own work I have argued that this equation is a new fundamental that I call a belief function.

(Personally, I might just call it a convention.)

Some recent authors have argued that rational expectations must be rejected and replaced by a rule that describes how agents use the past to forecast the future. That approach has similarities to the use of a belief function to determine outcomes, and when added to a multiple equilibrium model of the kind I favor, it will play the same role as the belief function. The important difference of multiple equilibrium models, from the conventional approach to equilibrium theory, is that the belief function can coexist with the assumption of rational expectations. Agents using a rule of this kind, will not find that their predictions are refuted by observation. ...

So his point here is that in a model with multiple equilibria, there is no fundamental reason why the economy should occupy one rather than another. You need to specify agents' expectations independently, and once you do, whatever outcome they expect, they'll be correct. This allows for an economy to experience involuntary unemployment, for example, as expectations of high or low income lead to increased or curtailed expenditure, which results in expected income, whatever it was, being realized. This is the logic of the Samuelson Cross we teach in introductory macro. But it's not, says Farmer, a disequilibrium in any meaningful way:

If by disequilibrium, I am permitted to mean that the economy may deviate for a long time, perhaps permanently, from a social optimum; then I have no trouble with championing the cause. But that would be an abuse of the the term 'disequilibrium'. If one takes the more normal use of disequilibrium to mean agents trading at non-Walrasian prices, ... I do not think we should revisit that agenda. Just as in classical and new-Keynesian models where there is a unique equilibrium, the concept of disequilibrium in multiple equilibrium models is an irrelevant distraction.

I quote this at such length because it's interesting. But also because, to me at least, it's rather strange. There's nothing wrong with the multiple equilibrium approach he's describing here, which seems like a useful way of thinking about a number of important questions. But to rule out a priori any story in which people's expectations are not fulfilled rules out a lot of other useful ways about thinking about important questions.

At INET in Berlin, the great Axel Leijonhufvud gave a talk where he described the defining feature of a crisis as the existence of inconsistent contractual commitments, so that some of them would have to be voided or violated.

What is the nature of our predicament? The web of contracts has developed serious inconsistencies. All the promises cannot possibly be fulfilled. Insisting that they should be fulfilled will cause a collapse of very large portions of the web.

But Farmer is telling us that economists not only don't need to, but positively should not, attempt to understand crises in this sense. It's an "irrelevant distraction" to consider the case where people entered into contracts with inconsistent expectations, which will not all be capable of being fulfilled. Farmer can hardly be unfamiliar with these ideas; after all he edited Leijonhufvud's festschrift volume. So why is he being so dogmatic here?

I had an interesting conversation with Rajiv Sethi after Leijonhufvud's talk; he said he thought that the inability to consider cases where plans were not realized was a fundamental theoretical shortcoming of mainstream macro models. I don't disagree.

The thing about the equilibrium approach, as Farmer presents it, isn't just that it rules out the possibility of people being systematically wrong; it rules out the possibility that they disagree. This strikes me as a strong and importantly empirically false proposition. (Keynes suggested that the effectiveness of monetary policy depends on the existence of both optimists and pessimists in financial markets.) In Farmer's multiple equilibrium models, whatever outcome is set by convention, that's the outcome expected by everyone. This is certainly reasonable in some cases, like the multiple equilibria of driving on the left or the right side of the road. Indeed, I suspect that the fact that people are irrationally confident in these kinds of conventions, and expect them to hold even more consistently than they do, is one of the main things that stabilizes these kind of equilibria. But not everything in economics looks like that.

Here's Figure 1 from my Fisher dynamics paper with Arjun Jayadev:

See those upward slopes way over on the left? Between 1929 and 1933, household debt relative to GDP rose by abut 40 percent, and nonfinancial business debt relative to GDP nearly doubled. This is not, of course, because families and businesses were borrowing more in the Depression; on the contrary, they were paying down debt as fast as they could. But in the classic debt-deflation story, falling prices and output meant that incomes were falling even fast than debt, so leverage actually increased.

