Reviewing Steve Keen

Australian economist Steve Keen has released a second edition of his book Debunking Economics.  It should be compulsory reading in any economics course, and certainly contains many lessons for policy makers.

I will state up front that I have been a follower of Keen’s work for some time, having read some of his academic publications , his top quality blog, and the first edition of Debunking Economics some years back

As the title suggests, this book is a step by step debunking of the mythological assumptions at the heart of neoclassical economic theory; the theory that is almost exclusively taught in undergraduate economics courses and subsequently drives much of the mainstream economic thinking in markets and public policy. Keen rails against the indoctrination of economics students through the teaching of completely debunked theories that even their originators have disowned (for example, Robert Solow has criticised the widespread misapplication of his growth model in the economics profession).

I would go so far as to say that the primary purpose of the book appears to be to shine a light on the ridiculously poor condition of economics as a discipline, and the perpetuation of falsified theories through poor, or narrow, teaching at universities.   Keen was certainly impressed when Havard’s first year economic students walked out on Greg Mankiw’s economics class last month, citing the narrow agenda presented in economics teaching as less than satisfactory.   But this was also one of my main concerns with the book.  I felt I was part of an alternative economic indoctrination from the repetitive emphasis on the poor state of the discipline.  My message to Steve – if someone is reading your book, they are highly intelligent and already critical of the discipline of economics.  They will get your point the first time.

Overall the book contains high quality accessible analysis.  Here is a short selection of some ideas from Keen’s book that really stuck with me.

Demand curves are any shape at all and supply curves don’t exist!

One of Keen’s core ideas from the first edition of the book, which has since been the subject of intense debate, is that demand curves can be any shape at all, and the Law of Demand, which suggest that demand curves are always downward sloping, is just a single special case all possible demand curves.  Given that the literature finds upward sloping demand curves for individual goods (either Giffen goods or Veblen goods) such as rice in China, or luxury branded items, as well as asset markets (through bandwagon effects and others) this seems quite plausible.

Indeed, the heart of Keen’s criticism of demand curve analysis is the fundamental aggregation flaw requiring that for a downward sloping market demand curve to exist, the whole market needs to me considered as a single individual at the mean income level with perfectly fixed preferences (which is a huge simplification of the few dozen pages of Keen’s analysis).  This is nonsense of course, since markets require different individuals with different tastes and preferences to actually function.  Keen cites numerous originators of microeconomic theory who have demonstrated that demand curves can have any shape at all (so long as they can be fitted by a polynomial equation).

The figure below, from the online supplement to Debunking Economics, demonstrates that uselessness of traditional microeconomic theories of demand once aggregation fallacies are rectified.

Regarding supply curves, Keen shows that marginal cost pricing almost never occurs in reality.  He builds on Piero Sraffra’s 1926 critique of theories of the firm, contending that production and price setting decisions are not the result of internal firm cost patterns, but solely from external market demand limitations (the share of the market able to be captured).  Although I would suggest again that the neoclassical ideal is a special case of the more general model Keen presents, and is particularly relevant in markets for natural resources, which do often face rising marginal costs.

Keen also demonstrates the aggregation fallacy that leads most economists to believe that monopolies will restrict output to increase prices relative to a competitive market.  In fact monopolists are likely to produce just as much as competitive firms, at the same market price. Neoclassical assumptions of perfect competition do not maximise profits, and therefore overestimate market output (as shown in the graph below).  The real problem with monopolists is their market bargaining power in specialist labour markets, which is why unions have a role to play.

Going further, Keen asserts that macroeconomics cannot have micro economic foundations due to its emergent properties, and should be studied at a separate level of understanding in the same way that chemists and biologists usually ignore subatomic physics to understand the properties of chemical systems.  Macroeconomics with micro foundations is the same as biology with foundations in subatomic physics – no meaningful information will come from the pursuit.

Equilibrium ideology

If there is one key theme that will become etched in your mind after reading Debunking Economics II, it is the idea that equilibrium is not a possible economic condition in reality.  Therefore, equilibrium economic models are useless in modelling real life economic systems.

While I agree with Keen, I believe he takes this idea a little too far for my liking.  There is value from static comparative analysis for the policy maker interested in the impact of new policies.  Treating the economy as a dynamic system provides no way of knowing which changes are policy related, and which are simply products of the system dynamics themselves.

