Quick Disclaimer

The following is a transcript of recorded content. Please note, these transcripts are not always perfect and may contain typos. If you notice any major mistakes, please feel free to report them by opening a Technical Support ticket under the Help menu at the top of the screen.

Full Transcript

Chris Martenson: Welcome to this Peak Prosperity podcast. I am your host Chris Martenson. Well, as of today, world's central banks are out of fresh ideas—as if they had any to begin with. I mean look, after seven years of printing and mispricing money and fostering a massive surge in the levels of debt, all they’ve got to show for their efforts are low to non-existent to in some cases negative rates of economic growth and an enormous largest ever, wealth gap. And, some nice, high equity prices. Hardly the sort of inspirational outcome they were really hoping for. So they keep doing more of the same in the hope it will all turn around soon enough. But what if their basic models are wrong? What if the core tenants of the economists running the monetary show are simply wrong?

Well if they have all this wrong, then a very large financial catastrophe is not only a possible outcome, but I consider it a likely outcome, which means there’s literally nothing quite as important to your financial future—or heck, your future in general—is understanding if the central banks have a snowball’s chance in August of achieving their aims of delivering a smooth and prosperous future.

Today’s guest is the perfect individual to help us sort out what’s going on and what the true risks really are in the story. Steve Keen is an Australian, an economist and author. He considers himself a Post Keynesian, criticizing neo-classical economists as inconsistent, unscientific and empirically unsupported. He’s the author of the book Debunking Economics, an excellent book by the way, and the popular blog DebtDeflation.com. Welcome Steve.

Steve Keen: Thank you Chris.

Chris Martenson: Well it’s really good to have you here, so let’s dive right in. What have the mainstream economists got wrong?

Steve Keen: Well the thing which is very hard for people who haven’t studied economics to actually get their head around is that mainstream economists developed reasons why they thought you could model capitalism without including the existence of banks, debt or money. I know that sounds like an outrageous statement, but in fact if you go and search on Paul Krugman’s blog you’ll see regular statements that you don’t need to consider the banks or money or indeed private debt, most of the time on the latter point. When you’re modeling the economy you can do perfectly well by ignoring them.

Now that is to my way of thinking, a bit like saying well you can be on the Serengeti Plains and you can perfectly ignore the approaching hill herd of Wildebeest. It’s just beyond belief that they can start from that point of view but that’s where they actually start from. And that’s the fundamental reason why they didn’t see this crisis coming, why they had no idea why it happened and why the attempts to cure it so far have been generally extremely unsuccessful except for the capacity to inflate asset prices and quite a bit of a wash over into the real economy. And why when they get back into trying to manage it again when they think they’re back to normal they actually got themselves back to abnormal but they don’t know what abnormal is.

Chris Martenson: So I need some help here because Steve this is — it’s inconceivable to me that you could just somehow think you can ignore debt in this story. I just — I don’t even understand that. So, take their position; how would they argue that you can safely ignore debt?

Steve Keen: Well they start — the simplest one they do is when they drive this into the heads of first year students at universities is what they call the money illusion. And they tell students “Well here’s a little model of how you behave” involving what they call indifference curves and budget lines. Work out the consumption level and then double all incomes and double all prices what happens? And the student says "nothing sir," and then they say, “That’s the point you see” it’s not the absolute level of prices and absolute level of money that matters; it’s relative prices and relative—they don't talk about relative incomes, it’s relative prices is all that matter. And therefore we can ignore money when we model how people behave at the micro level. That’s stage one in the level of delusion they’ve built up.

