Debunking Economics

In the new 2011 edition of his magnum opus Debunking Economics: The Naked Emperor Dethroned, Australian economics professor Steve Keen comes out guns blazing, blasting the “Panglossian view” of neoclassical economics that did so much to get us into the credit boom and bust that we are still struggling to recover from.

Keen, unlike most of his peers, understands the role of debt in the economy, both as fuel for a boom and as an enormous anchor that prevents recovery during a bust. He also clearly shows how private financial institutions create most of the debt in the economy, not the government or central banks.  Mainstream economists did not see the 2008 crisis coming because, frankly, the tools they use have no way to take the role of private debt into account.  It’s not that mainstream economists are stupid; far from it.  Most are highly intelligent.  There just happens to be a rather large hole in their body of research that Professor Keen has sought to fill.

In the preface, he writes that “as a means to understand the behavior of a complex market economy, the so-called science of economics is a mélange of myths that make the ancient Ptolemaic earth-centric view of the solar system look positively sophisticated in comparison,” adding also that “economics is too important to be left to the economists.”

Well said, Professor.

In this age of popular angst in which our reigning politico-economic system—and the Federal Reserve in particular—is under attack from both the Tea Party on the right and Occupy Wall Street on the left, it is easy to dismiss Professor Keen as just another fringe, anti-establishment doom monger.   But Professor Keen is no Johnny-come-lately, and I advise readers to take his words very seriously.   While his fiery rhetoric has made him a bit of a black sheep among his peers in the profession, he can rightly call “scoreboard.”  He was one of the few professional economists to predict the 2008 meltdown, correctly pointing out the risks of the private-sector debt explosion and sounding the alarms of the disaster to come as early as December 2005.  For his efforts, he received the Revere Award from the Real World Economic Review for the being economist “who most cogently warned of the crisis, and whose work is most likely to prevent future crises.”   Keen is a man we would all be wise to listen to.

He’s also highly likely to make you uncomfortable, which is a cross that all contrarians bear.  As a race, humans crave certainty, and—like a proverbial ostrich with its head buried in the sand—they tend to hide from any evidence that might call that certainty into question.

Economists are no better than the rest of us on this count and might even be worse.  Economists (and political scientists too, for that matter) tend to be dogmatic in their views.  Like a die-hard Marxist who insists that communism could work “if only it were implemented correctly,” it seems that no amount of evidence to the contrary can convince a neoclassical economist that the market is not always efficient and that instant liquidity is not the solution to every problem.

As Keen writes of his peers,

I came to the conclusion that the reason [economists] displayed such anti-intellectual, apparently socially destructive, and apparently ideological behavior lay deeper than any superficial pathologies.  Instead, the way in which they had been educated had given them the behavioral traits of zealots rather than of dispassionate intellectuals.

As anyone who has tried to banter with an advocate of some esoteric religion knows, there is no point in trying to debate fundamental beliefs with a zealot.

On a personal note, I’ve had the same frustrations in speaking to gold bugs and Austrian economists who, knowingly or not, speak of gold in mystical terms usually reserved for religions and extreme political movements.  That gold is the “one true currency,” sounds remarkably similar to the Islamic tenet that Islam is the “one true religion” or that the Catholic Church is the one, true “universal church.”  Gold may or may not be a good investment or a suitable asset to base an international monetary system on; this is a subject for intelligent debate.  But you can’t have an intelligent debate with an ideologue.

For those with only a cursory knowledge of the popular schools of economic thought, let this serve as a crash course:

Neoclassical School:  The vast majority of economists, including Fed Chairman Ben Bernanke and most policy wonks for both the Republicans and the Democrats, can be loosely classified as “Neoclassical” economists.  The Neoclassical School is what you would think of as “mainstream economics.”  There is a general belief in the efficiency of markets with a sprinkling of Keynesian ideas about the role of government spending during recessions and Monetarist ideas about the role of the central bank and official interest rates.  Where neoclassical economics differ with one another—such as on the proper size of the state, the size of social safety nets, the level of regulation and taxation needed, etc.—they tend to argue at the margins.  There is general consensus that, all else equal, markets and trade should be as free as possible, though regulation and fiscal and monetary policy have their respective places.  While I consider myself a “free market” guy, I do think it is only prudent to look at the other side of the coin.

