Why neoclassical economics has failed - Book summary of The New Economics by Steve Keen

This is a good book. In "The New Economics," Steve Keen methodically pulls apart the ideas underpinning neoclassical economics from a number of different angles. One of the key themes is that the linear mathematics of neoclassical ideas, such as supply and demand curves, create a false impression of our economy as naturally tending towards equilibrium. A more accurate description and mathematics would resemble the kind of non-linear equations that give rise to the endlessly dynamic behaviors of the strange attractor of the Lorenz equations. In this video, I will provide a high-level summary of some of the major flaws of neoclassical economics that Keen lays out. Roughly echoing the structure of the book, we will explore how money is created, model the complexity of the economy, examine the role of energy, and discuss the fascinating gap between the rhetoric and mathematics of neoclassical economics.

But first, what motivated Keane to write this book? One of the most damning recent charges against mainstream neoclassical thinking is that it completely failed to predict the 2007 global financial crisis. The crisis and the sluggish recovery from it surprised both the economists who advise governments on economic policy and the academics who develop the theories and write the textbooks that train new economists. Not only had they expected a continuation of the boom conditions that had preceded the crisis, they, in fact, believed that a crisis could not occur. Keane then makes comparisons with real sciences, where such a significant empirical failure would hasten a paradigm shift, as it would become untenable to ignore the gap between the dominant theory and reality.

Keene's frustration is that, except for a periphery of scattered heterodox academics, the majority of mainstream economists seem determined to cling to ideas from the neoclassical approach, despite the mounting empirical and theoretical evidence against it. This isn't just some quaint academic dispute. The ideas of economics often underpin major political choices that impact millions of people's lives and indeed our relationship with the biosphere. They shape many of the dynamics and incentives of our society. If we don't improve our understanding and, thereby, our policies around our political economy, we have no hope of changing the perverse incentives that are driving so many parts of the metacrisis we are facing.

I completely share Keane's agenda to find a new economics. Next, let's look at some of the theoretical arguments against the dominant neoclassical paradigm. Money is a strange phenomenon; it is such an important aspect of modern life, unfortunately. Yet, it still seems to be quite peculiar.

It seems to be so widely misunderstood. The critical misconception at the heart of near-classical thinking about money is that we should think of it as a promissory note standing in place of a commodity, typically gold. Now, of course, this can be a useful and simple way to think about money as a first approximation, and there have been times in history in many countries where the currency has indeed been backed by or simply made of gold or silver. However, this hasn't been true for dollars or pounds for over 50 years, and it was often not true for many currencies in the past.

Keane references the work of Professor Christine Desanne, who highlights the coinage of the 8th-century King Offa as a good example of a fiat currency that enabled a thriving economy without being backed by the silver from which the coins were made. What gave the coin value was not the commodity it contained; the coin was valued at more than the silver’s worth, but rather by the kingdom itself, which was established as much by the power of the coin as by the power of the sword. What enforced the use of the coin was both its creation by the kingdom and the requirement that taxes be paid in coin, replacing a previous practice of forced appropriation. Thus, instead of thinking about money as merely a token representing gold, Keane and many others argue that the dependable value of fiat currency is actually backed by the power and authority of the issuing state. Especially in today's world, where we so rarely handle actual notes or coins, money is best understood and modeled in terms of the double-entry bookkeeping of the banks that keep the records of how much money each of us actually has.

Talking about modeling, another thread of the book is Keane's introduction to and use of an open-source program called Minsky, named after the economist Hyman Minsky. Keane developed the program with his colleagues in order to construct dynamic models of the economy using Godley tables to perform the double-entry bookkeeping of the entities in the economy. While I am using the Minsky program for some of the graphics in this video, I will not go into greater detail about it or the specifics of the models that Keane introduces in his book. Instead, I want to provide a quick overview of how the creation of money by private banks is conceptualized using simpler graphics. The economist Wynne Godley developed the Godley tables as a way to keep track of the stocks and flows within an economy.

For each entity in the economy, their stocks represent their total assets, which are the value of things that belong to them, and their liabilities, which are the things that they owe to other people. The difference between these two is known as their equity or net worth, representing the value of what they own outright after accounting for what they owe to others. To remain consistent, assets minus liabilities minus equity must always equal zero. The flows consist of the double-entry transactions that update these stocks. In our simple example here, we will imagine a private bank that starts off with $100 of assets as its initial equity. At the bottom, I will keep a running total of the transactions.

Then imagine a client named Bill comes along and deposits $100 into his account. This adds to the assets of the bank but also creates an equal and opposite liability for the bank in Bill's client account. It's a liability for the bank since someday Bill may come and ask for his money back. Now let's imagine they also have a second client, Jane, who initially deposits $200. If Bill goes to Jane's shop and buys some goods for $20, then the transaction representing this use of money in the shop is simply a debit from Bill's client account and a credit to Jane's account.