As an exercise in understanding the macro economy, dynamic modelling is highly valuable, and I hope that Keen’s work in this area continues to provide new insights, particularly with respect to developing policy in enhance system stability.

Overlooking the role of money

The economics profession in general has a very basic assumption about money.  They ignore it.  Keen is one of a small group of economists actually examining how the monetary system links with the physical production systems in the economy.  Keen explains why the rate of change of new debt (the credit accelerator) is an important macroeconomic indicator, due to the way debt brings forward future demand, creating a current total demand greater than the current productive capacity of the economy.  The reverse is true when deleveraging begins, with subsequent impact on employment (as shown below).

Keen’s monetary model also demonstrates that bailing out borrows rather than lenders during credit crunch will be much more effective tool for containing unemployment than bailing out lenders.

One area of Keen’s work I found most intriguing was his analysis of the writings of Karl Marx.  Keen takes a pragmatic approach to the classicists, highlighting their constructive contributions to economics, which have stood the test of time and are supported with empirical evidence, and even debunking the often erroneous ideals symptomatic of the era that they are often remembered by.  Some ideas really do stand the test of time, as insightful MB reader Lori pointed out recently Marx also wrote that science and knowledge are the most important productive forces in the economy; a principle complexity theorists are now pursuing empirically.

The book left me thinking, if current neoclassical economic theories are so obviously flawed, what will spring up in its place? If I recall, it was Thomas Kuhn, musing over the battle of scientific paradigms, who suggested that evidence does not destroy theories -new theories destroy old theories.  With current global economic events as a backdrop, I can’t help feel that a scientific revolution is coming to economics.  And if Steve Keen has his way, it will happen sooner rather than later in the form of dynamic systems analysis.

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  1. Perhaps Keen has written this book for those of us with a lesser grasp than you of the subject matter, and hence the ‘repetative’ nature of his writing. A good review that will make me lash out a few dollars for a heavy read. Thx.

    • He could have had more repetition in the detailed arguments he constructs as a way to better explain them to an audience without a technical background. Rather I found the repetition of the message regarding the sorry state of the discipline unnecessary. This is particularly the case when I know there is a growing portion of the profession, particularly in academia, who feel much the same way as Keen, but are pursuing their own alternative methods of analysis.

  2. “Why Most Things Fail” by Paul Ormerod includes an easy-to-read debunking of several nice “just so” economic theories like the ones with predictable demand and supply curves and equilibrium points.

    Cameron, have you read “Human Action” by Ludwig Von Mises? If there is a “prophet without honour” in economics, it is him.

    “….I can’t help feel that a scientific revolution is coming to economics. And if Steve Keen has his way, it will happen sooner rather than later in the form of dynamic systems analysis.”

    I still doubt that much of a “science” can be made out of such complexity-ridden things as societies and their economies. The biggest blindness that afflicts the economics profession, and that is most obvious to the small minority who DO see it, is the effect of “culture” on economic outcomes.

    I respect Steve Keen regardless. I think he would enjoy Alan W. Evans’ books that deal with a specific and serious mis-teaching of economics; that of “supply” of land. Keen himself seems to have missed this so far.

    • Read complexity, published I think in 1988 from the new force of study in this field. You can measure anything.

  3. “Keen asserts that macroeconomics cannot have micro economic foundations due to its emergent properties, and should be studied at a separate level of understanding in the same way that chemists and biologists usually ignore subatomic physics to understand the properties of chemical systems. Macroeconomics with micro foundations is the same as biology with foundations in subatomic physics – no meaningful information will come from the pursuit.”

    Disagree with this statement and its a bad analogy. Micro economics do not create systems that are independent and have little effect at the macro level. In fact the key to understanding the effect of macro policy is to understand the micro effects.

    Otherwise a great review

    • My understanding of Keens views on this is to flip this around:

      i.e. you may be able to infer micro effects from macro policy but you cannot infer macro effects by formulating a macro theory based on micro theories.

      So for starters the micro theories are wrong but even if they were not macro theories cannot be derived from them without imposing assumptions and simplifications which render the resulting macro theory a total dud.

      To that extent the analogy is good. If you were a reductionist scientist and could monitor every atomic particle then you could in principle predict chemistry/biology. But this is not practically possible. Similarly you cannot monitor the economic progress of every entity in an economy therefore generalizations are required. But making generalizations, which are substantial in the case of economics, and then aggregating gives poor macro results.

