Steve Keen Out-Thinks Larry Summers


Inside the beltway and among mainstream economists, Larry Summers has the reputation of being a genius.

But Australian PhD economist Steve Keen points out a huge gap in the thinking of Summers – and all neoclassical economists.

Specifically, in an essay written today, Keen explains the weakness in the Obama administration’s approach to the economic crisis:

Following the advice of neoclassical economists, Obama has got not a bang but a whimper out of the many bucks he has thrown at the financial system.

In explaining his recovery program in April, President Obama noted that:

“there are a lot of Americans who understandably think that government money would be better spent going directly to families and businesses instead of banks – ‘where’s our bailout?,’ they ask”.

He justified giving the money to the lenders, rather than to the debtors, on the basis of “the multiplier effect” from bank lending:

the truth is that a dollar of capital in a bank can actually result in eight or ten dollars of loans to families and businesses, a multiplier effect that can ultimately lead to a faster pace of economic growth. (page 3 of the speech)

This argument comes straight out of the neoclassical economics textbook. Fortunately, due to the clear manner in which Obama enunciates it, the flaw in this textbook argument is vividly apparent in his speech.

This “multiplier effect” will only work if American families and businesses are willing to take on yet more debt: “a dollar of capital in a bank can actually result in eight or ten dollars of loans”.

So the only way the roughly US$1 trillion of money that the Federal Reserve has injected into the banks will result in additional spending is if American families and businesses take out another US$8-10 trillion in loans.

What are the odds that this will happen, when they already owe more than they have ever owed in the history of America? …

If the money multiplier was going to “ride to the rescue”, private debt would need to rise from its current level of US$41.5 trillion to about US$50 trillion, and this ratio would rise to about 375%—more than twice the level that ushered in the Great Depression…

But the amount of consumer credit outstanding has plummeted:

Total seasonally adjusted consumer debt fell $21.55 billion, or at a 10.4% annual rate, in July 2009 alone. Credit-card debt fell $6.11 billion, or 8.5%, to $905.58 billion. This is the record 11th straight monthly drop in credit card debt. Non-revolving credit, such as auto loans, personal loans and student loans fell a record $15.44 billion or 11.7% to $1.57 trillion.

As many people have pointed out, the reduction in American consumer spending is a long-term trend. For example, Alix Partners finds:

While American industry is struggling to get through what could become the worst recession since the Great Depression, Americans say that even after the recession ends, their spending will return to just 86% of pre-recession levels, which would take a trillion dollars per year out of the U.S. economy for years to come. According to this in-depth survey of more than 5,000 people, Americans plan to save (and therefore not spend) an astounding 14% of their total earnings post-recession, with the replenishment of their 401(k) and other retirement savings leading the way among their biggest long-term concern.

As Huffington Post notes:

“There will be a fundamental shift in the kind of cars we buy, a fundamental shift in the homes we buy, and a fundamental shift in consumption generally,” says Matt Murray, an economist at the University of Tennessee. “And that is not something that took place in the 1980s.”

So consumers will borrow less, and the Summers’ plan of multiplying the trillions thrown at the banks by the government won’t result in any meaningful multiplier effect.

Keen continues:

I’ve recently developed a genuinely monetary, credit-driven model of the economy, and one of its first insights is that Obama has been sold a pup on the right way to stimulate the economy: he would have got far more bang for his buck by giving the stimulus to the debtors rather than the creditors.

The following figure shows three simulations of this model in which a change in the willingness of lenders to lend and borrowers to borrow causes a “credit crunch” in year 25. In year 26, the government injects $100 billion into the economy—which at that stage has output of about $1,000 billion, so it’s a pretty huge injection, in two different ways: it injects $100 million into bank reserves, or it puts $100 billion into the bank accounts of firms, who are the debtors in this model.

The model shows that you get far more “bang for your buck” by giving the money to firms, rather than banks. Unemployment falls in both case below the level that would have applied in the absence of the stimulus, but the reduction in unemployment is far greater when the firms get the stimulus, not the banks: unemployment peaks at over 18 percent without the stimulus, just over 13 percent with the stimulus going to the banks, but under 11 percent with the stimulus being given to the firms.

The time path of the recession is also greatly altered. The recession is shorter with the stimulus, but there’s actually a mini-boom in the middle of it with the firm-directed stimulus, versus a simply lower peak to unemployment with the bank-directed stimulus.

