This is the first chapter in the second edition of Debunking Economics. Except for the brief introduction, the Postscript, and the section headings, it consists entirely of extracts from the first edition, which was written in 1999 and 2000. These indicate that–far from being an unpredictable event, as many neoclassical economists assert–the crisis of 2007 was an obvious consequence of the rampant forces of speculation that neoclassical economics both encouraged and ignored. Neoclassical economists were effectively trained to not see this crisis coming, by theoretical fallacies that led them to ignore crucial real-world phenomena like the ballooning levels of private debt, and rampant speculation and fraud in the finance sector.

Predicting the “unpredictable”

A major motivation for writing the first edition of this book was my feeling in 2000 that a serious economic crisis was imminent, and that it was therefore an apt time to explain to the wider, non-academic community how economic theory was not merely inherently flawed, but had helped cause the calamity I expected. At the time, I thought that the bursting of the DotCom Bubble would mark the beginning of the crisis—though I was cautious in saying so, because my work in modeling Minsky’s Financial Instability Hypothesis (Keen 1995) had confirmed one aspect of his theory, the capacity of government spending to prevent a debt crisis that would have occurred in a pure credit economy.

Statements that a crisis may occur were edited out of this edition, because the crisis has occurred—after the Subprime Bubble, which was in the background during the DotCom bubble, finally burst as well.[1] But these pre-crisis statements remain important, because they indicate that, without the blinkers that neoclassical economic theory puts over the eyes of economists, the crisis now known as The Great Recession was not an unpredictable “Black Swan” event, but an almost blindingly obvious certainty. The only question-mark was over when it would occur, not if.

This brief chapter therefore provides excerpts from the first edition on the likelihood of a crisis as seen from the vantage point of non-neoclassical economics—and in particular, Minsky’s “Financial Instability Hypothesis”—in 2000 and early 2001. I hope these pre-crisis observations persuade you to reject the “Nobody could have seen this coming” smokescreen. Rather than being a “Black Swan”, The Great Recession was a “White Swan” made invisible to neoclassical economists because their theory makes them ignore the key factors that caused it: debt, disequilibrium, and time.

The destabilizing effect of neoclassical economics

The belief that a capitalist economy is inherently stabilizing is also one for which inhabitants of market economies may pay dearly in the future. As they were initially during the Great Depression, economists today may be the main force preventing the introduction of countervailing measures to any future economic slump. Economics may make our recessions deeper, longer and more intractable, when the public is entitled to expect economics to have precisely the opposite effect.

Fortunately for economists, the macroeconomy – at least in the United States – appeared to be functioning fairly well at the end of the year 2000. It is thus possible for economists to believe and preach almost anything, because they can bask in the entirely coincidental fact that the macroeconomy appears healthy.

However, this accidental success may not last long if the pressures which have been clearly growing in the financial side of the economy finally erupt. (Keen 2001, p. 213)

Possibility of debt-deflation in the USA

If a crisis does occur after the Internet Bubble finally bursts, then it could occur in a milieu of low inflation (unless oil price pressures lead to an inflationary spiral). Firms are likely to react to this crisis by dropping their margins in an attempt to move stock, or to hang on to market share at the expense of their competitors. This behavior could well turn low inflation into deflation.

The possibility therefore exists that America could once again be afflicted with a debt deflation – though its severity could be attenuated by the inevitable increase in government spending that such a crisis would trigger. America could well join Japan on the list of the global economy’s ‘walking wounded’ – mired in a debt-induced recession, with static or falling prices and a seemingly intractable burden of private debt. (Keen 2001, p. 254)

The likelihood of a Japanese outcome for America after the crash

Only time will tell whether the bursting of the Internet Bubble will lead to as dire an outcome as the Great Depression. Certainly, on many indicators, the 1990s bubble has left its septuagenarian relative in the shade. The price to earnings ratio peaked at over one and a half times the level set in 1929, the private and corporate debt to output ratio is possibly three times what it was prior to the Great Crash, and prices, though rising in some sectors, are generally quiescent. On all these fronts, Fisher’s debt-deflation theory of great depressions seems a feasible outcome.

On the other hand, Minsky argued that ‘Big Government’ could stabilize an unstable economy, by providing firms with cash flow from which their debt commitments could be financed despite a collapse in private spending. Certainly, the US government of 2000 is ‘big’ when compared to its 1920s counterpart, and its automatic and policy interventions will probably attenuate any economic crash to something far milder than the Great Depression. What appears more likely for post-Internet America is a drawn-out recession like that experienced by Japan since its Bubble Economy collapsed in 1990. (Keen 2001, pp. 256-257)

The impact of the Maastricht Treaty on Europe during a crisis

Macroeconomics is economic policy par excellence, but economic theory itself has virtually reached the position that there should be no macroeconomic policy. The clearest evidence of this is the Maastricht Treaty, which made restricting budget deficits to no more than 3% of GDP a condition for membership of the European Union. While some fudging has been allowed to make membership possible in the first place, when an economic crisis eventually strikes, Europe’s governments may be compelled to impose austerity upon economies which will be in desperate need of a stimulus. (Keen 2001 , pp. 212-213)