Neoclassical economics hinges on a few assumptions that any non-ideologue would immediately know where untrue (and which Keen relentlessly critiques throughout the book):

  1. People act independently and on the basis of full information. (Under this assumption, irrational bubbles would be impossible; how anyone believes this given the recurrence of bubbles in history is a mystery.)
  2. People have rational preferences that can be quantified (Again, this point is dubious at best.  We are humans, not Vulcans.)
  3. Markets are rational and tend towards equilibrium (which implies that booms and busts are the exception and not the rule.)
  4. What is true of the individual is true of the group.  (Keynes attacked this as the Fallacy of Composition; more on that later.)

While the Neoclassical School’s emphasis on the benefits of trade and free markets is generally spot on, the school clearly has its limitations.   Its dogmatic belief in the efficiency of markets is, frankly, ridiculous and flies in the face experience.  And again, it suffers from the Fallacy of Composition, which we will discuss shortly.

Austrian School: Formerly the domain of gold bugs and various stripes of libertarians, the Austrian School of economics has recently risen to prominence with the popularity of Congressman and perennial presidential candidate Ron Paul.  Representative Michele Bachmann also describes herself as an Austrian and claims to read the works of von Mises on her beach vacations.   For the literary enthusiasts out there, Ayn Rand, author of The Fountainhead and Atlas Shrugged could be loosely lumped in with the Austrians, though she was not an economist and had her own school of thought known as Objectivism.

Friedrich von Hayek—who taught for years at my alma mater, the London School of Economics—and Ludwig von Mises were the main proponents for the movement in its early days, which rose in response to the creeping statism that grew out of the Keynesian movement in the years after World War II.  The Austrian School objects to the hyper-precision quantification of most modern economic methods, insisting that economics is too complex and too subject to fickle human tastes to be accurately measured.  On this count, I would have to agree.   Unfortunately, they also tend to have a near obsession with the Federal Reserve and the effects of managed interest rates which Austrians believe inevitably lead to inefficient “mal-investment.”     For some of the more puritanical Austrians, the Federal Reserve is not simply an inefficient institution; it’s a source of societal moral rot.  (The Austrians seem to ignore that, even under a gold standard, irrational booms and busts were still a fact of life.  It appears that the human emotions of greed and fear were concocted in the conference room of the New York Fed by a cabal of sinister bankers.)   On balance, the Austrians have an emphasis on limited government and personal freedom which is refreshing and admirable, but they tend to be a little too radical to fully take seriously.

Hard-core Austrians would have been content to let every bank in America fail, even if it meant 50 percent unemployment and conditions worse than the Great Depression, because it would have struck them as being “just.”  It’s easy to be a radical when you know there is no possibility that what you advocate will come to pass and that you’ll never have to live with the consequences.

Keynesian School / Post-Keynesian School:  Keen would count himself among the Post-Keynesians.  For our purposes here, Keynesians and Post-Keynesians are close enough to be lumped together as one.  Keynesianism can be defined more by what it is not than what it is.  It is not a dogmatic grand unifying theory.  It is more of a hodgepodge of pragmatic adjustments to what Keynes considered shortcomings of a pure market economy.

John Maynard Keynes cobbled together what we now call “Keynesian economics” from what he saw as shortcomings of mainstream economics during the Great Depression.   Delving into the arcane, Keynes believed that “Say’s Law,” a tenet of classical economics that claims that supply creates its own demand, was a half-truth at best.  Sometimes supply didn’t create its own demand.  Sometimes you have overcapacity, falling prices, and weak aggregate demand.  Sometimes an economy can settle at an equilibrium far below full capacity.  Because of “sticky wages” and “sticky prices,” sometime the unemployment rate can stay uncomfortably high.  Sometimes—just sometimes—the real world doesn’t look like an economics text book, and waiting for things to work out in the long-run is not always a viable option.  In the long run, we’re all dead.

