Home > The Economics Profession > How not to win an economic argument

How not to win an economic argument

from Steve Keen

A critique of a yet-to-be-published paper of mine (“Loanable Funds, Endogenous Money and Aggregate Demand”, forthcoming in the Review of Keynesian Economics later this year; the link is to a partial blog post of that paper) by non-mainstream economist Tom Palley reminds me of one of my favourite ripostes by a politician, back in the days before spin doctors stopped them saying anything offensive — or indeed anything interesting.

As Sir Robert Menzies, former Australian prime minister and leader of the conservative Liberal Party, was giving a campaign speech in 1954, a heckler called out “Mr Menzies, I wouldn’t vote for you if you were the Archangel Gabriel”. Menzies shot back: “Madam, if I were the Archangel Gabriel, you would not be in my constituency.”

So it is with Tom’s critique. He criticises me for a whole range of things that I didn’t discuss, that he thinks I should have discussed, and for techniques I used that he thinks I shouldn’t have used. But Tom wasn’t in my intended audience for this paper — and not because he “wouldn’t be in my constituency”, but because he is. We have our differences, but we’re generally on the same side on the topic of this paper — and I didn’t write it for people who agree with me, but for those who don’t on two key issues: the role of banks, debt and money in the economy, and the role of the change in debt in aggregate demand.

There are plenty of people in the ‘disagree’ camp — almost all of them prominent mainstream economists. But the fact that they do disagree with me on this point is, in some respects, mind-blowing. This disagreement has something in common with the Medieval Scholastic “How many angels can dance on the head of a pin?” debates, in that the ordinary folk of the Middle Ages couldn’t believe that the leading intellectuals of the day wasted their time on such topics. Today’s hoi-polloi have a similar reaction: of course banks, debt and money matter in the economy, and of course private debt affects demand: why are economists even debating it?

But debate it they do, and by far the majority position among economists is that (a) banks, debt and money are fripperies that can and should be ignored in macroeconomic models, and (b) that private debt generally doesn’t affect demand (the exception being “except during a liquidity trap”).

I’m with the hoi-polloi on this one: the dominant position in economics is simply nuts. But how do you convince someone who believes that they’re being logical that they are in fact nutty — especially when they’ve been awarded Nobel Prizes for their nutty ideas?

My approach was to take the other side’s model, and show that if their assumptions were correct, they were right: banks could be ignored in macroeconomics, and changes in private debt had only a miniscule effect on demand.

Then I made one realistic small change, and hey presto — banks were essential to macroeconomics, and changes in private debt were the main game (but not the only one) in changing aggregate demand.

There was a challenge here: because mainstream economists don’t believe that banks, debt and money matter, the vast majority of mainstream models don’t have banks, debt or money in them. But there was one such model — by my old mate Paul Krugman and his techno-whiz colleague Gauti Eggertsson, in the online Appendix to their “Debt, Deleveraging, and the Liquidity Trap” paper. Banks did indeed exist in this model, but they functioned as mainstream economists believe they do: as “mere intermediaries between savers and borrowers”. The banking sector took deposits from the public — which was broken down into consumer-goods producers and investment-goods producers — and then, in return for an intermediation fee, facilitated loans from the consumer sector to the investment sector.

That was pretty easy for me to model in my program Minsky. I created a model with a banking sector that stored everybody’s deposits, but made no loans itself. Instead the consumer-goods sector lent to the investment sector, so loans were an asset of the former and a liability of the latter — and all the bank got out of it was a fee paid by the consumer goods sector. That set-up is shown in Figure 1, with the direction of flow shown by the arrows.

Figure 1: Flows of money in Loanable Funds
Graph for How not to win an economic argument

Then I added the other basic financial transactions in the simplest manner possible: both the consumer and investment goods producers had to hire workers, and buy inputs from each other, and both bankers and workers bought consumer goods.

To simulate this model, I needed to put some numbers to the flows, and the simplest manner in which to do this was to relate all rates of spending to the money in bank accounts. I made absolutely no assumptions about why people spend (or lend) — thus circumventing the religious wars in economics over how behaviour is determined — and the rates of spending could be varied at will as the model ran.

You can try it yourself if you like, by downloading and installing Minsky, running this model (right-click and choose “Save As” to save it, otherwise you’ll get XML gobbledegook in your browser and nothing on your hard disk), and varying the spending and lending rates to change the parameter values as the model runs. Figure 2 shows the model, and how it behaves if the parameters aren’t changed.

