Steve Keen is an excellent, left-field economist, and more importantly, is a fellow Australian. He hosts a fascinating and prolific blog called “Debtwatch”, that reports monthly on the dangers of excessive, private debt.
His primary message is that the “Efficient Markets Hypothesis”, which has dominated academic thinking about finance, even after the Global Financial Crisis, is fundamentally flawed. This hypothesis essentially states that all information is always built into markets. Hence, they operate perfectly in line with how Neoclassical Theory would expect them to operate (i.e. with supply and demand in perfect equilibrium and prices reflecting this perfectly).
To keep the economy going, the models would differ by:Neoclassical would fight unemployment with inflation (government spending is needed to bolster aggregate demand in times of unemployment) Austrian would fight inflation with unemployment (no government spending, it’s arbitrary and intrinsically votes motivated)
However, Steve Keen’s main research focus has been the development of an alternative, empirically grounded theory, known as the “Financial Instability Hypothesis”. Echoing somewhat the Austrian school of thought, he argues that financial markets are inherently unstable. Well, that’s perhaps not a particularly big stretch of the imagination? Nevertheless, many economists, including those who work with me, frequently cite models that pivot on the premise that markets tend to a perfect equilibrium – it makes the Math easier for one. However, surely commonsense would tell us that no complex system ever obtains equilibrium. All systems are constantly influenced by external stimuli and thus the playing field is always moving and evolving; hence creating new equilibria. Consequently, I wholeheartedly agree with Steve Keen’s scepticism about the “Efficient Markets Hypothesis”.
In addition, the “Efficient Markets Hypothesis” implies that people operating within a market generally act in line with the expectations of Neoclassical Theory, namely Rationally. However, many economists have disputed the this concept. Behavioural economists attribute the imperfections in financial markets to a combination of cognitive biases such as overconfidence, overreaction, information bias, human errors in reasoning, and let’s not forget, irrational, emotional responses. Humans are fallible, markets can surely never really be perfectly efficient and rational in their decision-making?
Thus, yes, I do agree with Steve Keen’s sentiments about the tenuousness of rational economic models, but I don’t necessarily follow his view all the way. A few days ago, a heated discussion about his blog occurred among some friends and one of them, Les Richardson, summed up the prevailing opinion quite eloquently. So, here’s a guest-post by Les commentating on Steve Keen’s economic philosophy:
Click here for the original post by Steve Keen.
Commentary by Les Richardson on Steve Keen:
Here’s my take on Steve Keen’s views of global economics as stated in his blog “The Debtwatch Manifesto“.
To be fair, I think he misses the point entirely. Well, there you have it… in a nutshell.
Right, for a start he’s a modern Keynesian. Keynes was about using the government to stimulate the economy, but that doesn’t mean he believed governments should just throw money out of the window, squandering it. Modern Keynesians no longer understand the differences between successful investment, unsuccessful investment, and just plain excessive spending.
The GFC was a bubble bust. Bubbles can occur for a variety of reasons, but usually it arises from a distortion in the market – and nothing creates distortions like government intervention and regulation.
The property bust in the U.S. (if the cause of the GFC), and the property bust in China, which will probably hit big time in 2012 or 2013, are interesting bubbles to examine because they are both the unforeseen results of government policy, but for quite different reasons.
In the U.S., the housing bubble was a direct consequence of deliberate policy to make housing more affordable, but through a Fascist approach (i.e. government coercion of the private sector) rather than Socialistic (i.e. government providing the housing itself). Banks were legislated to give high risk loans, essentially as a cost of doing business in a particular area. As a tax, that can be done (and the effects are like any other tax), but in the U.S., they took it a lot further. Business will go wherever it can – the government wanted people to get housing, and the banks to fund it, so the oft-described “greed” aspect was really just delivering government policy at a profit. Sensible credit considerations did not apply, as the banks were required to do it anyway (there are parallels here to the building of blatantly, non-viable, wind farms). Government, guaranteed entities (Freddie Mac and Fannie Mae) were underwriting these mortgages, and in any case, as long as property prices continued rising, repossessed properties could be sold and all outstandings recovered. Buyers/Investors also had minimal risk, provided they used mostly borrowed money, as they could return the keys at any time and effectively end the mortgage at any time, leaving the bank to cover any shortfall (here in Australia, if the property cannot be sold to cover the entire mortgage, the mortgagee must make up the shortfall).
