Steve Keen: “Can We Avoid Another Financial Crisis?”

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Economic theory is like a layer cake: Explanations within one layer make sense, but once you move to another layer, they no longer apply. Economist Steve Keen‘s new book “Can We Avoid Another Financial Crisis?” is an illustrative example. 

The good news is that Keen accurately describes the current economic system; the bad news is that the answer to the question in the title is “no.” (And, despite what I believe is his accurate overall assessment, he misses, or skips over, a few key, hidden elements of economic theory.)

Keen defines his question within the layer of a corrupt banking system, the system we have now. He explains how it is that banks create money in the form of debt, and how this leads to financial instability. In the book he quotes the Bank of England’s own economists:

“In the modern economy, most money takes the form of bank deposits. But how those bank deposits are created is often misunderstood: the principal way is through commercial banks making loans. Whenever a bank makes a loan, it simultaneously creates a matching deposit in the borrower’s bank account, thereby creating new money.”

Keen builds on the work of Hyman Minsky and Joseph Schumpeter to explain why it is that private debt created out of nothing by private banks leads to economic instability.

“Desired investment in excess of retained earnings is financed by debt. This leads to a cyclical process in capitalism which also causes a secular tendency to accumulate too much private debt over a number of cycles,” writes Keen.

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The boom-bust cycle is as follows: During the early stages of a debt cycle, debt drives investment, which increases demand. The growing economy can easily service the debt, and most loans are repaid. The longer this benign growth phase lasts, the more banks are incentivized to throw caution to the wind and loan more; asset values backing the loans are also rising in value at this point, which encourages recklessness.

At some point, debt levels become so high that the weaker economic players cannot maintain their interest payments, setting off a wave of defaults which leads the the money supply to contract, and leads to losses at banks. Banks then reduce their lending, further shrinking the money supply (where money is debt) even further, slowing economic activity. At this point, even strong players are in trouble and are forced to liquidate assets. The vicious cycle simply continues.

“The slump turns euphoric expectations into depressed ones and reverses the interest rate, asset price, and income distribution dynamics that the boom set in train. Aggregate demand falls, leading to falling employment and declining wage and materials costs,” writes Keen.

People who have witnessed the subprime boom and bust would mostly agree with this assessment. So why haven’t mainstream economists figured it out?

Mainstream Economics Ignores Debt

In his first major book “Debunking Economics,” Keen promised there was going to be “no more Mr. Nice Guy” toward mainstream economists who completely ignore private debt in their models, forecasts, and policy recommendations.

Keen continues with the same tenor in his current book and dishes out criticism of the profession where it is due, explaining why the mainstream keeps getting it wrong.

“Minsky’s theory is compelling, but it was ignored by the economics mainstream when he first developed it because he refused to make the assumptions that they then insisted were required to develop ‘good’ economic theory,” writes Keen.

Keen, who is extremely well-read in all fields of economics, uses source material from his ideological opponents to debunk their own logic. Here, he quotes former Federal Reserve (Fed) Chairman Benjamin Bernanke:

“Hyman Minsky (1977) and Charles Kindleberger (1978) have in several places argued for the inherent instability of the financial system but in doing so have had to depart from the assumption of rational economic behavior. [A footnote adds] ‘I do not deny the possible importance of irrationality in economic life; however it seems that the best research strategy is to push the rationality postulate as far as it will go.’ (Bernanke, 2000, p. 43)”

Too many illogical and irrational assumptions are the reasons why mainstream economics is suffering from a crisis of confidence.

Technically inclined readers can delve into Keen’s explanation as to why the mainstream extrapolation of macroeconomics from microeconomics is wrong, why the macroeconomy should be modeled after a dynamic system, why a corrupt banking system creates inequality, and why private debt cycles always look best just before the storm hits.

The lay reader can skip all that and go straight to Keen’s explanation of the private debt busts of 1990 Japan and 2008 subprime crisis.

The book is essentially an extended academic monograph, bristling with references to arcane papers, footnotes, and nerdy graphs. It stands as a reliable and fairly straightforward explanation for an educated reader as to what drives economic booms in a corrupt banking system (namely, one based on private debt) and why it is responsible for all manner of pernicious consequences, like busts and income inequality.

Can We Avoid Another Financial Crisis?

Keen answers the $1 trillion dollar question with a resounding “no.” This is because too many countries rode a wave of private debt explosion during the last boom, and are now in the equivalent of economic purgatory. Keen identifies China as the biggest threat.

“They face the junkie’s dilemma, a choice between going ‘Cold Turkey’ now, or continue to shoot up (on credit) and experience a bigger bust later. China is undoubtedly the biggest country facing the debt junkie’s dilemma now. But it doesn’t lack for company,” he writes.

Other countries with a high level of private debt and a reliance on debt to fuel economic demand—Keen calls them “debt zombies”—are Australia, Belgium, Canada, South Korea, Norway, and Sweden.

In total, the influence of China and these smaller economies is simply too great for the world to avoid a financial crisis.

Solutions

According to Keen, the solution within this layer of economic theory is more government regulation of the banking system and government deficits to counter a fall in private demand — which is essentially the policy response to the 2008 financial crisis.

More aggressive options are quantitative easing in the form of “helicopter money,” where the central bank monetizes government debt, and the government then writes a check to households to either pay down debt or spend it in case there isn’t any debt to pay down. There could also be a more official debt jubilee where debt is simply forgiven.

“On its own, a Modern Debt Jubilee would not be enough: all it would do is reset the clock to allow another speculative debt bubble to take off. Currently, private money creation is ‘a by‐product of the activities of a casino’ (Keynes, 1936, p. 159), rather than what it primarily should be: the consequence of the funding of corporate investment and entrepreneurial activity,” writes Keen.

The ultimate objective would be for the government to counter excessive private debt bonanzas.

Being an agnostic thinker, Keen also entertains concepts of government issued money and cryptocurrencies, although he doesn’t think they can eventually replace the banking system, partly because of scale, partly because of political resistance.

“As long as that model holds sway over politicians and the general public, sensible reforms will face an uphill battle—even without the resistance of the finance sector to the proposals, which of course will be enormous.”

And within this layer of the economic layer cake, within the constraints of our current political economy, Keen is again absolutely right.

The Hidden Layer

At another layer of economic theory, however, Keen and Minsky are incorrect to argue that capitalism itself causes booms and busts and that more government is the ultimate solution for all economic layers, especially the financial one.  

In a free market for money, banks that give out too much debt with low-quality collateral would have their liabilities devalued in the market, and depositors would take their business elsewhere. This competitive process would drain the offending banks of reserves and eventually lead to bankruptcy—without a bailout—unless they improved their lending processes. 

It is only when governments impose legal tender laws or accept private bank liabilities at face value in the payment of taxes that such over-issued and poorly backed liabilities retain their value, leading to the boom and bust cycle. It is also the government which bails out offending banks time and again to save the corrupt system, leading to the moral hazard Mr. Keen describes.   

Most modern economists, including Keen in this book, ignore this fundamental state interference in the market and then conclude that more government is needed to solve the very problems that government intervention created in the first place.

To Keen’s credit, he has researched historical instances of free market banking and concludes that the history does not confirm the Austrian theory of reflux. Thus, he stands on one side of a hotly contested academic debate, while scholars of the Austrian school of economics stand on the other.

Today, however, we have only this bastardized version of capitalism, where governments and banks collude to create the instability Mr. Keen deals with in this book. It is this layer of the system that Mr. Keen describes for the educated reader: Accurately, convincingly, and with a touch of mordant humor.

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