Figure 2: The Loanable Funds model with default parameter values, run for 160 years



To change them as the model runs, click on a slider (or put your mouse cursor over one of the sliders and use the arrow keys to change its value). You’ll get an outcome something like that in Figure 3, where GDP does indeed change over time — but the changes precisely mirror those in the velocity of money (which is simply the ratio of GDP to the money stock).

Figure 3: Very every parameter in Loanable Funds and GDP flatlines over 160 years
Graph for How not to win an economic argument

Then, to model the Endogenous Money vision of banking that Tom and I share, I took this model and made two simple changes: lending was from the bank to the investment goods sector (and therefore also interest payments and debt repayments), and there was no intermediation fee. The corresponding table of financial flows is shown in Figure 4 (right-click here to download the model).

Figure 4: Money flows in Endogenous Money
Graph for How not to win an economic argument

Spinning the parameter values in this model leads to a vastly different outcome, because the growth of loans by the banking sector caused the money supply to grow as well. That’s the essential difference between the mainstream Loanable Funds and the Endogenous Money vision of banking, and that was the key point of my paper and the models in it.

Figure 5: Very every parameter in Endogenous Money and GDP booms and busts over 160 years
Graph for How not to win an economic argument

This is how the banking sector actually operates in the real world, and I am far from the only one who has been trying — so far unsuccessfully — to get this message through the thick skulls of mainstream economists. The Bank of England recently had a go, and Lord Adair Turner — hardly someone to be dismissed as a “Banking Mystic” — has recently weighed in:

“We tend to assume that: … Banks take deposits from savers and lend money to finance capital investment, but in fact banks create money and purchasing power, and most lending is unrelated to capital investment.” (Lord Adair Turner, March 26th 2014)

The Endogenous Money model mirrors what happens in the real world, whereas Loanable Funds is a myth that suits mainstream economists because it fits in with their equilibrium fantasy about the nature of capitalism. This Loanable Funds myth that private debt doesn’t matter to macroeconomics cost society dearly, because it is the reason why mainstream economists didn’t see the economic crisis coming.

Now, if I wanted to build a complete economic model, I’d have added all sorts of additional features — and indeed Tom criticises me for not adding those additional features. But I didn’t add them because this was a deliberately parsimonious model. Why didn’t I model people taking money out of the banking system as cash? Because Krugman and Eggertsson’s didn’t. Why don’t I have consumers borrowing as well as firms? Because Krugman and Eggertsson didn’t either. And so on.

What Tom has done in his critique is ignore the context of the Endogenous Money model in my paper, and then criticise that model in isolation. Well sure, the model can be criticised, but those criticisms are irrelevant to why I developed it, and how it was used in this paper.

In effect, Tom has picked word out of sentence, and criticised the word: why did Shakespeare have Hamlet use the word “question” in “To be or not to be: that is the question”, when “dilemma” is a much better word?

I knew a bloke who used to think like that, way back in my student days in the 1970s. If you said something to him, he would choose the word in your sentence that most interested him, and extemporise on it. It made for amusing but of course pointless discussions as he wandered about Sydney University, throwing marijuana seeds into the flower beds.


  1. April 7, 2014 at 5:49 pm

    “…why did Shakespeare have Hamlet use the word “question” in ‘To be or not to be: that is the question’, when ‘dilemma’ is a much better word?”

    I wish I’d said that.

  2. Nick Edmonds
    April 7, 2014 at 6:03 pm

    You say that you “relate all rates of spending to the money in bank accounts.” From looking at your paper, I take this to mean that you are making the assumption that expenditure is based solely on holdings of money balances. If you make the assumption that expenditure is based on the quantity of money, it is not surprising if you conclude that only changes on the quantity of money will change expenditure.

    In fact, this idea that expenditure is restricted by the pot of available money, that if somebody lends that money to someone else, they have to cut their own spending, isn’t that exactly the loanable funds fallacy?

    • April 7, 2014 at 10:19 pm

      “In fact, this idea that expenditure is restricted by the pot of available money, that if somebody lends that money to someone else, they have to cut their own spending, isn’t that exactly the loanable funds fallacy?”

      I am not sure what you are referring to here. Are you saying that whenever someone loans money to someone else they have to cut there own spending by 15% of what they loan out to be compliant with reserve requirements?