The Efficient Markets Hypothesis encouraging debt-financed speculation

[According to the Efficient Markets Hypothesis] The trading profile of the stock market should therefore be like that of an almost extinct volcano. Instead, even back in the 1960s when this [Sharpe] paper was written, the stock market behaved like a very active volcano. It has become even more so since, and in 1987 it did a reasonable, though short-lived, impression of Krakatau. In 2000, we saw 25% movements in a week. October 2000 lived up to the justified reputation of that month during bull markets; heaven only knows how severe the volatility will be when the bubble finally bursts. (p. 232)

What can I say? By promulgating the efficient markets hypothesis, which is predicated on each investor having the foresight of Nostradamus, economic theory has encouraged the world to play a dangerous game of stock market speculation. When that game comes unstuck, America in particular will most likely find itself as badly hobbled by debt as Japan has been for the past decade. This speculative flame may have ignited anyway, but there is little doubt that economists have played the role of petrol throwers rather than firemen. When crisis strikes, conventional economists will be the last people on the planet who can be expected to provide sage advice on how to return to prosperity – unless, as often happens in such circumstances, they drop their theoretical dogmas in favor of common sense.

When the Great Crash of 1929 led to the Great Depression of the 1930s, many of the erstwhile heroes of the finance sector found themselves in the docks. It is unlikely that any particular economists will find themselves so arraigned, but there is little doubt that economic theory has been complicit in encouraging America’s investing public to once again delude itself into a crisis. (Keen 2001, p. 256)

Deregulation and Crisis

Deregulation of the financial sector was not the sole cause of the financial instability of the past twenty years. But it has certainly contributed to its severity, by removing some of the limited constraints to cyclical behavior which exist in a regulated system.

These deregulations were mooted as ‘reforms’ by their proponents, but they were in reality retrograde steps, which have set our financial system up for a real crisis. I can only hope that, if the crisis is serious enough, then genuine reform to the finance sector will be contemplated. Reform, of course, cannot make capitalism stable; but it can remove the elements of our corporate system which contribute most strongly to instability.

The major institutional culprit has to be the finance sector itself, and in particular the elements of the stock market which lead to it behaving more like a casino than a place of reasoned calculation…

Surely, when the Internet Bubble really bursts, it will be time to admit that one fundamental excess of the market as currently organized is its ability to allow sky-high valuations to develop. (Keen 2001, pp. 255-256)

The history of crises causing—and not causing—paradigm shifts in economics

This is far from the first book to attack the validity of economics, and it is unlikely to be the last. As Kirman commented, economic theory has seen off many attacks, not because it has been strong enough to withstand them, but because it has been strong enough to ignore them.

Part of that strength has come from the irrelevance of economics. You don’t need an accurate theory of economics to build an economy in the same sense that you need an accurate theory of propulsion to build a rocket. The market economy began its evolution long before the term ‘economics’ was ever coined, and it will doubtless continue to evolve regardless of whether the dominant economic theory is valid. Therefore, so long as the economy itself has some underlying strength, it is a moot point as to whether any challenge to economic orthodoxy will succeed.

However, while to some extent irrelevant, economics is not ‘mostly harmless’. The false confidence it has engendered in the stability of the market economy has encouraged policy-makers to dismantle some of the institutions which initially evolved to try to keep its instability within limits. ‘Economic reform’, undertaken in the belief that it will make society function better, has instead made modern capitalism a poorer social system: more unequal, more fragile, more unstable. And in some instances, as in Russia, a naive faith in economic theory has led to outcomes which, had they been inflicted by weapons rather than by policy, would have led their perpetrators to the International Court of Justice.

However, while to some extent irrelevant, economics is not ‘mostly harmless’. The false confidence it has engendered in the stability of the market economy has encouraged policy-makers to dismantle some of the institutions which initially evolved to try to keep its instability within limits. ‘Economic reform’, undertaken in the belief that it will make society function better, has instead made modern capitalism a poorer social system: more unequal, more fragile, more unstable. And in some instances, as in Russia, a naive faith in economic theory has led to outcomes which, had they been inflicted by weapons rather than by policy, would have led their perpetrators to the International Court of Justice.

But even such a large-scale failure as Russia seems to have little impact upon the development of economic theory. For economics to change, it appears that things have to ‘go wrong’ on a global scale, in ways which the prevailing theory believed was impossible. There have been two such periods this century.

The first and most severe was the Great Depression, and in that calamity, Keynes turned economic theory upside down. However, Keynes’s insights were rapidly emasculated, as Chapter 9 showed. ‘Keynesian economics’ became dominant, but it certainly was not the economics of Keynes.