      S Keen seems to read this blog on occasion so maybe he might be tempted to post a comment and clarify this.

      • Think of the world as computer game.
        Let’s say a 1st person shooter.
        Ok, so you’re running around on what looks like dirt, sounds like dirt, but is actually just a single polygon representing dirt with a texture and sound mapped to it.

        Now you fire a rocket. It could be implemented with complicated formulas to represent the electromechanical explosive trigger, and the complex mix of chemicals inside the rocket, thus simulating the real explosion.

        Or you could tell it to play an explosion effect and a sound when it hits something.

        Models don’t need to be super complicated to offer a convincing overview. Sure the physics aren’t going to be come close to real life, but to the player, the physics are as predictable as real life.

    • There is something in that, that may explain the connection that a very few academics are focused on, between “culture” and economic outcomes.

      The McKinsey Institute has also done some very interesting research in which they suggest that “IF ONLY” equivalent businesses were run with the same common sense efficiency in the 3rd world as in the 1st, that alone would make a huge difference to macro-economic outcomes in the 3rd world. Check out William LEWIS, “The Power of Productivity”.

  4. In addition to “equilibrium ideology” is that there are so many different, and conflicting, definitions of equilibrium.

    The economics profession in general has a very basic assumption about money. They ignore it.

    One can only wonder why Steve Keens ideas about private debt would be considered fringe.

    My favourite anecdote from the book is the Fed bloke who surveyed businesses and found that their feedback contradicted economic theory and concluded that the businesses surveyed misunderstood the questions (rather than concluding that firms don’t operate like textbook theories tell them they do!)

  5. I’m currently going through the book – slowly and carefully – to try to grasp some of the more complex and obscure points of contention.

    I do agree with Cameron that the idea that using a fully dynamic approach to modeling the economy is too much. Even engineering approaches problems in a static manner first before moving on to the dynamics component.

    I think though that Steve Keen’s point is that economics doesn’t use ANY dynamic modeling and only pretends to with DSGE.

    • I do agree with Cameron that the idea that using a fully dynamic approach to modeling the economy is too much. Even engineering approaches problems in a static manner first before moving on to the dynamics component.

      How long must we persist with static modelling before moving on to dynamic modelling — which engineers apparently do?

      If you observe that an economy changes over time then it follows that it must be described by dynamically, i.e. time as one of the variables.

      You cite engineers but an engineer or scientist sitting in an economic class would observe e.g. that an economy that has a long run outcome and a short run outcome must be described by equations that include time; the long run outcome is what the equations reduce to as t->infinity and the short run being the t->0 limiting case. But economics doesn’t seem to have this at all, instead we are presented with these long run and short run outcomes as binary states with no mechanism to explain the transition between them.

      Ditto supply and demand curves mentioned in this article. It should be plain as the nose on your face that these things — if they exist at all — must be dynamic and therefore must be 3 dimensional not 2 dimensional. What can you learn from a static supply/demand curve? Is the supply demand curve for horse buggy’s the same today as it was 120 years ago? Is the supply demand curve for iPods the same today as it was before they were created? It is surely the dynamics where the interest lies, i.e. the third axis representing time.

      That doesn’t mean that Keen’s approach is right or even the best, but at least he is having a crack. The world is a flowing river yet 99.9% of economists want to model it as a glacier.

      • RMA – I do agree with you. As you say, time MUST be taken into account in any model in the real world. However, Cameron’s point is that by using fully dynamic modelling, this leads to not being able to take stock and look at what is happening in the now. Dynamic models should be used to predict what may happen. Static examinations of dynamic models (which Cameron refers to) have their place in all sciences.

        All engineering equations can be simplified to remove the time component to observe the here and now effects of your system, which you will inevitably be interested in at some point.

        As an engineer myself, I absolutely agree that looking at the economy solely through the eyes of a static model is at best delusional and at worst downright dangerous. This is part of why I have always maintained, even in the mid-2000’s that we would face a big economic crisis. I wish I was wrong, but here we are.

  6. The challenging part in the future will be accurately understanding speaking about econimic schools of thought.
    Did the professor just say Keynesian or Keensian?

    Naturally, Steve would probably have it called Keynes-Minsky-Keen (Keyminkee?)because he’s a humble man at heart.

  7. Diogenes the CynicMEMBER

    +1 his first book was great and is DtC’s library, made me wonder if I learned anything useful from studying economics at university. What are the changes to the second edition?