      • Nick Edmonds
        April 8, 2014 at 6:40 am

        I’m not sure why Keen believes this (it seems implausible to me) but I don’t think it has anything to do with reserve requirements.

      • davetaylor1
        April 8, 2014 at 9:17 pm

        Nick, Keen doesn’t believe this. He is making a model which simulates the position Krugman and Eggertson used in their model. “Banks did indeed exist in [Krugman’s] model, but they functioned as mainstream economists believe they do: as “mere intermediaries between savers and borrowers”. He goes on to show it is wrong in that it doesn’t account for growth of money.

      • April 9, 2014 at 10:10 am

        I guess Keen will have to tell us himself what he believes. But it does seem to be implied by his paper. What he seems to be saying is that, for an increase in debt to have a macroeconomic impact, it has to involve the creation of additional money. This can only result where a bank is making the loan.

        He says “…the topic of this paper, which is a strictly structural one: does bank lending—as opposed to lending by non-bank agents to each other—significantly alter the macrodynamics of the economy?”.

        And in his conclusion: “Given that bank lending creates money and repayment of debt destroys it, the change in debt plays an integral role in macroeconomics by dynamically varying the level of aggregate demand.”

        His “loanable funds” version of the model is presented as demonstrating why lending by non-banks cannot have a macroeconomic effect. He does indeed claim that this represents Krugman and Eggertsson’s model, but he also claims that their model cannot relate an increase in debt to an increase in demand, because it fails to take account of endogenous money. So, again, his position seems to be that without endogenous money creation, loanable funds holds sway. In fact, this seems to be the whole point of his paper.

        However, whilst money endogeneity is indeed part of post-Keynesian economics, it is never been the case that the it was needed to demonstrate the fallacy of loanable funds (I read quite a good explanation of this point recently, in section 3.3 of this paper: http://werdiscussion.worldeconomicsassociation.org/?post=does-saving-increase-the-supply-of-credit-a-critique-of-loanable-funds-theory ).

        So by relying on money creation as his explanation of why loanable funds does not apply, Keen appears to be saying that it does in fact apply where no new money is created, as in lending between individuals. If he does not think that is the case, he needs an explanation that is not based on money creation, but that would be a very different paper, I think.

        (Incidentally, I don’t know how well his model does represent Krugman and Eggertsson, because in their paper, a change in the level of debt does have an impact on demand, whether it’s bank lending or direct lending between individuals.)

  3. Rhonda Kovac
    April 7, 2014 at 7:31 pm

    The problem, apparently endemic among neoclassicists, of refusal to accept valid criticism is frustrating and angering. But we should rise above our outrage and approach it as we would any other social or practical challenge.

    In much the same way that, as heterodox critics have pointed out with respect to economic goals, it is impossible to be completely morally/prescriptively neutral–that is, all our research and action presumes some implicit practical goal–so we should consider that it is impossible for academic process to be totally separable from feelings, biases and other psychological entities. Scholars should admit they are human, and deal with the matter dispassionately and scientifically.

    Certain research conventions–such as double-blind–already do this, tacitly acknowledging the role of human bias and irrationality in scientific inquiry. An expanded set of such protocols for the social sciences could be helpful here.

    (By the way, the remark of Sir Robert Menzies is reminiscent of an interchange between Lady Astor and Winston Churchill:

    Lady Astor: Sir, if you were my husband I would give you poison.
    Churchill: If you were my wife I would take it.)

  4. April 7, 2014 at 8:32 pm

    Could “Minsky” prove:
    Banks that issue new money by ‘loans'(Ex. mortgages) that carry terms and conditions of ‘ interest’ create an income stream that generates a least 100% from old money (already in existence).
    2001 to 2005 Mortgage loans went from $9 trillion to $12 trillion
    From 2001 for the next 30 years @ $9trillion in loans @ 6% interest would create deposits into the banks in order for the notes to be paid an amount greater than $18 trillion.
    Banks need only 6% of the $9 trillion ($54 billion) on their balance sheet, none of which needs to be their money-it need only to be ‘deposited, entrusted to them.
    Can “Minsky” prove that “Banks by issuing new money by loans not only create that issuance but also have an asset that creates for the bank a means to gain
    at least that amount as a profit.
    The cause of the 2008-9 collapse and why a ‘systemic failure’ came to light.

