Unveiling Steve Keen’s Revolutionary Challenge to Mainstream Economics

Sophi Says Philosobytes Level 3: Discover philosophical principles, some of which are tricky.Steve Keen — perhaps not the household name like Adam Smith or John Maynard Keynes, but definitely a thorn in the side of conventional economics. Born in 1953 in Sydney, Australia, Keen has become something of a rockstar in the world of heterodox economics, particularly known for his outspoken criticism of neoclassical economics. With a background that spans science and economics, his insights are as sharp as they are incisive, challenging the very foundations on which economic theories stand.

Educated at the University of Sydney and later at the University of New South Wales, Keen earned his credentials in a field that he would come to critique vigorously. His 2001 book, “Debunking Economics,” not only shakes the foundational myths of economic thought but also invites us, the laypeople and scholars alike, to question what we thought we knew about the economy. Keen’s career, marked by a penchant for challenging the status quo, includes a stint as an associate professor at the University of Western Sydney and his current role as a professor and a researcher. Always equipped with a sharp wit and a sharper pen, Keen’s work continues to provoke, educate, and sometimes, entertain the economic world.

Steve Keen in 2013Summary – Theories and Key Ideas

Steve Keen’s critical voice in economics is grounded in several key principles that question mainstream economic theories:

  1. Critique of Neoclassical Economics: Keen argues that neoclassical economic theories, with their rational economic agents and equilibrium models, fail to predict or account for real-world economic crises.
  2. Importance of Hyman Minsky’s Financial Instability Hypothesis: He emphasises the work of economist Hyman Minsky, who suggested that financial markets are inherently unstable and that periods of economic stability lead to riskier investments and eventually to financial crises.
  3. Rejection of the Loanable Funds Theory: Keen disputes the traditional view that loans are made from existing savings, arguing instead that banks create money through lending, which has different implications for economic policy and regulation.
  4. Debt-Deflation Theory of Economic Crises: He highlights the role of rising debt and falling asset prices in causing economic downturns, challenging the mainstream economics’ focus on general price inflation.
  5. Use of Dynamic Systems in Economic Modeling: Unlike the static models used in conventional economics, Keen advocates for dynamic systems that can better simulate the nonlinear behaviours seen in real economies.

Let’s begin by exploring Keen’s critique of neoclassical economics, shall we? This will set the stage to understand his broader challenge to mainstream economic theories.

Critique of Neoclassical Economics

Steve Keen’s critique of neoclassical economics is not just a footnote in his career; it is the bedrock upon which he builds his economic philosophy. This critique forms a pivotal part of his quest against mainstream economics, questioning the very assumptions that many economists take for granted. So, what’s all the fuss about?

The Foundations of Neoclassical Economics

Neoclassical economics, the dominant framework since the late 19th century, relies heavily on the assumption of rational individuals maximizing utility and firms maximizing profits, all operating within a system that naturally tends towards equilibrium. The beauty of this theory, according to its proponents, lies in its elegant mathematical models which supposedly provide clear insights into complex economic dynamics.

Keen’s Challenge

Steve Keen, however, begs to differ—and not quietly. He argues that the core assumption of rational economic agents operating in an equilibrium does not capture the chaotic realities of economic life. According to Keen, economies are inherently dynamic systems characterised by feedback loops, non-linear relationships, and far from equilibrium dynamics.

  1. Rationality and Equilibrium: Keen points out that the idea of rational agents perfectly informed and always making utility-maximizing decisions is not just unrealistic, but fundamentally flawed. Real humans are subject to biases, misinformation, and the sheer unpredictability of life. Moreover, the focus on equilibrium ignores the frequent and sometimes severe market fluctuations that are evident in financial crises.
  2. Predictive Failures: A cornerstone of Keen’s critique is that neoclassical economics has repeatedly failed to predict major economic crises. The 2008 financial crisis, for instance, was largely unforeseen by mainstream economists. Keen attributes this failure to the flawed baseline assumptions of neoclassical theory, which overlook the accumulation of private debt and its role in financial stability.
  3. Mathematical Models and Reality: Keen is particularly critical of the reliance on static mathematical models that do not reflect the dynamic processes of real economies. He advocates for a shift towards complex, dynamic systems modeling that incorporates factors like debt levels, financial flows, and genuine uncertainty—elements that he argues are critical to understanding real economic conditions.