Second level is when they get to talking about the banking system at all, they develop a model they call loanable funds. And loanable funds like everything else in economics—economic theory—tries to reduce economics to a pair of intersecting supply and demand curves. And on the demand curve they talk about people’s demand for money being sacrificing liquidity for yield. If you have a high interest rate you’re willing to sacrifice liquidity and therefore not have money in liquid form, a lower interest rate, you want to have high demand for money. [Inaudible 00:04:47] the downward sloping demand curve that they like to have. The supply curve they effectively say supply is under the control of the central bank, but they add to that an argument that the extent to which people are willing to provide money depends upon the rate of return they get for it. So a high rate of interest they’re willing to supply more. In other words they treat money just like the market for apples, like the market for printers, like the market for cars, etc., etc; so it’s no different to any other market.

And when it comes to explaining why this is done at the macro level the implication of loanable funds is that loanable funds involves Chris Martenson lending to Steve Keen. It doesn’t involve the bank of Martenson — the Martenson Bank lending to Steve Keen the individual. And they didn’t say that well if Chris Martenson lends to Steve Keen, Chris has to allocate some money that he was going to spend to a flow of money to lend to Steve; therefore Chris' spending falls by the amount of the flow that he’s lending to Steve. Whereas Steve can go out and shop with the money that Chris is lending him with of course and interest rate bill coming along as well. With that flow of money Steve has to spend more; so Chris spends as a lender spends less. Steve as a lender spends more. The two pretty much cancel themselves out unless I’m much more of a spendthrift than you, which by the way I probably am, and therefore it’s a second order effect. You can ignore it at the first order level.

Now that completely ignores the fact that when you lend me money you don’t create any money. But if a bank lends me money it does create money.

Chris Martenson: Right.

Steve Keen: This creation process of money lending is ignored and derided and satirized and ridiculed by the mainstream, which has people like myself pulling my hair out in exasperation. And finally the world — the Bank of England joined me in exasperation and published a beautiful little paper beginning of last year called "Money Creation in the Modern Economy" and pointed out that when an individual lends to another individual there’s no net money creation and there is an offsetting decrease in demand by the lender, increase in demand by the borrower.

But when you look at it from the bank's point of view, when a bank makes a loan to an individual it records an additional asset for its own, the loan, which means its assets rise and its liabilities rise which is deposits — it puts money in the person's account. The person then spends that money and you therefore get a generation of demand out of the creation of debt. Now that is — that’s the analysis that I take. It’s the analysis that the Bank of England is onto. The Federal Reserve is still off in cloud cookoo land, believing the stuff that Krugman spouts in his column in The New York Times. And consequently they ignore the role of the creation of money by banks as a creation of demand, and equally importantly, when debt is paid down and people deleverage as they did during the financial crisis that deleveraging is a destruction of demand. So they’re ignoring the major factor that’s causing the ups and downs to global economy.

Chris Martenson: Is this what you meant when you wrote recently you said, “You shouldn’t just ignore what you cannot explain”? It feels to me like the central banks, at least the Federal Reserve, they’re ignoring this debt function.

Steve Keen: They’re completely ignoring it and it’s what — what it’s actually beautiful described by Kahneman in his book, Thinking, Fast and Slow, is theory induced blindness. Because it’s — as you said it’s hard for you to even imagine people trying to model the economy without including banks, debt and money in it. But they have this theory induced blindness that says banks, debt and money don’t matter. So they don’t even look at the data to begin with. But when you show the data to them, their theory gets in the way of them even perceiving it. They say, "well, I want to see—you've got correlation there, what’s the causation?" Or, "I want to see panel data rather than just one country," and I show them 20 countries and they give the same response, ignoring it. It is just a blindness to the whole issue.

Chris Martenson: Well you know it’s interesting, I read that same paper you did when the Bank of England came out and I was shocked for two reasons. One, that it took them that long to figure that out, and I think they also kind of concluded that bank reserves are not essential to the whole process of loaning, that in fact loans come first and the bank will make a loan if it’s got a good loan; it’ll find the reserves later if it needs to. And so they figured that part out too. But I’ve been reading for over a decade when I became aware of it, but I can find books that go back a very long ways that understand the money creation mechanism and its role on demand.