The second was the ‘stagflationary crisis’ – the coincidence of low growth, rising unemployment and high inflation during the 1970s. That crisis led to the final overthrow of the emasculated creature that Keynesian economics had become, and its replacement by an economic orthodoxy which was even more virile than that against which Keynes had railed.

One step forward and two steps back – with the first step backwards being taken when the economy was doing well, in the aftermath of the Depression and WWII and hence when the ramblings of economists could comfortably be ignored.

That historical record is both comforting and disturbing. Change is possible in economics, but normally only when the fabric of society itself seems threatened; and change without crisis can involve the forgetting of recent advances.

It is possible, therefore, that economic theory may continue to function mainly as a surrogate ideology for the market economy, right up until the day, in some distant future, when society evolves into something so profoundly different that it no longer warrants the moniker ‘capitalism’.

I hope, however, that events follow a different chain. I am not wishing an economic crisis upon the modern world – instead, I think one has been well and truly put in train by the cumulative processes described in chapters 10 and 11. If that crisis eventuates – one which neoclassical economic theory argues is not possible – then economics will once again come under close and critical scrutiny. (Keen 2001, pp. 311-312)

Public reactions to the failure of Neoclassical Economics

This time, the chances are much better that something new and indigestibly different from the prevailing wisdom will emanate from the crisis. As this book has shown, critical economists are much more aware of the flaws in conventional economics than they were during Keynes’s day, non-orthodox analysis is much more fully developed, and advances in many other fields of science are there for the taking, if economics can be persuaded – by force of circumstance – to abandon its obsession with equilibrium.

The first factor should mean that the lines will be much more clearly drawn between the old orthodoxy and the new. The latter two should mean that the techniques of the old orthodoxy will look passé, rather than stimulating, to a new generation of economists schooled in complexity and evolutionary theory.

But ultimately, schooling is both the answer and the problem. If a new economics is to evolve, then it must do so in an extremely hostile environment – the academic journals and academic departments of Economics and Finance, where neoclassic orthodoxy has for so long held sway.^[2] The nurturing of a new way of thinking about economics could largely be left in the hands of those who have shown themselves incapable of escaping from a 19th century perspective.

There are two possible palliatives against that danger. The first is the development, by non-orthodox economists, of a vibrant alternative approach to analyzing the economy which is founded in realism, rather than idealism. Such a development would show that there is an alternative to thinking about the economy in a neoclassical way, and offer future students of economics a new and hopefully exciting research program to which they can contribute.

The second is an informed and vigilant public. If you have struggled to the end of this book, then you now have a very strong grasp on the problems in conventional economic thought, and the need for alternative approaches to economics. Depending on your situation, you can use this knowledge as a lever in all sorts of ways.

If you are or you advise a person in authority in the private or public sectors, you should know now not to take the advice of economists on faith. They have received far too easy a ride as the accepted vessels of economic knowledge. Ask a few enquiring questions, and see whether those vessels ring hollow. When the time comes to appoint advisers on economic matters, quiz the applicants for their breadth of appreciation of alternative ways to ‘think economically’, and look for the heterodox thinker rather than just the econometric technician.

If you are a parent with a child who is about to undertake an economics or business degree, then you’re in a position to pressure potential schools to take a pluralist approach to education in economics. A quick glance through course structure booklets and subject outlines should be enough to confirm what approach they take at present.

If you are a student now? Well, your position is somewhat compromised: you have to pass exams, after all! I hope that, after reading this book, you will be better equipped to do that. But you are also equipped to ‘disturb the equilibrium’ of both your fellow students and your teachers, if they are themselves ignorant of the issues raised in this book.

You have a voice, which has been perhaps been quiescent on matters economic because you have in the past deferred to the authority of the economist. There is no reason to remain quiet.

I commented at the beginning of this book that economics was too important to leave to the economists. I end on the same note. (Keen 2001, pp. 312-313)

Postscript 2011

As these excerpts emphasize, the never-ending crisis in which the US and much of the OECD is now ensnared was no “Black Swan”. Its inevitability was obvious to anyone who paid attention to the level of debt-financed speculation taking place, and considered what would happen to the economy when the debt-driven party came to an end. The fact that the vast majority of economists pay no attention at all to these issues is why they were taken by surprise.

It may astonish non-economists to learn that conventionally trained economists ignore the role of credit and private debt in the economy—and frankly, it is astonishing. But it is the truth. Even today, only a handful of the most rebellious of mainstream “neoclassical” economists—people like Joe Stiglitz and Paul Krugman—pay any attention to the role of private debt in the economy, and even they do so from the perspective of an economic theory in which money and debt play no intrinsic role. An economic theory that ignores the role of money and debt in a market economy cannot possibly make sense of the complex, monetary, credit-based economy in which we live. Yet that is the theory that has dominated economics for the last half century. If the market economy is to have a future, this widely believed but inherently delusional model has to be jettisoned.