The Response and Implications

Keen’s critique has not gone unchallenged, of course. Supporters of neoclassical economics argue that the theory provides valuable insights and that its mathematical models are useful for certain types of policy analysis. However, Keen’s relentless criticism has pushed some economists to reconsider the foundations of their models, especially regarding the role of banks, debt, and financial instability.

The implications of accepting Keen’s critique extend beyond academia. If mainstream economic policies are built on questionable assumptions, as Keen suggests, then there is a real risk that these policies could lead to suboptimal outcomes, or worse, exacerbate economic instability. By challenging these foundations, Keen is not just rewriting economic textbooks; he’s calling for a fundamental rethinking of how we manage and understand economic systems.

 Importance of Hyman Minsky’s Financial Instability Hypothesis

In the narrative of economic theories, where many sing hymns to stability and predictability, Steve Keen champions the discordant notes of Hyman Minsky’s Financial Instability Hypothesis. This theory, which underscores the inherent instability of financial markets, plays a crucial role in Keen’s economic thought. Here’s a closer look at why Minsky matters so much to Keen.

Understanding Minsky’s Hypothesis

Hyman Minsky, an American economist whose ideas gained prominence posthumously following the 2008 financial crisis, proposed that financial markets are fundamentally unstable. Minsky argued that during periods of economic prosperity, firms and consumers alike become overly optimistic, taking on more debt because they anticipate continued growth. This increasing leverage fuels asset bubbles. However, at some point, the burden of debt becomes unsustainable, leading to a rapid deleveraging process, asset sell-offs, and inevitably, a financial crisis.

Keen’s Endorsement and Expansion

Steve Keen was one of the early and vocal proponents of Minsky’s ideas, integrating them into his broader critique of neoclassical economics. Keen extends Minsky’s hypothesis by focusing on the dynamics of debt accumulation and its critical role in financial crises:

  1. Debt Accumulation as a Crisis Precursor: Keen emphasizes that it’s not just the presence of debt, but the pace at which it accumulates that signals upcoming trouble. For Keen, tracking the levels of private debt gives a clearer picture of economic health than conventional indicators like GDP growth or unemployment rates.
  2. Modeling Economic Dynamics: Keen uses dynamic systems modeling to simulate how debt-fueled investment drives the economy into periods of boom and bust. These models challenge the static equilibrium models of neoclassical economics, showing how minor changes in economic variables like interest rates or investment returns can have disproportionately large effects on the entire system.
  3. Policy Implications: The acceptance of Minsky’s hypothesis into mainstream economic thought, as advocated by Keen, would radically change economic policy-making. It suggests that regulators should focus more on controlling credit growth and monitoring financial bubbles rather than just managing inflation or unemployment figures.

Wider Acceptance and Challenges

While Minsky’s hypothesis was largely ignored during his lifetime, the 2008 crisis brought renewed attention to his theories, with Keen being a significant figure in this revival. Today, there’s a growing acceptance that financial instability is not an aberration but a regular feature of capitalist economies. However, integrating this into mainstream economic policy remains a challenge, as it requires a fundamental shift away from long-held beliefs about market self-correction and equilibrium.

The significance of Minsky’s hypothesis in Keen’s work underscores a broader narrative: the economic world is far more complex and unstable than traditional models suggest. It’s a reminder that economic theories are not just academic exercises; they shape the real world in profound ways.

Rejection of the Loanable Funds Theory

Steve Keen’s rejection of the Loanable Funds Theory is a critical aspect of his economic philosophy, one that directly challenges a core principle of mainstream economics. This theory, which posits that loans are made from existing savings, underpins many conventional economic models and policies. Let’s delve into why Keen dismisses this idea and what he proposes instead.

What is the Loanable Funds Theory?

The Loanable Funds Theory suggests that the supply of money for loans is determined by the amount of savings in the economy. According to this view, banks are mere intermediaries that facilitate the transfer of savings from savers to borrowers. Interest rates, therefore, are seen as the price that equilibrates the supply of savings and the demand for borrowing.

