Reconciling Krugman and Keen using nef’s model
Photo credit: 00Joshi
September 7, 2012 // By: Emanuele Campiglio
A few months ago a heated row took place between the economists Paul Krugman, American Nobel prize winner, and Steve Keen, the Australian author of a book entitled “Debunking Economics”. The argument, which triggered wide debate across the blogosphere, was sparked by a difference in the way the two looked at things such as the process of credit creation and the role of debt in the wider macroeconomic framework.
The dispute was ignited by a paper prepared by Steve Keen for the INET conference in Berlin, in which he asserted that changes in the levels of debt add to the economy’s aggregate demand. In other words, aggregate demand in an economy can be different from income, and the difference is equal to the net change in the level of debt. The concept can appear a bit odd, and certainly sounds very different from what Krugman so often repeats: “Your spending is my income, and my spending is your income”!
The point that Steve Keen makes is very subtle and it’s no wonder that even an economist as experienced as Krugman struggled to get it. We at nef, being involved in macroeconomic modeling ourselves, have tried to unravel the issue using our own tools. We therefore built a simplified version of our model to run numerical simulations of different scenarios (have a look at this if you want to have a taste of the complete model).
Below you can find a presentation that explains our analysis. You can flip through the pages or download it from this link. In this work:
- We clarify Keen’s analysis. We do so by explicitly identifying two
- Realized expenditures;
- Planned (or desired) expenditures.
- We show that the main difference between him and Krugman (and the main
source of confusion in the debate) is the way they think of aggregate demand:
- Krugman identifies Aggregate Demand with Realized Expenditure;
- Keen instead defines Aggregate Demand with Planned Expenditure.
- We show through numerical simulations that both Keen and Krugman are
right in their own logic:
- Realized Expenditure (Krugman’s Aggregate Demand) is indeed equal to Aggregate Income. That is equivalent to say that what has been actually spent will result to be someone else’s income.
- Planned Expenditure (Keen’s Aggregate Demand) can instead be different from Aggregate Income and the discrepancy is, as Keen argues, equal to the net change in the levels of debt.
- We argue that Keen’s definition of Aggregate Demand is more appropriate, especially if the role of credit creation by private banks in shaping macroeconomic dynamics is to be understood.
- We show how, in the simplified model we present, no growth can take place without the creation of credit by banks. The net change in the level of debt (what we call ‘Net Credit Creation’ = Credit Creation less Debt Repayment) is the single most important variable affecting the dynamics of the economy.
- Finally, we expand Keen’s idea to include the supply side (i.e. the production process) into the picture. This allows us to consider the case in which planned expenditure doesn’t become realized expenditure because of a supply bottleneck.
This presentation will be followed very soon by another one dealing with the way we model banks and credit creation, and by a full working paper. We hope this could contribute to bring the debate a step further. And of course, any comment is more than welcome.