Misleading Models

In Debunking Economics, Steve Keen gives two reasons why mainstream economists did not see the global financial crisis coming.

• The economic models of these economists assume that economies always move towards equilibrium. External shocks may push an economy away from equilibrium for a short time, but it will quickly adjust back towards equilibrium. A long-term economic depression cannot exist in these models, because they are always trending back to equilibrium.

  Keen quotes Robert Solow.

  I start from the presumption that we want macroeconomics to account for the occasional aggregative pathologies that beset modern capitalist economies, like recession, intervals of stagnation, inflation, ‘stagflation’… A model that rules out pathologies by definition is unlikely to help (p. 259).

  Keen also quotes Minsky
  

  Can ‘It’—a great Depression—happen again: And if ‘It’ can happen, why didn’t it occur in the 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 question, it is necessary to have an economic theory, which makes a great depression one of the possible states in which our type of capitalist economy can find itself (p. 381).

  Mainstream economists could not foresee the global financial crisis because their models could not forecast a crisis.

• The models of the mainstream economists did not include debt. They assume that money is neutral and does not affect the real economy. Likewise, debt is left out of their models, because they assume that it just shifts purchasing power from one person to another. They assume that debt does not affect the real economy.

  Keen quotes Paul Krugman as confirmation.
  

  Given both the prominence of debt in popular discussion of economic difficulties and the long tradition of invoking debt as a key factor in major economic contractions, one might have expected debt to be at the heart of most mainstream macroeconomic models—especially the analysis at the hear of monetary and fiscal policy. Perhaps somewhat surprisingly, however it is quite common to abstract altogether from this feature of the economy (p.321).

  Unfortunately, by leaving debt out of their models, they could not explain or foresee the effects of debt deflation.