Naked capitalism and the scary model | Steve Keen | Commentary | Business Spectator 6/07/10 12:16 PM

Commentary Comment

Naked capitalism and the scary model

Steve Keen
Published 6:29 AM, 6 Jul 2010 Last update 10:18 AM, 6 Jul 2010

I met with Yves Smith of Naked Capitalism on the weekend, at a superb Japanese restaurant
that only New York locals could find (and I'll keep its location quiet for their benefit – too much
publicity could spoil a spectacular thing). Yves was kind enough to post details of my latest
academic paper at her site in a post she entitled Steve Keen's scary Minsky model.
Yves found the model scary, not because it revealed anything about the economy that she
didn't already know, but because it so easily reproduced the Ponzi features of the economy
she knows so well.
I have yet to attempt to fit the model to data – and given its non-linearity, that won't be easy –
but its qualitative behaviour is very close to what we've experienced. As in the real world, the
model shows a series of booms and busts give the superficial appearance of an economy
entering a 'Great Moderation' – just before it collapses.

click the image to enlarge

The motive force driving the crash is the ratio of debt to GDP – a key feature of the real world
that the mainstream economists who dominate the world's academic university departments,
central banks and treasuries ignore. In the model, as in the real world, this ratio rises in a
boom as businesses take on debt to finance investment and speculation, and then falls in a
slump when things don't work out in line with the euphoric expectations that developed during
the boom. Cash flows during the slump don't allow borrowers to reduce the debt to GDP ratio
to the pre-boom level, but the period of relative stability after the crisis leads to expectations –
and debt – taking off once more.

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Naked capitalism and the scary model | Steve Keen | Commentary | Business Spectator 6/07/10 12:16 PM

click the image to enlarge

click the image to enlarge

Ultimately, such an extreme level of debt is accumulated that debt servicing exceeds available
cash flows, and a permanent slump ensues – a Depression.
There are four behavioural functions in the model that mimic the behaviour of the major
private actors in the economy – workers, capitalists and bankers. Workers' wage rises are
related to the level of employment and the rate of inflation; capitalists' investment and debt
repayment plans are related to the rate of profit; and the willingness of banks to lend is also a
function of the rate of profit.

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Naked capitalism and the scary model | Steve Keen | Commentary | Business Spectator 6/07/10 12:16 PM

The model is explicitly monetary – with bank accounts for workers, bankers and capitalists –
and the crisis is marked by a collapse in deposits and a rise in inactive bank reserves.

click the image to enlarge

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Naked capitalism and the scary model | Steve Keen | Commentary | Business Spectator 6/07/10 12:16 PM

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The same phenomenon is evident in the data, though the sharpness of the turnaround is far
greater than can be replicated by the smooth functions in my model.
There's a lot more work to do before the model is complete – notably including the impact of a
government sector that can add its own spending power to a depressed economy – but its
basic features fulfil Minsky's challenge:
Can "It"– a Great Depression – happen again? And if "It" can happen, why didn't "It" occur in
the [first 35] years since World War II? These are questions that naturally follow from both the
historical record and the comparative success of the past thirty-five years. To answer these
questions it is necessary to have an economic theory which makes great depressions one of
the possible states in which our type of capitalist economy can find itself.
This is the first economic model ever that meets Minsky's standards for realism. Its final stage
emphasises a message that Michael Hudson, one of the very few others to see this crisis
coming, puts very simply: "Debts that can't be repaid, won't be repaid". As Americans now
seem to be realising, the financial crisis has not gone away, because the debt that caused it is
still there.
Having got ourselves into a debt-induced economic crisis, the only permanent way out is to
reduce the debt – either directly by abolishing large slabs of it, or indirectly by inflating it away.
I have very little confidence in the ability of the Federal Reserve to do the latter, while the
former will take a level of political fortitude that is far beyond our current politicians.

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