The total liability of the bank and the total existing money remain the same. In the modern world, this is essentially what money and the use of money are. Double-entry accounting is conducted by updating rows in the databases of banks. Coins and notes are now just rare special cases of this double-entry accounting. Actual cash is, in some sense, no more complex to understand than a general gift token that everybody must accept.

The significant dynamics of money are now all digital. So, how do private banks actually create money? Well, imagine that Jane wants to expand her shop and so asks to borrow $1,000 from the bank. This is done through double-entry updates to the bank's balance sheet. This time, there's an increase in the liability of what the bank now owes Jane of $1,000.

But the bank also gains a new asset: the $1,000 interest-bearing debt that Jane now owes back to the bank. It is an asset because other banks, for example, may well be happy to buy the debt, especially if it is a good debt that will be worth more than the original $1,000 due to the additional interest that Jane will also have to pay as the cost of borrowing. However, notice that in our example, if we roll back a bit before lending the money to Jane, the bank did not have $1,000 to lend out. It only had $400 in total assets beforehand. Therefore, it didn't really use other people's money to lend to Jane.

The bank simply created the money by updating their liability to Jane in her bank account. However, this extra liability was offset by the new debt asset of the bank, so the bank's equity, or its own net worth, hasn't changed. In the book, Keane points out that there's an important difference between this view of money creation by private banks and the standard narrative from neoclassical economics. The narrative suggests that private banks only create money by loaning out deposits from other clients. This loanable funds perspective indicates that private banks only multiply the money originally created by the central bank.

Of course, there are details I'm skipping over in this simple example, such as the role of reserve ratios and the ways that private banks link back to the central bank of the government, which actually stands behind the currency and also, of course, creates new money. What's important here is that the traditional economics perspective wants to see money and private banks as mere lubricants to the trade between participants in a market—a mere veil over barter. They therefore think that the private banks' macro-level impacts can mostly be abstracted away. Keane, for example, highlights this quote from Nobel Laureate Paul Krugman, a very prominent and well-known economist, talking about private debt. Think of it this way.

When debt is rising, it's not the economy as a whole borrowing more money. It is, rather, a case of less patient people—people who, for whatever reason, want to spend sooner rather than later—borrowing from more patient people. To be clear, Krugman isn't exactly a fan of neoclassical economics either. However, this quote from Krugman highlights just how widespread the idea is that private banks don't really create new money and new debt through lending. They're just moving money around.

In this view, only the central bank truly creates new money. This is one reason why many economists remained relatively calm about the significant build-up of private debt just before the 2007 crash. Mainstream economists were more focused on the supposed end of the boom and bust cycle, with ever-decreasing volatility in some key economic indicators, which gave the impression of a global economy moving toward equilibrium—a trend labeled "the Great Moderation." In contrast, Keane notes that rising private debt, not rising government debt, is the main indicator of an approaching crisis. Private debt, rather than government debt, can depress economic activity when it becomes too high.

Keane goes on to show that with the correct modeling of private debt, it becomes clear that the creation and destruction of money by private bank lending naturally leads to unstable dynamics. Keene describes in his book a model that captures more of the non-linear impacts that private debt can have on the economy. In particular, Keene notes that in this model, while at first the size of successive recessions reduces, just like before the 2007 crash, after a while the recessions grow larger again. Even without an external exogenous shock, no equilibrium is ever reached because the real economy behaves more like the strange attractor of the Lorenz equations. So Keane is very critical of the way that mainstream economists think about and model money, saying, for example, that money is only introduced in mainstream economics when explaining inflation, which is blamed on the currency issuer creating too much money too quickly relative to the real rate of growth of the economy.

Now, inflation is another whole monetary dynamic that I will make more videos about someday. But it's worth noting that Keynes' views here have some significant overlap with modern monetary theory. Keane makes a number of references to Stephanie Kelton's excellent book *The Deficit Myth,* which I have already reviewed and should be linked to above. Getting back to Keane's book, another theme of his critique of neoclassical economics is not just about the type of mathematical modeling used, but also the particular simplifications that they employ in order to build their models. We've already seen the loanable funds simplification for private bank lending.

I want to mention two others here that Keane discusses and that I think are particularly noteworthy. The first oversimplification is quite amusing. Neoclassical theorists would like to derive the macro-level supply and demand curves of a market from the aggregation of the micro-level individual demand curves. Typically, increases in the price of a good lead to a decrease in an individual's demand for that good. The difficulty with this kind of aggregation is that each individual has a different set of preferences regarding how to spend any extra income they receive.

If you give $10 to a homeless person, they will spend it differently than if you give the same $10 to a billionaire. Similarly, if the price of apples increases due to higher demand, this will impact the income and purchasing preferences of someone whose business profits from apple sales differently than it would for other people. The effect will be more pronounced for those who sell more apples compared to others. However, you cannot simply aggregate all of the individual demand curves if their characteristics can vary so significantly. To handle this aggregation, neoclassical theorists have traditionally made a remarkable assumption, as highlighted by this quote that Keane takes from a neoclassical textbook on microeconomics.

