Monday, September 30, 2013

Paul Krugman and Steve Keen had an argument

I have been going over a heated debate from early last year between economists Paul Krugman and Steve Keen and I would like to set down a few thoughts about it. Let me right off state for the record that I am one of those who believe that Mr. Krugman came off much the worst of it. That does not mean that I am entirely satisfied with either the diagnosis or prescription offered by Mr. Keen.

The issue was basically over the efficacy of central bank monetary policy in curing or preventing recessions. Mr. Krugman has high confidence that central bank monetary policies, if conducted properly, have almost unlimited power to control levels of aggregate demand and thereby prevent or terminate major deviations from full employment and stable consumer prices in the aggregate. Mr. Keen however, argues that in the modern banking system private commercial banks, not the government's central bank, are in effective control of the "endogenous money" supply, and it is their willingness to lend that is the major determinant, at least on the margin, of aggregate demand.

Mr. Keen is a follower of Hyman Minsky who authored a famous theory of financial instability, which I regard as basically a theory of financial psychology not unrelated to Keynesian "animal spirits". While Mr. Krugman invites us to seek comfort and shelter in government regulation of money and banking, Mr. Keen's alternative view would seem to leave the economy exposed to inevitable Minskian financial tempests. Actually, Mr. Keen does have an interesting proposal of "Jubilee shares" which may well have merit for preventing excess speculation and volatility in the equity markets but I do not believe it adequately solves the general financial instability problem. It could even make it more acute.

I do not see, as Minsky or Keynes did, psychology as a driving force of financial excess. It would be fair to say that on this point I share Mr. Krugman's skepticism of the "confidence fairy". Rather I think financial instability results from too much "liquidity" -- a.k.a. "credit", a.k.a. "debt". Because all debt anticipates payment in the future all debt borrows from the future. Debt effectively "consumes" future resources by committing them to present needs. The obvious danger lies in "eating the seed corn" -- short-sighted consumption of resources that leaves us poorer over time. If more credit is used than is consistent with sustainable consumption over the long term then the excess liquidity, for lack of productive alternative, must flow into waste and speculation -- the former being the untimely depletion of valuable resources, shrinking the economic pie, and the latter being a form of gambling which on balance punishes saving and production to reward rent-seeking, reallocating the economic pie. Psychology has little to do with it.

With endogenous money theory, demand for credit brings forth its creation and that does indeed suggest that investor or business or consumer psychology, being a source of normal credit, is also responsible for excessive credit. But money is also created exogenously by central banks. Central banks purposefully create enough credit to target a positive, "modest", level of consumer price inflation as a hedge against a dreaded deflationary spiral. I believe this monetary stimulus is enough to create and sustain asset bubbles which only grow in time until they must eventually burst, causing waste and speculation along the way.

Getting back to Mr. Keen's "Jubilee shares", they might well accomplish the goal of protecting equity markets from speculative liquidity inflows but the excess liquidity would simply have to go somewhere else -- likely to some place where it would be harder to notice and cause even greater economic harm. It is also over complicated. The complications are arbitrary in nature and designed to forestall some obvious problems and are, to me, a sure sign that the basic idea is fundamentally flawed.

Simpler and more promising, I believe, is a general financial transaction tax -- a generalization of a tax on currency trading recommended in 1972 by economics Nobel Laureate James Tobin specifically as a means to reduce volatility and speculation in that market. However, while such a tax would make a more complete dam and levy system to wall off more of the financial sector from inflows of excess liquidity it still fails to prevent the excess liquidity in the first place. Maybe it would be enough to save the real economy from Too Big to Extinguish Debt, (the real problem behind Too Big to Fail Banks), but I am not sure.

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