Steve Keen: Yeah I mean you go back to before the 1930s, you find it was common place to understand this. It’s really just a recent fetish coming out of the American mainstream economists, largely beginning with Tobin back in the 1950’s. Tobin himself actually effectively ended up disowning the concept that he helped to bring in that banks didn’t matter. In his later work he became a good friend of Stephanie Colton who is one of the leading thinkers in endogenous money these days. And now thankfully working in the United States, I think Congress office as an advisor. So her intelligence is turning up in the Congress.

But this belief that banks, debt and money don’t matter to macro economics really was a fetish of what I call the Samuel Sonian approach to economics which evolved in America, called itself Keynesian but had bugger all to do with Keynes. And the more extreme right wing version of that being what Milton Freedman developed and gave rise to what they now call new classical economics. They’re even more strident at ignoring the role of virtually everything apart from indifference curves and — which are fictitious and marginal cost curves which are equally fictitious. So it’s an American thing, and it’s not just — the intriguing thing is you look back on the 1930’s and so on, before the 1930’s, it wasn’t just progressive economists like it is today who make this case. It was quite conservative economists who also saw it. For example if you read the general theory, you’ll find Keynes counter posing his views to Pigou and seeing Pigou as being the expression of the conservatives. Pigou had a book called Industrial Fluctuations, written I think in 1927 where he correlated the change in level of private debt to the rate of unemployment and made the case that the change in debt generated demand and this is a major part of why there was a correlation between it and the level of unemployment.

So even somebody that Keynes regarded his conservative foil in the pre-second World War period understood the role of banks, debt and money in the economy. It’s been obliterated from the text books, but of course it hasn’t been obliterated from reality, which is why we had the financial crisis.

Chris Martenson: So let’s talk about one last piece of economic so-called reality; behavioral economics tells us that people are irrational, right? Predictably so. And we — you and I we already know that because we interact with people and we’re humans and so we understand that. But classical economics still assumes people are rational. Again, this is a bad assumption, correct?

Steve Keen: I think we’re actually doing them a favor calling what they described as their behavior as rational because it’s not what they described as rational, because it is not rational at all. It’s prophetic. Their definition of rational is that someone has a model which can help them accurately predict the future. And if you walk into the street and say “I have someone that has a model that can predict the future”, how would you describe that person? And the person you said, “Oh you mean Nostradamus or Jesus or do you mean a prophet?” And they say “Oh no, I mean you. You’re a rational person, therefore you have a model that can help you predict the future accurately." They’d lock you up. Now that’s what they actually developed as the definition of rational. And the reason that happened, when you look in the development of history of economic over time is in some ways it was an inevitable necessity for them to reach this absurd position because they tried to argue that you could work out the economy without considering people’s expectations of the future. When you read Keynes, he  said he uses classical economic theory as one of those pretty polite techniques suitable for a well paneled ballroom in stable conditions, which tries to deal with the present by extracting from the fact that we know very little about the future. Which was an accurate characterization of the mainstream economics at the time Keynes wrote.

But what they’ve tried to do by supplanting Keynes is rather than saying we can ignore the future, the only way they can tame the impact of the uncertainty of the future on the decisions we make today is to presume we can accurately predict the future. So falling for this nonsense of rational expectations was a necessary consequence of trying to build an equilibrium model of the economy, and that’s where they’ve ended up. Interestingly enough there’s a paper by one of the leading apparatchiks in this whole area called Robert Barrow. Robert Barrow wrote a paper in 1984 I think called "The State of Rational Expectations in 1984." And he wrote in the paper that one of the cleverest things about the rational expectations revolution as they describe it — this is a direct quote, “The appropriation of the word rational” by which case it meant that anybody who wanted to oppose them had to either support irrational behavior or talk about deviation from rationality which is a very difficult thing for economists to do. So he’s actually admitting they stole the word from the dictionary. That’s what appropriation means. So I’m appropriating it back and I now describe what they call as rational expectations as prophetic expectations. That’s what they use in their models to cancel out any uncertainty about the future, any capacity for state actions to affect the level of the economy and also any capacity for crisis to happen because if you could predict the future of course you’d never walk into a crisis, would you?