Let us now hypothesize that there is a process—a benevolent central authority, perhaps—that, for any given prices \( p \), utilizes an aggregate wealth function \( w \) to redistribute wealth in order to maximize social welfare. Wealth redistribution is assumed in order to facilitate the mathematics needed to derive the supply and demand curve of the neoclassical free market. This is the very economics that underpins the Thatcher, Reagan, and neoliberal politics that the world has been living under for decades, which has actually resulted in massive increases in income and wealth inequalities since the 1970s. There is an extraordinary gap between the political rhetoric and the underlying mathematics. Keane obviously discusses this in more depth and provides additional examples of such simplifying assumptions that, on their face, appear absurd and also contradict the empirical evidence of what actually happens in our economy.

But there is one more of these oversimplifications that I want to mention here, which is around energy, resources, and waste. Adam Smith is seen by many as the father of economics, but Keen disagrees, arguing that it was Smith who introduced an unhelpful bias into economic thinking right from these early days, as Smith highlighted labor as the core engine of economic wealth creation in his labor theory of value. Whereas earlier pre-classical economists, the Physiocrats, highlighted land and other free gifts from nature as the fundamental input to the economy. Keen suggests that this early excessive focus on labor and capital is what led, through generations of economists, to the neoclassical models that now downplay or misunderstand the importance of energy and other natural resources in their models of production.

In contrast, Keane notes that any model of economics must be consistent with the second law of thermodynamics. Energy is required to perform useful work, and any use of energy can never be perfectly efficient, inevitably creating waste. The ultimate source of this energy is always a free gift from nature. Many mainstream economists have realized that energy is absent from the inputs of the models they use, but some standard approaches to rectify this simply add energy as a separate new input term alongside labor and capital.

And Keane argues that this completely misses the point because, as Keane puts it, capital without energy is a sculpture, and labor without energy is a corpse. These are great phrases. Thus, Keane suggests that to improve the standard models of production, the labor and capital input terms should be proportionate to their respective usage of energy. He states that energy can therefore be incorporated into the models of production simply by treating both labor and capital as means by which energy is harnessed to perform useful work. This approach aligns well with the following graph from the book, which shows how closely changes in GDP and changes in energy use are correlated. Furthermore, with the second law of thermodynamics in mind, Keane also notes that to produce output, we must create waste.

Waste can be minimized, but not completely eliminated. It must be dumped into the biosphere, at least while production occurs only on planet Earth. Otherwise, there can be no production. This leads to Keene referencing an interesting calculation by physicist Tom Murphy, who calculates that after 400 years of 2.3% economic growth, the amount of heat waste generated would mean that the surface of the Earth reaches boiling point. Murray's calculation has nothing to do with the greenhouse effect and climate change.

It's purely about the rate at which human economic activity generates waste heat compared to the rate at which the Earth can radiate heat out into space. Indeed, I read a similar kind of calculation about the physical limits to the growth of resource usage, even for space-faring civilizations, in the book *What We Owe the Future* by William MacAskill. In a few thousand years, there simply aren't enough atoms. There are indeed hard physical limits to long-term continuous economic growth. The idea that there are limits to growth has been known and debated for many decades.

And Keane, of course, references the famous 1972 "Limits to Growth" report by the Club of Rome, which earlier challenged the mainstream neoclassical orthodoxy of continual growth that ignores ecological limits and market externalities. Since then, we have experienced over 50 years of neoclassical business as usual, with neoliberal politics dominating much of the world's economy. Keane discusses this history, how neoclassical economic ideas have dominated the academic world, and how this has led many mainstream economists to be seemingly unconcerned about the prospects of significant climate change in the coming decades. While the limits to growth can be ignored in the short term, they are rooted in basic physics and ecology in the long run.

And today, 2024, marks, in the long run, 50 years since then. So we're getting dangerously close to, or even beyond, those limits now. This is why I completely agree with Keane that there is an urgent need for a theoretical revolution in the field of economics. Mainstream neoclassical economics has clearly been a part of the world and has failed to provide a good theory of the real political economy.

But it is not a trivial problem to replace it, and Keane isn't claiming to have all the answers. Rather, his book is a call to others to get involved in finding a better way of understanding and modeling our political economy so that we can learn to live in a fairer, more sustainable, and probably circular economy. That is certainly a project I want to be involved with where I can, and I will continue to follow this channel. If you're interested in this kind of thing, then Keane's book is well worth a read. But have you read it already?

And what did you think of his critique of neoclassical economics? Where do you think the possible solutions may lie? Please continue the discussion in the comments below. Thank you for watching.