  8. Keen’s book sounds interesting.

    I think part of the reason economists cling to neo-classical theory and its un-real assumptions is because the only real alternative is to return to Ricardo. Building upon Ricardo’s work then leads back to surplus theories.

    Also, I don’t think it is true that mainstream economics ignores money. It definitely ignores debt. This is a big problem.

  9. I dislike Steve Keen’s adoption of overly complex mathematical modelling and differential equations to represent human behaviour.

    I’d much sooner accept the Austrian school’s praxeological approach to how human behaviour constitutes markets.

    Trying to torture the data into complex models to make forecasts is what Goldman Sachs and the IPCC try to do.

    • As I commented at 7.13 am,

      “….Cameron, have you read “Human Action” by Ludwig Von Mises? If there is a “prophet without honour” in economics, it is him…..”

      • Not since this morning 😉 but I have read quite deal from von Mises.

        @Jono, the Austrians have very good ways to describe the process of competition and innovation, but they forget to link this to the real world of common property, politics, irrational behaviour, incompetent rule setters etc.

        They also ignore much of anthropological study of how societies develop commerce, which is goes against many of their fundamental reasoning.

  10. Certainly looks like a decent read and I will probably check it out. Seems like he has some pretty good insights.

    However, his ideas about monopoly seem extremely flawed. They MIGHT be applicable to industries that produce products that are easily subsituted and have relatively low demand, but even then you would be hard to find an example of an efficient monopoly with excellent customer service with a low priced product.

    A perfect example are Casino’s. The difference between the level of service and house odds a customer gets at an Australian Casino is worlds apart compared to the super competitive markets of Maccau and Las Vegas.

    Poker, for example (the game I play), has a rake of 10% at Crown in melbourne, with a high cap and time taken on top of that. There are maybe 2 service staff bringing drinks to the table and they are bar prices. Contrast this to Vegas where rake is 5% with a low cap and free drinks for all players.

    Then you look at airlines, who doesn’t remember when competition started up and prices went through the floor? Would you say there are more or less flights now than before?

    Then there’s public transport, something that has a very obvious substitute and even these companies can’t get it right. But the unions certainly enjoy generous benefits despite low productivity.

    How someone can argue that monopolies provide products and the same price for the same level of service and the same level of productivity is truly beyond comprehension. Common sense alone dictates this idea is just silly.

    Other than that, seems like a decent read.

    • The main point is that if neoclassical assumptions are correct, private monopolies will produce the same quantity at the same price, or possibly cheaper, than many competitive firms. Or in reverse, competitive markets won’t produce a greater quantity of goods that a monopolist.

      This position is now quite widely accepted. I’ve attended the last two Australian regulatory economics conferences where there was a bit of soul searching going on about revisiting why we are regulating monopolies if not to ensure adequate quantity of production.

      He doesn’t dismiss problems with monopolies altogether – such as the lack of incentive to innovate, their bargaining power in the labour market, etc – just that the fundamental neoclassical justification for monopoly hating is wrong. This not does mean that there are other more solid principles upon which to base regulation of monopolies. I will probably write more about monopoly regulation in the future, drawing on these more broad principles.

  11. > Therefore, equilibrium economic models
    > are useless in modelling real life
    > economic systems.

    But they are easily theoretically tractable and anyone who works or worked at an academic institution knows that it is publish or perish. There are many similar examples in other disciplines e.g. stationary stochastic processes which although dynamic by nature expose rather simple dynamics. What Keen does is very insightful from the qualitative point of view i.e. understanding general direction and outcomes of certain processes. The quantitative predictive value of his models is very likely quite limited. He may deduce the nature of endgame but not its timing. With modern computers and numerical methods of solving complex systems of differential equations Steve does not have to worry about finding analytical solutions which from his point of view are irrelevant. Getting the equations right and capturing system dependencies is far more important than the mathematics behind them. What he does is a kind of experimental economics in which you can try different logical assumptions and see if the outcome matches real life.

  12. Received my copy last nite and started reading, I am a finance noob.

    But I like the theory compenents as there are sociological and business links.

    Also real world experience.

    I have been reading SK since 2006 as well.

    At times he can be a bit much with “I am right” but I prefer this to the eternal spruiking by ‘others’ whom have no epistemological basis to stand on whatsoever!

    Well as yet I have not seen an evidenced based approach that comes close to challenging Steve Keen.