Roger Farmer, if I'm understanding him correctly, is saying that we must see this increase in debt-income ratios as an equilibrium phenomenon. He is saying that households and businesses taking out loans in 1928 must have known that their incomes were going to fall by half over the next five years, while their debt payments would stay unchanged, and chose to borrow anyway. He is saying not just that he believes that, but that as economists we should not consider any other view; we can rule out on methodological grounds the  possibility that the economic collapse of the early 1930s caught people by surprise. To Irving Fisher, to Keynes, to almost anyone, to me, the rise in debt ratios in the early 1930s looks like a pure disequilibrium phenomenon; people were trading at false prices, signing nominal contracts whose real terms would end up being quite different from what they expected. It's one of the most important stories in macroeconomics, but Farmer is saying that we should forbid ourselves from telling it. I don't get it.

What am I missing here?

New Post at Rortybomb

A week ago, Mike Konczal asked me to guest blog at Rortybomb. I've finally managed to post something, a critical look at arguments that low interest rates in the 2000s are the underlying cause of the Great Recession. Go read, and comment, there.

The Case of Keen

(Warning: To anyone reading this who's not immersed in the debates of the econo blogosphere, this post will fully live up the blog's subtitle.)

One of the big things this past week was Krugman's criticism of Steve Keen. This was a Big Deal, since it is, sadly, rare for someone of Krugman's stature to engage with anyone in the heterodox world. Unfortunately it wasn't a productive exchange; no real information was exchanged, and neither side, IMveryHO, covered themselves in glory. For anyone interested in what's wrong with Krugman's side, there's a good discussion in the comments to this Nick Rowe post. Here I am going to focus on Keen.

Keen's most recent paper is here; it gives the clearest statement of his view that I've seen. As I see it, there are two parts to it. First, he argues that a tradition running from Minsky back to Keynes and Schumpeter (and, I would add, Wicksell and on back to the "caps" in 17th century Sweden) sees money as endogenously created by the banking system, rather than exogenously set by central banks (or, earlier, by the supply of gold). This means that banks can lend to borrowers without a prior decision by anyone to save, which in turn means that changes in the terms on which banks extend credit are an important source of fluctuations in aggregate demand that drive movements in output and prices. With all this, I am in perfect agreement.

But then he tries to formalize these ideas. And about the best thing you can say about his formalization is that it uses terms in such an idiosyncratic way that communication is all but impossible. I know I'm not the only one who's found Keen's stuff a bit like the novel Untitled in Martin Amis' The Information, which literally cannot be read. But let's make an attempt. Here are what seem to be the two key elements.

Keen repeatedly says that "aggregate demand is income plus change in debt." There are many variations on this through his writing, he evidently regards it as a central contribution. But what does it mean? To a non-economist, it appears to be a challenge to another, presumably orthodox, view that aggregate demand is equal to income. But if you are an economist you know that there is no such view, whether neoclassical, Keynesian or radical.

What economist do believe, across the spectrum, is that total expenditure = total output = total income, or Y = Z = C + I + G + X - M. Given the way our national accounts are set up, this is an identity. The question, as always, is which way causality runs. The term "aggregate demand" is shorthand for the argument that causality runs from aggregate expenditure to aggregate income, whereas pre-Keynesian orthodoxy held that causality ran strictly from income to expenditure. (It's worth noting that in this debate Krugman is solidly with Keen -- and me -- on the Keynesian side.) But there isn't any separate variable called "aggregate demand"; AD is just another name for aggregate expenditure insofar as it determines output. Nobody ever says that AD is equal to income; what they typically say is that AD is a function of income, along with other variables such as interest rates, wealth, and changes in sentiment. (People do say that income is equal to AD, but that is a very different claim, and it's true by definition.)

I can imagine various more or less sensible things Keen might have meant by the statement, but it feels kind of silly to speculate. As written it makes no sense at all.

The second formalism is Keen's equation, which he gives the jawbreaker of a name "the Walras-Schumpeter-Minsky's Law":

Y(t) + dD/dt = GDP(t) + NAT(t).

Y is income, D is debt, and NAT is net asset turnover. This last is defined as "the price index for assets P, times their quantity Q, times the annual turnover T expressed as a fraction of the number of assets, T<1: NAT = P*Q*T."

And now we really run into problems.