Chris Martenson: No, no. So if I add this all up, by failing fundamentally to account for the proper role of debt in the economy and demand and the way it pulls demand forward from the future into the present, appropriating the word "rational" and misusing it badly in models — this whole idea that we have some form of equilibrium economics as if it were a closed form equation where if we just dialed everything right we could have this perfect steady state of full employment, full capacity, all that. Given all those things, if you put them in a spot that says you’ve got a bad model, Steve what’s the risk of having bad models at the heart of your monetary policies?

Steve Keen: Well certainly you’re going to run into a wall you don’t even see coming your way. This is of course what happened in the financial crisis. If you look at the conventional literature, they simply can’t explain where it came from apart from saying it was due to a big exogenous shock. Now I don’t know where you noticed it; I didn’t see any meteor landing next to my city. Did one hit yours? Exogenous shock means something from outside the planet pretty much, outside the economy. There's a paper by, what’s his name? Ireland, think of the country Ireland — talking about the failure to suspect crisis during 2010, running during 2010 and he wrote saying that the failure to anticipate the crisis makes you think maybe we should revise our whole economic theory approach. He then said, "no, if you take a look at it we can find that the reason the crisis happened in 2007 is the economy was hit by exogenous shocks to technology and preferences," which are the two categories they talk about, technology and preferences for consumers, "of roughly the same scale and size as that in previous down turns. But they’ve then got bigger and lasted longer. And therefore we can explain the crisis because there were shocks to technology and preferences."

Well what were they, mate? Identify them please. What happened, did consumers suddenly start disliking Coca Cola? Was there a wave of people buying fresh water rather than Pepsi? What’s going on there that explains this huge movement? And of course they can’t do it so they bring everything down to exogenous shocks. And of course the real world would be an exogenous shock if you leave it out of your model. And fundamentally what they’ve done is, by leaving out the banking sector, any crises that emanate from the financial system will be a surprise to their models. Now they’re bringing in — ever since the crisis hit, they decided they needed to included the financial system in their source of things that impede the market from reaching a perfect equilibrium. But as usual—and you’d know this well—they incorporated as they incorporate everything else, saying the financial sector is now a source of additional friction. Of course friction is something that slows you down.

If you believe the system is going to converge to an equilibrium, then the friction will mean you get to equilibrium more slowly. It doesn’t explain acceleration and why you suddenly fly off rapidly and have a crisis so they can explain why once a shock hits the financial sector means you take longer to get back to equilibrium. But it doesn’t explain the financial sector as a source of accelerance that caused the crisis in the first place.

Chris Martenson: It all sounds so self serving because you know one of the things that the central banks really want to do is to, at least from my perspective, is to enable sovereign entities to deficit spend and so they need a large and willing pool of people who are willing to absorb that debt. And if those don’t exist they will themselves become that willing pool. It feels to me like the whole thing is a bit self serving because —

Steve Keen: No it’s not; there I’m going to disagree with you. That is — in fact the same economists who developed this fantasy, one thing they do want to do is they want to justify a role for the central bank in setting the reserve interest rate. So that’s a major part of their model, so they want to justify the status and importance of the central bank, as a setter of the price of money. That’s what they want to do. In terms of the volume of loans being generated by the government, they are actually in favor of 100% of those — if the government runs a deficit, they’re in favor of that entirely being financed by selling bonds to the public. And they are — they would prefer to see the government running a surplus, not having a deficit at all. So you’re seeing — I can understand where you get that position from, but the fundamental nature of their thinking is that the economy is best that the government is a size zero. That’s the extreme neoclassical. Of course, people like Krugman don’t believe that and that’s something in his favor. But the extreme neoclassicals actually believe that you should get the government down to virtually not existing at all. They believe the private sector works perfectly well without any government intervention whatsoever. And when you look at the horror that’s being imposed on Europe right now, the fact that there is a fetish running government surplus over here is another product of the economic theory.

