RfD Steve Keen: “You need to learn the difference between simplifying assumptions and fantasy.”

Steve Keen was interviewed on Wednesday in the Room for Discussion stage at the University of Amsterdam. Keen is a well-known heterodox economist critical of neo-classical economics, arguing that it is not empirically supported and its foundations are flawed. Keen asserts that private debt is one of the greatest indicators of financial instability. This claim was supported by his accurate prediction of the 2008 financial crisis, which brought him swiftly into the spotlight, before swiftly throwing him out again. Why is someone whose models are so supported by empirical evidence so often disregarded? 

Keen’s relationship to neo-classical economics can be described as rocky in an ideal situation. His view is that “we have to get rid of neo-classical economics,” saying that it is easy to understand and creates a persuasive fantasy of an ideal world with clear equilibrium and metrics. His book The New Economics, in his eyes, serves as a manifesto, as it argues on what economics should be, not what it is. This position has made Keen quite unpopular with many renowned Economists, as he is often telling people that their views and opinions are wrong. He drew an analogy by comparing his situation to digging around Jerusalem in search of Christ’s tomb, only to find that you have become the second body since the Vatican guards have killed you. Essentially says that if you try to call out the fallacy that is neo-classical economics, those who have power in the field will immediately discredit you. This has created what Keens calls a “Juggernaut” that cannot be stopped. Since so much of economics has been built around these ideas, it is almost impossible to change course, and the field is stuck in an ever-repeating loop. He claims that this is in large part due to the ease and idealism of classic concepts, that traditional equilibria feel so good, everything shifts to this new and satisfying equilibrium, but Keen claims this is nonsense and we need to treat it as such.

Delving deeper into the working of his argument, RfD asked specifically about the roles of supply and demand models for an economy. He claims that the assumptions are too extreme. During a post-lecture discussion, a younger economist said that we need assumptions and that without them, economics is too difficult. With them, we have representative models of the economy that help simplify our understanding. Keen’s response was, “Mate, you need to learn the difference between simplifying assumptions and fantasy.” So what does this mean? What makes so many of these assumptions overly simple? One of Keen’s primary focuses throughout his economic models is private debt and the lack of its measurement in neo-classical models. However, this is not his only criticism. “Can anyone tell me the equilibrium price of a car?” No one raised their hand. Why? Modern markets simply do not have price competition in the way neo-classical economics talks about it. Keen’s buys blueberries from the market instead of Dirk because the quality is better. No good is homogenous, firms do not maximize profit by setting marginal cost to marginal revenue, they maximize profit through market share. Firms set a price above their marginal costs and try to outcompete others and make money through the volume of sales. This concept is not part of neo-classical economics. In his own words,

“Neo-classical fantasy diverts us from the real world.”

So, why does Keen still teach neo-classical economics in his lectures? In his own words, if there is a rival paradigm, it will be shut down by others in the field. It is extremely difficult to change expert opinions because many of them have spent their entire lives focused on these ideas. He was forced out of his department in Sydney due to some extreme criticisms towards his way of thought. He says that because of this, academics who challenge the status quo are pushed out of major universities, and their voices are shut down. 

So how does Keen falsify neo-classical models? He provided some simple statistics in his interview, a correlation between unemployment and the growth of private debt being close to -0.93. Cyclically adjusted price-to-earnings ratios were also strongly correlated with changes in marginal debt, with a correlation coefficient of 0.7. Although this isn’t the extent of his work, it at least alludes to a rather significant relationship between private debt and economic indicators. Clearly, this an area that requires more attention. His main argument has become the value of private debt within economic models, and his stats provide some evidence that it should be investigated, and his predictions prove that it works. Michael Kumhof is the only neoclassical that has ever included private debt, and his dynamic stochastic models have proven to be extremely accurate. Currently, banks do not use private debt but instead use financial frictions to explain difficulties in equilibrium restoration. Making these models fit is extremely difficult, and banks are at the forefront of experiencing this. Keens believes these “financial frictions” are nonsense and that economists need to rethink the models they use. One of his major inspirations was Minsky, who wrote debunking economics, which uses private debt as a part of economic well-being. He found that a change in credit that would cause a financial crisis has to have a range of at least +15% to -5% in order for a financial crisis to occur, which helps explain why stock markets overpredict recessions. Keen believes it is possible that Trump could cause such a crash, with increased consumer costs forcing many to take on extra debt.

Flipping to the present, Keen’s main focus is now the climate. He claims that the climate is not an externality of the market, but in fact the foundation of markets. Keen's called William Nordhaus's publications "the worst garbage he has ever read.” Now, Noordhaus is a well-known climate change economist, and not the only one Keens criticizes on climate economics. So, what is the problem with current economic approaches to climate change? One major factor Keen mentioned was the separation of the economy into 3 sectors. Severe, Moderately, and Negligibly exposed to climate change. Over 85% of the economy was put into the negligible sector, including underground mining, oil drilling, and many, many non-environmentally friendly sectors. But the outrage does not end here. According to Keen, neoclassical economists claimed that a 7-degree increase in temperatures would cause a 25% loss in global GDP, while climate economists say 5 is near armageddon. Where is the discrepancy? According to Keen, economists do not account for changes in weather and major environmental changes. For example, the loss of the Amazon Rainforest, Antarctic Shelf, Siberian Permafrost, and Greenland’s glaciers would only cause a 1.6% loss in GDP. In Keen’s words, “this is delusional.” To simply brush off environmental changes as tiny impacts on GDP is irresponsible, and the consequences could be extreme. 

Then how do you model an economy for climate change? Keen says we simply cannot. The climate is the very foundation of the world economy. Without a climate, we do not have an economy. Rather than trying to minimize externalities to the climate, we need to go full-on panic mode to save the climate. Currently, 4/5ths of energy comes from fossil fuels. Keen believes the world needs an extreme shift and to go into a wartime economy, rationing supplies and limiting energy consumption until we see a reversion of the climate crisis. Without such action, he sees little hope for our future. 

So how do Keen’s models translate into policy? He currently has a proof of concept that is being used by finance firms and outperforming markets using his software Ravel. This model was made by an interested economist and used over 25 system states.

Steve Keen is certainly a loud figure in economics, so what should one take away from his message? One, that neoclassical models are flawed, and we need to explore other options for our economy. Two, the climate is not an afterthought; it is the foundation of all economics. Three, when you have an opinion different than the status quo, you need to be loud for people to hear it, “Being polite didn’t work, so fuck it, I’ll be rude.”