To smooth over some of the rougher edges of a free-market economy, Keynes argued that the state could be a stabilizing force.  One of the more controversial elements of his work was his advocacy for “countercyclical measures.”  Keynes argued that governments should run deficits during recessions to spur demand with the understanding that the debts racked up during the hard times would be paid back with surpluses during the good times.  Alas, while this sounds great in theory, the always-pragmatic Keynes seemed to have a complete misunderstanding of how real-world politics works.  Borrowing money is easy for a politician.  Paying back proves to be remarkably hard.  (Note: Though he is a “Post-Keynesian” economist, Keen makes it clear that that countercyclical Keynesian deficit spending is not going to fix an economic plagued by debt deflation.  More on that to come.)

Governments on both sides of the Atlantic used Keynes work to justify the massive expansion of the state after World War II, and the stagnation that followed led to Keynesian economics falling into disrepute by the late 1970s.

Where Keynes’s work would appear to justify socialism, I find it outright dangerous.  But much of Keynes’ work is politically neutral, and his insights into markets were largely spot on.

In particular, Keynes tore apart the notion that what is good for the individual is automatically good for the group.  This is the Fallacy of Composition and is perhaps best illustrated by Keynes’s Paradox of Thrift.  While it is considered responsible behavior for an individual to spend less and save more, if everyone did it at the same time the economy would collapse.  Keynes’ disciples, including Steve Keen, have taken this notion further.  In Debunking Economics, Keen writes:

One of the great difficulties in convincing believers that neoclassical economics fundamentally misunderstands capitalism is that, at a superficial level and individual level, it seems to make so much sense.  This is one reason for the success of the plethora of books like The Undercover Economist and Freakonomics that apply economic thinking to everyday and individual issues: at an individual level, the basic concepts of utility maximizing and profit-maximizing behavior seems sound.

As I explain later, there are flaws with these ideas even at the individual level, but by and large, they have more than a grain of wisdom at this level.  Since they seem to make sense of the personal dilemmas we face, it is fairly easy to believe that they make sense at the level of society as well.

This reason this does not follow is that most economic phenomena at the social level—the level of markets and whole economies rather than individual consumers and producers—are “emergent phenomena”: they occur because of our interactions with each other—which neoclassical economics cannot describe—rather than because of our individual natures, which neoclassical economics seems to describe rather well. 

Keynesians, better than neoclassicals, “get” that economics is a social science.  It’s a lot closer to psychology than it is to physics.  (In this respect, Austrian Economics is also closer to the truth than Neoclassical.)

Neoclassical Economics (and Marxist Economics too, for that matter) focuses almost exclusively on the supply side of the equation.  Demand is almost an afterthought, some that just kind of “happens” and doesn’t need to be explained.  I consider that a shortcoming and consider Keynes’ workin this respect to be insightful.

Much of Steve Keen’s work in Debunking Economics and elsewhere is an expansion on the work of two prominent Post-Keynesians: Hyman Minsky and Irving Fisher.

Minsky’s Financial Instability Hypothesis is brilliant.  While Neoclassical Economics insists that market economies naturally tend towards equilibrium, Minsky argues exactly the opposite.  Stability begets instability, and vice versa.  A long period of stability lulls market participants into a false sense of security and encourages them to take on excessive debts and excessive risks.  This inevitably leads to instability and crisis—as it did in 2008—which in turn causes market participants to go too far in the opposite direction, becoming too risk averse.  Try to get a mortgage today at a major bank, and you’ll see what I mean.  The only way to moderate this never-ending oscillation is to avoid the massive accumulation of debts, which can only be done by strictly regulating the banking system.

The aftermath of excessive debt is, unfortunately, what Irving Fisher called “Debt Deflation.”

Debt deflation is a nightmare.  It starts with a debt-fueled boom.  When the boom turns to bust, prices fall, which makes the value of the outstanding debt rise in real terms.  The more that consumers and businesses cut back their spending to pay back their debts, the more the economy sinks, the further prices fall, and the higher the value of the debt rises.  It’s a vicious cycle in which the harder you try to pay off the debts, the more burdensome they become.  This is where Greece is today and where the rest of the developed world may soon be going.

Japan is a perfect example of Irving Fisher debt deflation in action, mixed with a fatal dose of bad demographics.  The last time prices rose significantly in Japan, Bill Clinton was the Governor of Arkansas.   Private debts have inched lower over the past two decades, but government debt has exploded in an attempt to follow the standard Keynesian policy of using government debt to spur demand.  Alas, this won’t end well for Japan. (John Mauldin calls Japan “a bug in search of a windshield,” and it is an apt metaphor.)