Chris Martenson: Well, so let me tell you where I get this view, and my view stems from this. You’ve shown before that it’s technically possible for a debt based money system to operate in a non exponential fashion, but all the real world data I have Steve, shows near perfect exponential behaviors, r-squareds of .99, right? This is both for debt and monetary aggregates individually.

Steve Keen: Yep.

Chris Martenson: So I see a big problem with having an exponential money system on a finite planet, that’s the core of my view. But mainstream economics I think—what I’m seeing from the central banks is I feel —this is my perception, they have got us on an exponential debt train and they need to continue that. And whether that continues in the public or the private sphere is a little bit irrelevant. I agree with you they would prefer it happen in the private sphere, but if it’s not happening there perfectly happy to continue that train in the public sphere if necessary, maybe under exigent circumstances. How do you respond?

Steve Keen: You’re wrong about their ideology and why they’re doing it. They don’t even know that that’s the case; they don’t think there is a particular trend and they’re preferred situation would be to drive public debt down relatively toward zero and they ignore private debt completely. So you’re gracing them with too much comprehension of the world in which they live. There’s a wonderful sci-fi book I read a short while ago called The Wyandotte Girl and it had a wonderful line in it where the protagonist was not at all a likable person who was described as suddenly realizing the world he understood was not actually the one in which he lived.

Chris Martenson: I regularly give people too much credit and so if I look at what — I thought for sure somebody in the Federal Reserve would have been following the same data I was which was starting in 1970 in the United States total credit market debt has been compounding at nearly 8% per annum, 7.9%. And income, GDP, GNI, whatever we want to measure, has been roughly half that rate. So to me it looks like since 1970 there’s been a very concerted effort to have credit and credit markets expanding at roughly twice the rate of the underlying income growth. To me that’s just a math problem waiting to happen. Are you telling me that in the Federal Reserve there’s nobody who looks at that and says, “Sooner or later that just breaks”?

Steve Keen: Yep, nobody looks at it in the Federal Reserve.

Chris Martenson: Really? That’s disappointing.

Steve Keen: I deal with these people on a daily basis and to give you an idea of how primitive their thinking is there—this is not the Federal Reserve, this is the Australian central bank, the IBA—but I was once at a speech by one of the deputy governors there and he and I had a chat after the whole thing and I was talking about the problems of the debt to GDP ratio, the private debt to GDP ratio. He quite literally said to me, “I don’t know why you worry about that because you’re preparing a stock to a flow”. He thought I was making a stock flow error. Now a stock flow error, you being a properly trained scientist and engineer, you know that the stock flow comparison is adding a stock to a flow and thinking you've got a meaningful amount [Inaudible 00:23:49] looking at rate of change, makes the mistake between — people often think interest can’t be paid and they're comparing—the loan doesn’t create the interest and they say "you should have given the interest for the loan as well as getting the loan." What they’re doing is they’re looking at dollars and dollars per unit of time and not realizing they can’t combine the two that way. But to make a comparison of stock to a flow, to get a ratio like you and I are working on in terms of debt to GDP ratio makes imminent sense because the ratio tells you how many years it will take to repay the debt you’re in. So that’s the level of stupidity. And it’s not that the guy is stupid at all; it’s that they simply have a mental framework that doesn’t allow them to consider that issue so they come up with nonsense reasons why not to think about it.

Chris Martenson: So let’s talk about this 200 trillion dollars of debt; I’m sure you saw that McKinsey study. The world is saddled with that monster amount. Can that ever be paid back?

Steve Keen: No.

Chris Martenson: Okay. What terms is it going to get dismantled then?