Keen’s Critique

Steve Keen argues that this theory fundamentally misunderstands how money and banking work in a modern economy. According to Keen, banks do not merely lend out pre-existing money deposited by savers. Instead, banks create money through lending. When a bank issues a loan, it simultaneously creates a deposit in the borrower’s account, thereby increasing the total money supply. This perspective aligns with the theory of endogenous money, which suggests that money is created internally within the economy, primarily through the operations of commercial banks.

  1. Money Creation: Keen points out that in reality, banks provide loans based on the creditworthiness of borrowers and their expectations of future repayments, rather than the availability of pre-existing savings. This process of money creation by banks is crucial for understanding economic dynamics, particularly in relation to inflation, asset bubbles, and financial stability.
  2. Economic Implications: The traditional Loanable Funds Theory underestimates the potential for banks to influence the economy through their lending practices. It also overlooks the possibility that banks can contribute to economic bubbles by extending credit beyond what is sustainable. By understanding that banks create money, policymakers can better design regulations to curb excessive lending and prevent financial crises.
  3. Policy Shifts: Keen’s rejection of the Loanable Funds Theory implies a significant shift in economic policy. It calls for more active regulation of banking practices and a rethinking of monetary policy. Instead of focusing solely on controlling the money supply through interest rates, policymakers should also consider direct measures to control credit creation and manage the health of the financial sector.

Broader Relevance

Steve Keen’s critique of the Loanable Funds Theory is part of his larger argument against the neoclassical focus on equilibrium and rationality. By challenging this fundamental economic theory, Keen not only highlights the active role of banks in the economy but also stresses the need for a more accurate understanding of financial instability and debt dynamics.

The rejection of traditional views like the Loanable Funds Theory showcases Keen’s innovative approach to economic issues and his commitment to developing a more realistic framework for understanding and managing the economy.

Debt-Deflation Theory of Economic Crises

Steve Keen’s exploration of the Debt-Deflation Theory of Economic Crises adds another layer to his comprehensive critique of mainstream economic thought. This theory, originally developed by Irving Fisher in the 1930s, resonates deeply with Keen’s views on the central role of debt in economic dynamics. Let’s unpack Keen’s adaptation and emphasis on this theory.

Understanding Debt-Deflation Theory

The Debt-Deflation Theory posits that significant economic crises often stem from the deleveraging process following a build-up of substantial debt. As debt levels rise, they may initially fuel economic expansion by increasing spending and investment. However, once these debt levels become unsustainable, a period of deleveraging begins, where borrowers reduce their spending to pay down debt. This reduction in spending leads to falling prices (deflation), which can exacerbate the debt burden by increasing the real value of debt, leading to a further reduction in spending and potentially triggering a deep economic downturn.

Keen’s Interpretation and Expansion

Steve Keen integrates Fisher’s theory with Minsky’s insights, arguing that not only is debt-deflation a normal part of capitalist economies, but it is also greatly exacerbated by the banking sector’s lending practices and the resulting cycles of credit expansion and contraction.

  1. Link to Minsky’s Financial Instability Hypothesis: Keen sees Minsky’s Financial Instability Hypothesis as a precursor to debt-deflation scenarios. During periods of economic stability and growth, banks and borrowers become overly optimistic, leading to increased leverage and higher debt levels. Once these debts become unmanageable, the system moves towards a Minsky moment—a sudden collapse of asset values and a rush to deleverage.
  2. Economic Modelling of Debt Dynamics: Keen uses dynamic systems modelling to demonstrate how debt levels interact with economic variables. His models show how initial debt-fueled growth can turn into a rapid contraction as parties scramble to reduce their debt levels, causing widespread economic fallout. This approach underscores the importance of including debt dynamics in economic models, which are often overlooked in neoclassical frameworks.
  3. Policy Implications: Recognizing the patterns of debt-deflation suggests that economic policies should focus more on the regulation of lending and debt accumulation rather than merely managing inflation and growth. Keen advocates for policies that could prevent excessive debt build-up, such as tighter lending standards and debt relief mechanisms, to avert severe debt-deflation spirals.