Overall, Keen has written a comprehensive work that I would recommend for any reader with an interest in economics.  Keen is a serious student of the profession, and the proof of his critique of mainstream economics is in the pudding.  Keen saw the crisis coming.  Neither Bernanke, nor Greenspan, nor any other Neoclassical economist did.  That, more than anything I can say, is testament to the importance of Keen’s work.

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The Incredible Shrinking Woman

Experienced debaters are familiar with the Latin term reductio ad absurdum. This is a tactic in which your opponent’s proposition is disproven by taking it to a logical extreme—or reducing it to the absurd.

For example, the statement that “Stocks always rise over the long run” or that “Over the long run, the economy will heal itself” can be countered with John Maynard Keynes quote that “In the long run, we are all dead.” Likewise, the common supply-side argument that lowering taxes always leads to increased tax revenues can be reduced to the absurd by offering to lower the tax rate to zero.

In continuing themes we have written about extensively in recent months—falling birthrates and decline of the traditional family in much of Asia and Europe—the venerable Economist decided to engage in a little reductio ad absurdum by forecasting when the female population of assorted countries will simply disappear. (See chart)

The Economist writes,

According to the United Nations, in 83 countries and territories around the world, women will not have enough daughters to replace themselves unless their fertility rates rise. In Hong Kong, for example, a cohort of 1,000 women is now expected to give birth to just 547 daughters. If nothing changed, those 547 daughters would be succeeded by 299 daughters of their own, and so on.

Extrapolating wildly, it would take only 25 generations for Hong Kong’s female population to shrink from 3.75m to just one. Given that Hong Kong’s average age of childbearing is 31.4 years, the territory would expect to see the birth of its last woman in the year 2798. By the same unflinching logic, Germany, Italy, Japan, Russia and Spain will not see out the next millennium. Even China has only 1,500 years left. See “The Last Woman, and the End of History

This is absurd, of course. These countries will not “disappear.” The native populations of many countries may indeed be replaced by immigrants or even foreign invaders, but Hong Kong is not going to be an empty ghost town in the year 2798 inhabited by a single Chinese woman.

The Economist knows this. The purpose of the article is not to predict the end of humanity but rather to drive home an important point—population shrinkage, which is already occurring in Japan, Russia, and parts of Europe, is a reality with which future generations will have to contend. In a modern economy, this means fewer consumers to sell your products to and fewer taxpayers to support the retirement needs of a large, elderly population.

The implications are not pretty. Even in the best case scenario, these countries are looking at the kind of sluggish economic growth that Japan has experienced for the better part of the past twenty years. And I’m not talking about the year 3000. I’m talking about now.

From here, the scenarios only get uglier. Who will care for the legions of sick and elderly? Will the cherished Western values of respect for human life be tossed out the window due to cold, hard economic reality? Will lower-income elderly patients be quietly euthanized for want of funds to care for them? On a bigger picture level, what are the geopolitical implications for these countries? How can you you expect to project power and influence when you lack the manpower to enforce it?

No one reading this article is likely to be around to find out, but the thoughts are disturbing nonetheless.

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The Ghosts of Milton Friedman and John Maynard Keynes

I originally penned this article for the August 2007 issue of the HS Dent Forecast–nearly three years ago.  My comments on deflation and consumer spending turned out to be right on the mark.

The late Milton Friedman may be the most accomplished economist of his generation. Just as his predecessor John Maynard Keynes influenced every aspect of economic thinking and policy in the 1930s, 40s, and 50s, virtually every significant development in recent decades towards free and open markets bears Friedman’s mark. Friedman’s Chicago School provided much of the intellectual fuel for the Reagan and Thatcher Revolutions in America and Britain. Even Augusto Pinochet, the Chilean military dictator, staffed his government with “Chicago Boys” who eventually gave Chile one of the most competitive economies in the developing world. Milton Friedman was a revolutionary who truly changed the world, though this piece is not about his intellectual exploits. Rather, it explains the economist’s theories on consumer behavior and relates them to our own research. We will attempt to add demographic insights into the venerable Milton Friedman’s work and discuss the implications for the next economic season.