Keen concludes simply:

So giving the stimulus to the debtors is a more potent way of reducing the impact of a credit crunch—the opposite of the advice given to Obama by his neoclassical advisers…

Obama has been sold a pup [i.e. tricked into buying something that is not worth anything] by neoclassical economics: not only did neoclassical theory help cause the crisis, by championing the growth of private debt and the asset bubbles it financed; it also is undermining efforts to reduce the severity of the crisis.

This is unfortunately the good news: the bad news is that this model only considers an economy undergoing a “credit crunch”, and not also one suffering from a serious debt overhang that only a direct reduction in debt can tackle. That is our actual problem, and while a stimulus will work for a while, the drag from debt-deleveraging is still present. The economy will therefore lapse back into recession soon after the stimulus is removed.


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  • I am not so sure that Steve has "out-thought" Larry. Larry is pretty sharp. You have to ask what the hidden agenda may be.My take is that Larry, Tim and Ben know that they are facing deflation and they have to stimulate monetarily and fiscally to increase C and I, and lower the dollar to stimulate NX. Households are highly leveraged and unwilling to borrow, and banks are unwilling to lend to them anyway — at least at non-usurious rates — because credit standards have tightened significantly after being way too loose.The ploy is to keep the Fed funds rate low and otherwise pour capital into the banks knowing that they will act like hedge funds and bid up equity prices. The FHA will continue to make subprime loans, and tax credits will provide the downs. A falling dollar will drive the equities market, will stimulating NX. Commodity speculation is a somewhat of danger, but, hey, get the IMF to sell gold, and twist some arms on oil if need be.The danger, of course, is inflation down the line, but they are worried about deflation now. As a precaution against criticism about incipient inflation, talk up "exit strategies" and seem deficit-hawkish.All the jabbering about banks being goosed with government reserves so they can lend to consumer is just that — jive to make people feel good about their money being poured into banks instead of at the bottom where people would feel it directly.While I agree with Steve's economic analysis, I don't believe that this is the way that Larry is thinking at all. It's just a cover for the heist in the hope that asset values can be reflated enough for another round of musical chairs and then, he hopes, IBGYBG.

  • The key question is how are incomes supposed to increase due to this stimulus?We have over-capacity – so we can't expect capital investment, we have de-leveraging, so we can't expect demand for debt.And we have "Bernanke Deflation" – which appears to consist of consumer asset deflation (retirement accounts, home equity and currency), business and financial asset inflation (equities, bonds and commodities), consumer price increases in relation to income stagnation and business cost decreases due to unemployment. Well played Ben!This so-called "stimulus" is Keynesian in name only. Obama would have had better results if he buried $100 billion somewhere in the US and hired 1,000,000 Americans to go find it.

  • Given the amount of issuance in the HY and other bond markets, it looks like firms rather than households will take up the multiplier challenge. Of course, much like the Japanese golf course and amusement park bubble, we can expect this to be spent on long term investments with a high productive capacity. Long Las Vegas casinos anyone?

  • Every dollar of stimulus spent by the government is (correctly) recognized by the consumer as a tax on future income.Hence, natural response to more stimulus is hoarding. This is why the monetarist explanation of the solution to the Great Depression is fundamentally flawed. In 2009, all consumer pay taxes (in some form), so the response to expected tax increases in the future is increased savings in the present.

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  • Dave Mowers

    What an awfully complicated way of describing “check kiting” by retail, commercial, investment banks and insurance companies. Why don’t you explain it so that 60% of the country who is poor can understand what has happened?

    Finance companies use small amounts of money to underpin loans in the form of actual loans, credit lines, credit cards, mortgages, etc. They do it by betting that everyone won’t use their money deposited in accounts tied to these instruments at the same time- ie: CHECK KITING. Check kiting when done by a bank is also called, money multiplier, leverage, asset transfer and many other obfuscating terms designed to confuse.

    When there is a “crunch” or market downturn you essentially have everyone trying to get their money they think they have but is not really there because the banks have given it all away in loans and credit lines. This logic was only necessary when mankind didn’t have mass production, distribution for worldwide injection of currency into markets. We have that capability now and have had it for a long long long time now. Solution, make loans with real money actually printed by the federal reserve instead of phantom money in the form of debt instruments- CHECK KITING. Rather than be honest with people the fed is making this WORSE by simply allowing banks to digitally add money to their accounts upon approval by the fed!


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