First of all, is this an accounting identity, or a behavioral equation? Does it hold exactly by definition, or does it describe an empirical regularity that holds only approximately? This is the most basic thing you need to know about any equation in economics, but Keen, as far as I can tell, doesn't say.

Second, in the national accounts and every economic tradition that I'm aware of, aggregate income Y is identically equal to GDP. They're just two ways of representing the same quantity. So it seems that Keen is using "income" in some idiosyncratic way that he never specifies. Alternatively, and more in the spirit of Minsky and Schumpeter, perhaps he is thinking of Y as anticipated or current-period income, and GDP as realized or next-period income. But again, it's not much use to speculate about what Keen might have meant.

The next problem is units. GDP and presumably Y are flows over a specified period (a year or a quarter); they are in units of dollars. dD/dt is an instantaneous rate of flow; it is in units of dollars per unit time. And NAT, as defined, is the product of two indexes times a fraction, so it is a dimensionless number. Well, you can't add variables with different units. That is just algebra. So again, whatever Keen has in mind, it is something other than what he wrote. And while it's easy enough to replace dD/dt with delta-D over the period that GDP is being measured, I really have no idea what to do with the NAT term.[1]

It doesn't help that at no point in the paper -- or in any of his other stuff that I've seen -- does he give any values for Y or NAT. He has lots of graphs of debt, output, employment, etc., showing -- to the surprise of no one -- that these cyclical variables are correlated. But since Y and NAT don't figure in any of them, it's not clear what work the Walras-Schumpeter-Minsky's Law is supposed to be doing. Again, if his point is that endogenous changes in credit supply are important to business cycles, I'm with him 100%. (Though so are, it's worth noting, some perfectly orthodox New Keynesians.) But if your idea is just that there is some important connection between A and B and C, the equation A = B + C is not a good way of saying it.

Honestly, it sometimes feels as though Steve Keen read a bunch of Minsky and Schumpeter and realized that the pace of credit creation plays a big part in the evolution of GDP. So he decided to theorize that relationship by writing, credit squiggly GDP. And when you try to find out what exactly is meant by squiggly, what you get are speeches about how orthodox economics ignores the role of the banking system.

Keen is taken seriously by serious people. He's presenting this paper at the big INET conference in Berlin next week. It's not OK that he writes in a way that makes it impossible to understand or evaluate his ideas. For better or worse, we in the world of unconventional economics cannot rely on the usual professional gatekeepers. So we have a special duty to police each other's work, not of course for ideology, but for meeting basic standards of logic and evidence. There are very important arguments in Schumpeter, Minsky, etc. about the role of the financial system in capitalism, which mainstream economics has downplayed, just as Keen says. And he may well have something important to add to those arguments. But until he writes in a language spoken by people other than himself, there's no way to know.



[1] Not to mention the odd stipulation that T < 0. Why is it impossible for the average turnover time of assets to be less than a year? Or does he really mean the fraction of assets that change hands at least once? What possible economic meaning could that have?


EDIT: I'm a bit unhappy about this post. It's too harsh on Keen. As Steve Randy Waldman suggests in comments, there probably is a valid insight in there, if one can just get past his opaque terminology. (Altho that's all the more reason for him to stop speaking in idiolect...) More importantly, posting this critique of Keen makes it seem like I am on Krugman's side, when his contributions to the debate have been every bit as bad in their own way -- as lucid as Keen is impenetrable, but also just embarassingly wrong, at least form where I'm sitting. This post by Michael Stephens Randy Wray at the Levy Institute blog does a good job laying out the issues. I agree with everything he says, I think.


EDIT 2:... and now here's Keen saying that

Krugman’s part of the economic establishment, which for thirty or forty years has got away with arguing that you can model a capitalist economy as if it had no banks in it, no money, and no debt… You just don’t have a model of capitalism if you don’t include those components. 

I'm also unhappy with that. Krugman (and New Keynesians/monetarists in general) are very specifically modeling an economy with money, but without banks. I agree with Keen that you do need to think about the financial system to understand macro dynamics, but you can't make the case for that if you can't correctly describe the position you are arguing against. I don't think we will make intellectual progress without being more careful about this stuff.