    Banks discovered a way to suck part of that “interest income gain” from the people and into their pockets. Not only was payment immediate but it was a deposit of a gain that was NOT recorded as an asset on their books.
    The mortgage defaults were not at fault.
    The banks blackmail and extortion of the appraisers to higher dollar loans were not a fault.
    These have been a part of the system forever. A system that has earned the Private for Profit Banks trillions upon trillions and could eventually “allow them to gain ALL of the wealth …(“The greatest inability of the human
    race is our inability to understand the exponential function”:
    When the banks discovered how to beat the Rule of 72, How they could satisfy their greed immediately, they captured ‘the interest income gains’ they secretly spend over the 30 years-immediately.
    They invented “MBSs” The trick was to collect “the non-existent future value of the asset-the loans without changing the assets value thereby allowing the banks to keep 100% of real money paid to them today. The asset remains the same and is zeroed out over time as it is paid.
    Here’s the deal:
    Hey, big money people, how would you like to be guaranteed $9 trillion INCOME over the next 30 years ?
    Just write us a check for $1 trillion. BTW it’s a AAA Security on our books that can’t go wrong.
    They took the money and ran.
    On the next offer after some questioing the banks had to give a little-they paid for insurance against loss in order to close the deal. Next time around they had to guarantee against loss (recourse).
    Here comes the systemic failure.
    The insurance company didn’t have enough money to cover the loses-not
    those of the “Ms” of the “MBSs” ;the losses of the future interest.
    The banks didn’t have the money to buy back (their guarantee)
    When “Banks” and “Insurance Companies” can’t pay and TRUST IS LOSS-
    That is “systemic failure”, albeit the mortgages are still a valuable asset baked by the real property whatever real % and the government; they did not fail.
    IF was the banks and the banks alone.

    “Believe nothing merely because you have been told it…But whatsoever, after due examination and analysis,you find to be kind, conducive to the good, the benefit,the welfare of all beings – that doctrine believe and cling to,and take it as your guide.”- Buddha.
    Inequality , injustice is like water, a part of life, but may, because of the size of its gaps, become toxic.
    The solution:
    “Capitalism is the “best” system to date devised by mankind. As it is administrated, perhaps, is where the “flaw” is manifested. If capitalism used its Central Bank properly,that is for the betterment of the common good, with equality and justice for all, capitalism would be the best ways and means to help “form a more perfect union….”, Pontifical Council.
    Comments by Justaluckyfool ( http://bit.ly/MlQWNs )
    ( “You are always welcome to share, copy, plagiarize, improve, etc..any comments.)
    *WHAT IF THE …The Fed Reserve were to become the CENTRAL BANK WORKING FOR THE PEOPLE (CBWFTP) instead of working for the Private For Profit Banks (PFPB) .
    Let’s try this game: Substitute the words “Central Bank Working For The People” (CBWFTP) where ever” Private For Profit Banks” (PFPB) appears.
    ****PFPB have $100 trillion in assets as mortgages on residential and commercial real property (RE) loans. The average compound interest rate is 4% for a term of 30 years. The PFPB would have created that $100 trillion ‘out of thin air’ which would have an attachment that would require $300 trillion to be paid to the PFPB in order for the loan to be paid in full. YES, take away the smoke and mirrors. Now we must replace (reduce to zero ) the initial loan amount by subtracting $100 trillion; leaving a profit,income,taxation from ‘somewhere else’ of $200 trillion. This amount goes as profits to the PFPB. Revenue they may use for their own selfish purposes.
    Why would you not want prosperity for yourselves and your children?
    Why would you not want $200 trillion turned over to Congress, to be used..”to form a more perfect Union, establish Justice, insure domestic Tranquility, provide for the common defense, promote the general Welfare, and secure the Blessings of Liberty to ourselves and our Posterity,…”
    Share: “You are always welcome to share, copy, plagiarize, improve, etc..“

  5. April 7, 2014 at 8:38 pm

    Where do mainstream economists think money comes from? Undisciplined central bankers? What would a “good” development outcome look like in the first model? Steadily increasing velocity? That would require the nominal currency to split just to remain practical. What if it did? Is practical velocity the limit?

    As for the endogenous money school, is there any special significance placed on the fact that money is created as debt instead of, say, value-add? Does the moral pressure of debt and/or the fact that money comes before production matter, or would it work just as well if banks created long-term money after asset production (with short term intermediation)?

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