Steve Keen: Well we should be writing off large parts of it, and I would actually write it off by the capacity of the government to create debt-free money. That would be using what I call the modern debt jubilee. So it would be quite feasible to do that on a grand scale and change the effective basis of a large part of our money supply from credit based to fiat based. So it’s quite feasible to do it that way.

We won’t do it that way of course. What we’ll do is let people go bankrupt and hound people who can’t pay their debts, etc., and force them to pay debts which are unsustainable like is happening in Greece right now. And what that will mean is rather than people being able to spend money, they’ll be forever paying off their debt with whatever income stream they have, and by doing it will depress demand in the economy so that as well as paying down their debt they’ll also reduce the size of the GDP and the ratio imbalance remains much the same. Of course the situation I’ve described has been the situation in Japan for the last 25 years. So this sort of madness can go on for a quarter of century. The only salve to it, and the reason that Japan has gotten away with it so successfully so far—there's two salves. One is the government running a deficit and running up its own debt. The government is the only organization that has its own bank, effectively. So that’s the reason the government can get away with running their debt. Government debt in Japan has gone from, I think when the crisis began in 1990, 75% of GDP to 250%. That’s provided a stimulus the economy wouldn’t have had without that incredible increase in government debt.

At the same time, Japan runs a huge trade surplus that also lets it get away with it for a large length of time. Globally of course there’s no such thing as a global trade surplus; so that particular avenue goes. The only solution to the level of private debt we’re in and the drag that’s putting on the global economy is to have a huge amount of government spending. But of course with governments running their own deficits as well, we get caught in a stalemate. And so the likely outcome of all this is stagnation with levels of debt that remain constant while GDP falls.

Chris Martenson: And that sounds like a recipe for having an ever increasing proportional flow of what real income and productivity is occurring from the general populous to the holders of that debt?

Steve Keen: Yeah, yep.

Chris Martenson: And so in the context of this wealth gap that we’ve got right now, which by the way I think is a bit false because it’s obviously been pumped up to some extent by the QE and other printing efforts of the central banks. But eventually just mathematically it sounds like if you play this debt game long enough and you don’t have some sort of rebalancing or if you’re over expressing debt relative to income sooner or later even if you have — unless interest rates go to pure zero, if there’s any nominal rate of interest at all what you’re going to find eventually is that 100% of your income ends up being consumed by debt payment somewhere. Not now, but at some point, is that right?

Steve Keen: That’s the eventual truth. You don’t get to 100% by any means, you get to the stage where you can’t stay alive and pay your debt at the same time. If you don’t make your debt payments, let’s say you’re talking people in a mortgage of course, then the house gets repossessed. Now that means that the pressure is on you unless you can walk away as Americans did, given the legal system there with you know, jingle mail. It gives you an inability to consume other things and so it’s just a gap — it’s the gap between what you’re getting as an income and what is the absolute necessary level of spending to maintain your minimum lifestyle. And if that gap falls to zero then you know the whole thing collapses because people go bankrupt and it just cascades through all their other spending and they go from being in a desirable level of disposable income to being wiped out. And that’s — that — we’re so close to that level at all times now because so little deleveraging occur during the crisis itself. So little deleveraging is possible.

Chris Martenson: Right, right. Let me back it our really wide for one second then I’m going to close in on Greece. I’m looking at things like the social security and entitlement shortfalls in the United States, and of course this is a net present value calculation; all future flows and outflows — inflows and outflows are balanced and then you get a number, right? And so when I go over to the Congressional budget office and I look at their projections for inflows, I see that they just smoothly give about a 3.3% rate of GDP growth for the United States for the next 100 years, right? So of course this is exponential growth, you model it out, you discover that by the year 2076 the United States alone in current dollar terms has a GDP as large as the entire world today. So given where we are with respect to oil, other resources, water, soil, things like that, I find it hard to intuitively — in fact I will reject this intuitively—that the idea that the United States will alone have an economy consuming as much as the 100% of the world today by 2076.