But First, a Word on Keynes…

Any discussion of consumption must first start with a review of John Maynard Keynes and his work. Pre-Keynes, most economic theory was focused on production, or the supply side of the equation. Consumption, driven by end-user demand, was merely an afterthought, something that just “happened” and didn’t need to be explained. This was best summarized by Say’s Law, a maxim memorized by every freshman economics student: “Supply creates its own demand.” By virtue of manufacturing something, you have created a demand for that something, since it can be traded for other goods. This could be called a “build it and they will come” strategy, to borrow a line from the movie Field of Dreams.

But what happens when supply doesn’t create its own demand. What happens – as in the Great Depression and in 1990s Japan – there is not sufficient demand to absorb a plentiful supply?

During the Great Depression in the US and UK, consumers stopped consuming, virtually snapping their wallets shut for more than a decade. This lead Keynes to his study of consumer behavior, which is best summarized by his Consumption Function (also required memorization by freshmen econ students), seen below in Figure 1.

Figure 1: Consumption Function

In a nutshell, Keynes’s formula says that people spend a constant percentage of their current incomes, once basic necessities are taken care of. So, Joe Sixpack cashes his paycheck every two weeks and spends, say, 75% of that paycheck each and every pay period of his life. When he gets a raise and his check rises, he spends 75% of the now higher amount. When times are hard and he takes a pay cut, he instantly cuts his spending down to 75% of the new, smaller, amount. Joe’s spending is completely flexible and based solely on his current income.

Of course, any non-economist would know this to be patently false, both for individuals and for entire societies. To start, most consumption in the modern economy is not really “discretionary.” Most significant expenditures – everything from the home mortgage to piano lessons for your daughter – are paid on some kind of monthly payment plan. Even though piano lessons can be stopped at any time, they generally aren’t. Likewise, your cable TV plan does not get upgraded to the deluxe, high-definition package one month and then get cut to basic cable or – gasp! – rabbit ears the next. Your cable bill is stable and changes only slightly over time.

Most expenses are very slow to change when income changes. One of the major benefits of the modern credit-driven economy is that it can provide for lifestyle stability. If money is a little tight this month, your family’s lifestyle does not have to radically change, at least not immediately. This is the primary reason that consumer spending is so resilient despite economic calamity and why economists have been consistently wrong in their forecasting of recessions. We’ll return to this theme shortly.

Keynes also fails to note that spending and saving habits are affected by level of wealth and – most importantly to our research – age and stage of life. We’ll give credit to Keynes for being the first person to approach consumption scientifically, but it is obvious that his model was incomplete and not reflective of the real world.

Many of these deficiencies were addressed by the economists Modigliani, Brumberg, and Ando in the 1950s and 60s in what became known as the Life Cycle Hypothesis (Figure 2). These economists graphically displayed what every household intuitively knows. People follow a life cycle of earning and spending. In early career, our incomes are low relative to our expenses, often forcing us to take out large debts for homes, cars, appliances, etc. In middle age, we earn enough money to meet all of our current expenses, plus save for retirement. And naturally, in retirement our income falls and we slowly spend down our savings.

Figure 2: Life Cycle

This model, though more advanced than Keynes’s, is still problematic. Notice that income makes a curve while consumption makes a straight line. This chart is suggesting that our consumer spending increases in a mild, linear fashion from birth until death. Of course, the foundation of HS Dent demographic research is that this is absolutely false. Spending follows a curve much like that of income, though on a different timeline. Consider Figure 3, what we will call the “HS Dent Modified Life Cycle.”

In this case, the income line has the same basic shape as in Figure 2, though the consumption line has been transformed into a curve.

Figure 3: HS Dent Modified Life Cycle Hypothesis

This familiar chart is the basis for the Spending Wave. We know, based on data from the US Bureau of Labor Statistics, that consumer spending is largely a function of age. We spend increasingly more raising our families until our late 40s, after which time we pare down our spending and save for retirement.