Broadening the Economic Perspective

By advocating for the integration of the Debt-Deflation Theory into modern economic analysis, Keen challenges the optimistic assumptions that underpin much of mainstream economic policy. His focus on the dangers of debt and deflation provides a sobering counterbalance to models that emphasize equilibrium and stability.

The broader relevance of this theory in Keen’s work is its call for a paradigm shift in economics—a move towards models that genuinely reflect the volatility and vulnerability of financial systems. By acknowledging and addressing these dynamics, economists and policymakers can better prepare for and mitigate the impacts of financial crises.

As we have explored several key aspects of Steve Keen’s economic philosophies, let’s now move to summarizing their importance and wider significance in the next section, shedding light on how these ideas have influenced broader economic thinking and policy.

Importance and Wider Significance

Steve Keen’s critique of mainstream economics and his promotion of alternative theories such as those of Hyman Minsky and Irving Fisher represent more than an academic quarrel; they signify a profound challenge to the way economic policies are formulated and understood. Let’s explore the importance and wider significance of Keen’s ideas, considering their influence on economic thought, policy, and broader societal impacts.

Influencing Economic Thought

  1. Revitalising Heterodox Economics: Steve Keen is a prominent figure in the resurgence of heterodox economics, which challenges the predominance of neoclassical thought. His work has inspired a new generation of economists to explore alternative models that better account for financial instability, debt dynamics, and real-world economic complexities. This shift is crucial for developing more robust economic theories that can withstand the pressures and pitfalls of the 21st-century economy.
  2. Promoting Dynamic Systems Modeling: Keen’s advocacy for using dynamic systems to model economic processes has contributed to a growing interest in this area among economists. These models, which incorporate feedback loops, non-linear interactions, and time dynamics, offer a more realistic portrayal of economic phenomena than the static models commonly used in neoclassical economics. This methodological shift is significant as it allows for better predictions and understanding of economic crises and fluctuations.

Influencing Policy

  1. Rethinking Economic Policies: Keen’s work has significant implications for economic policy, particularly in the realms of financial regulation and macroeconomic stability. His emphasis on the dangers of high debt levels and his critique of the banking sector’s role in creating financial bubbles have led to calls for more stringent controls on credit creation and more proactive approaches to debt management.
  2. Influence on Economic Reforms: In the wake of the 2008 financial crisis, which Keen notably warned about, there has been an increased openness among policymakers to consider reforms that address the issues Keen highlights, such as the need for better mechanisms to curb speculative lending and to manage financial cycles more effectively.

Broader Societal Impact

  1. Public Discourse and Education: Keen’s ability to communicate complex economic ideas in an accessible manner has helped raise public awareness about the limitations of traditional economic models and the potential dangers they pose if followed uncritically. His books and public speeches play a vital role in educating the public and encouraging more informed discussions about economic policies and their impacts.
  2. Influence on Political Movements: Keen’s ideas have resonated with various political movements that advocate for economic reform, particularly those concerned with inequality, sustainability, and financial stability. His critiques of conventional economic practices have provided a theoretical backbone for arguments in favour of more equitable and sustainable economic structures.

Steve Keen’s contributions to economics thus extend far beyond academic debates; they influence real-world policies and have a lasting impact on how society understands and manages its economic systems. The wider acceptance and integration of his theories could lead to more stable, sustainable, and equitable economic outcomes.

To further explore Steve Keen’s work, it’s beneficial to engage with a range of resources. Here’s a reading list and some online resources to help deepen your understanding of his economic theories.

Reading List
  1. “Debunking Economics” by Steve Keen – A comprehensive critique of mainstream economic theories.
  2. “The New Economics: A Bigger Picture” by David Boyle and Andrew Simms – Includes discussions on alternative economic ideas influenced by thinkers like Keen.
  3. “Can We Avoid Another Financial Crisis?” by Steve Keen – A concise exploration of how to prevent future economic crises by understanding the role of debt and financial instability.

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Online Resources:

Image attribution:MeJudice, CC BY 3.0, via Wikimedia Commons

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