Put together a “no risk” position for investors, and a “no risk” position for the lender, insurers, enablers etc, and you have a bubble forming. Because the whole set-up was underpinned by rising house values (this was how everyone could liquidate their positions) it lasted for as long as the house prices went up. When they waivered in 2007-2008, the entire system collapsed very quickly.
The contribution of CDO’s (Collateralized debt obligations), and ratings agency’s, and AAA-rated, credit wrapping – the whole Wall Street phenomenon – served to make it a bigger bubble than it might otherwise have been. This is because everyone got in on the act to trade in the “extra” market created by the simple fact that so many houses were being built to be sold to people who could not afford them on sub-prime loans. Sub-prime loans grew in volume over decades, so it was actually part of the business landscape, but changes in the law from the initial Carter era laws, beefed up under Clinton, and run riot with under the last 6 years of Bush once the Democrats got control of Congress, escalated the growth. Freddie Mac and Fannie Mae blatantly lied about their exposures to sub-prime loans to Congress (they have recently pleaded guilty to the SEC for this), and Barney Frank, as Chairman of the overseeing House Committee, blocked all attempts to investigate.
The markets can be criticised for acting stupidly in attempting to implement government policy, but, like electricity retailers mandated to source “renewable” energy, to a large degree they had little choice.
This policy of coercing banks to lend massively to customers who could never afford to pay the loans back, was doomed in the long term, and the crash was inevitable. Like any crash, the longer it took to occur, the bigger the bubble, the worse it became. Government intervention, and a system which protected investors from losses, underscored by 25 years of rising house prices, put off the day of reckoning, but it was inevitable in the end.
The corporate profit motive was a component in the process, true, but only to the extent that it encouraged active participation by the private sector. It was not the cause of the problem (and if it had been, the bubble would have burst a lot earlier because of the lack of artificial, warping factors). The banks were just a catalyst to flawed, governmental policy.
In China, the story is a bit different. The government there has made it very difficult for individual investors to invest their money profitably. Interest rates on deposits are regulated and too low – lower than inflation. One of the few avenues open to the small scale investor is the property market – and with a billion people, that’s also what the government wants. But, by only allowing that one basic investment avenue, the government has created a market distortion, and artificial incentive which has guaranteed property development has moved ahead of demand – ergo a bubble has formed. It is a completely different type of distortion to the U.S. government’s, but the effect will nonetheless be similar. It hasn’t been going on as long, but the scale of China is so big that the effect will be a strong one.
Steve Keen talks about Neoclassical economics – basically (his namesake) Keynes – and clearly has no time for it. Like a lot of left-leaning economists or commentators, he misunderstands Keynes as badly as he does, his great rival of the day, Hayek.
Whilst Keynes is about what the benefits that government can do, Hayek is about the damage they can do – which viewpoint is correct really depends on the outcome. Keynes is used as an excuse for unbridled government control and expenditure, and governments generally have a poor record at getting it right. Hayek’s basic premise is that the government sucks resources from the private sector, and lacks economic corrective mechanisms (i.e. when the private sector gets it wrong, it goes bust – whereas when the government squanders money it just increases taxes and suck more resources from the economy).
Steve Keen talks about private debt being the problem, but that’s misplaced. It is to a large degree the symptom not the cause. He doesn’t look at the root causes, I believe. Private borrowing, particularly in respect of the property market in the U.S., flourished because people thought it was risk free. They could just return the keys to wipe the obligation, but of course it is never that simple. Many bankrupted themselves first, trying to avoid giving up the property(s), because they were living beyond their means. Here the irresponsibility – and Moral Hazard – clearly lay with the lenders rather than the borrowers.
This is a very important point – Keen absolves investors of blame. And many would agree with him.
What he is really saying is people lack the ability to be responsible for their own actions (every sub-prime loan had an real-live applicant at the other end ). They really need the government to manage things for them – and we can see how that turns out. Give a person a handout and he’ll take it without much consideration. Even if instead of giving him a fish to eat, you could have given the fishing rod and would have quickly figured out how touse it and be self-sufficient. Try to think of any prosperous countries where the government controls the economy so voraciously? Ones like China have only started to find prosperity by freeing their economies up.
Central planning had its “fair go” in the Soviet block and it limped slowly and inevitably to economic collapse. A vibrant economy needs a government to empower its citizens and encourage them, not treat them all like the lowest common denominator and give them unsustainable handouts from the diminishing few who are actaully productive.