The Permanent Income Hypothesis

In 1957, Milton Friedman made his own modifications to the Consumption Function and to the Life Cycle Hypothesis, dubbed the Permanent Income Hypothesis. Friedman’s idea was this: people base their consumer spending on what they consider their “permanent” income, or their average income over time. They do this in an attempt to maintain a relatively constant standard of living, even though their incomes may vary wildly over time. This goes a long way to explaining why Americans love consumer debt as much as they do. It’s ok to spend more that you make today, because your salary will be high enough after that next promotion to pay it all back. [Note: this was true of American attitudes in 2007; it’s far from true today, as deleveraging is the rule of the day.]

Keynes’s model, remember, assumed that people spent a constant proportion of their current incomes, i.e. each paycheck. Friedman assumes that people are forward-looking and base consumption decisions today on income expectations for tomorrow. Changes in current income, if perceived to be temporary, have little effect on spending. Friedman correctly realized that a family’s standard of living is “sticky.” When dad’s bonus check is a little disappointing one year, the family does not instantly eschew Neiman Marcus in favor of Wal-Mart. Whether for pride, concern for their children, or simple inertia, Americans are slow to ratchet down their lifestyles. Consider the case of the past six years [2001-2007]. America has suffered one of its worst bear markets in history in the wake of the dot-com bust. We had the most horrific terrorist attack arguably in world history on September 11, 2001. We’ve had two wars and a commodity boom that has seen the price of oil more than triple. Yet in spite of it all, Americans never stopped spending money [during the 2001-2007 period].  Keynes might have despaired that this behavior was irrational, but under Friedman’s model there is nothing irrational about it at all. American consumers are simply optimists who, seeing better times in the future, decide to enjoy the benefits of consumption today.

The Other Side of the Coin

Interestingly, none of these theories go into much detail on consumption as a function of age and what this implies in an aging society. Keynes’s model does not incorporate time at all, and Life Cycle theorists and Milton Friedman both assume that consumption rises in a linear fashion from birth to death. Keynes’s model may be the least dangerous in this sense, as nothing is as destructive to a forecasting model as linear thinking and extrapolation. The tendency to project current conditions into infinity leads to booms and busts. Remember the dot-com boom? It seems ridiculous now, but professional investors implicitly assumed that growth rates that were far in excess of historical norms would continue indefinitely into the future: “Our website is attracting 100,000 new eyeballs per day….”

Milton Friedman was an optimist and a true believer in the market system, and these are some of his most memorable and endearing qualities. They are what allowed the man to spread his views so effectively and radically change the world for the better. It is only natural, in Friedman’s optimistic mind, for consumer spending to march upward more or less continuously with only mild setbacks here and there. But we know that this is not true. People do indeed increase their spending for most of their lives, but once they hit their 50s they spend less on virtually everything.

Friedman is partially right, of course. A person’s income and expectation of future income clearly affects the level of consumption today. A janitor is not likely to buy a Porche, because at no time in his life will his income justify such a purchase. But how many Porches (or boats, or expensive clothes, or Rolex watches) do you see 70-year-old men buying?

These are luxury goods, of course. What about more mundane items? How many washing machines, sofas, or coffee machines does a 70-year-old man buy? Common sense would tell you that the answer is “not very many.” Is the reason, as Friedman’s hypothesis would suggest, because an elderly man realizes that his future income with which to pay for these items is modest? Or might it be for the more obvious reason that the man has already accumulated more than enough of these things in his 70 years?


Demographic trends suggest a decade-long lull in consumer spending starting around 2009 or 2010 as the Baby Boomers begin to spend less and save more for retirement. This will be a repeat, almost twenty years later, of the same scenario that Japan faced during the 1990s. When US consumer spending begins to falter, there will no doubt be plenty of economists attempting to explain the phenomenon by using some variation of Friedman’s permanent income hypothesis: “Americans are spending less money today because they see dark economic times ahead with declining incomes and standards of living….”

Then, any and every policy under the sun will be recommended on how to “fix” the problem. No doubt, Keynes’s Depression-era work will also be resurrected, and phrases like “liquidity trap” will become popular again in economic circles. [Note: Real world events followed this part of the forecast like a movie script.]

None of these ideas are likely to make much difference in spurring demand. They certainly didn’t in Japan, and there was no lack of trying. Japan eventually recovered to an extent, as the US will too. But the recovery in demand was a result of changes in demographic trends, not a policy miracle.