Reconciling Krugman and Keen using nef model

Reconciling Krugman and KeenAn analysis of the relation between debt and aggregate demand using nef model Emanuele Campiglio Giovanni Bernardo New Economics Foundation London 23/07/2012

Outline1. Introduction: the Keen – Krugman debate2. The relation between debt and aggregate demand3. Our contribution to the debate4. The theoretical model5. Scenario simulations6. A step further: the supply side7. Conclusions Emanuele Campiglio – Giovanni Bernardo – New Economics Foundation

Introduction: the two contendersPaul Krugman, everybody knows him. Nobel Prize foreconomics in 2008 for his work on trade andinternational economics. Prolific politicalcommentator, he writes a blog in the New York Times(link). Steve Keen, professor in economics and author of “Debunking Economics”. Keen is developing a formal analysis of the intuitions of American economist Hyman Minsky (1919- 1996), focusing on the role of debt in macroeconomic dynamics. A quite recent version of the model can be downloaded here. Emanuele Campiglio – Giovanni Bernardo – New Economics Foundation

The bone of contention• In March/April 2012 the two have been the protagonists of a heated debate on money, debt and aggregate demand.• All was sparked 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.• Krugman disagreed, and replied with a post on his NYT blog. Keen replied to Krugman, and so on. The feud went on for a while, involving other economists and generating a wide debate on the blogosphere.• A (slightly pro-Keen) chronological summary can be found at this link. Emanuele Campiglio – Giovanni Bernardo – New Economics Foundation

Debt and aggregate demand• What is Keen’s idea exactly, and why has it generated such a passionate reaction from Krugman?• A formal explanation by Keen can be found here, but in a nutshell, what Keen argues is that the aggregate demand in an economy can be different from income, and that the difference builds up to the net change in the level of debt.• In other words: Aggregate Demand = Income + Net change in debt AD=Y+ΔD• This sounds very different from what Krugman so often repeats: “Your spending is my income, and my spending is your income”.• Although both Keen and Krugman can be considered as “demand-side economists”, their visions are strongly different when it comes to debt and how this affects the economic dynamics. As Krugman himself wrote in one of his blogs: “Keen then goes on to assert that lending is, by definition (at least as I understand it), an addition to aggregate demand. I guess I don’t get that at all. (..) I think it has something to do with the notion that creating money = creating demand, but again that isn’t right in any model I understand.” Emanuele Campiglio – Giovanni Bernardo – New Economics Foundation

Our contribution (1)• In this presentation we use nef macroeconomic model to clarify Keen’s analysis. We do so by explicitly identifying two different variables: 1. Realized expenditures (ER); 2. Planned (or desired) expenditures (EP).• We show how 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.• Using numerical simulations, we show 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 at the end of each period recorded income will be equal to recorded expenditure. 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. Emanuele Campiglio – Giovanni Bernardo – New Economics Foundation

What is demand?• The question then becomes: What is the right definition of Aggregate Demand?• We tend to agree with Keen on this: planned expenditures (what firms, households and governments plan today to spend tomorrow) are the crucial variable when defining the aggregate demand of an economy.• As Hyman Minsky put it: “For real aggregate demand to be increasing, (..) it is necessary that current spending plans, summed over all sectors, be greater than current received income and that some market technique exist by which aggregate spending in excess of aggregate anticipated income can be financed.” (Minsky, H. P., 1982, Can "it" happen again? : essays on instability and finance. Armonk, N.Y., M.E. Sharpe) Emanuele Campiglio – Giovanni Bernardo – New Economics Foundation

Banks and credit• Who finances the gap between the current spending plans and current income? Banks.• The private banking system is responsible for the creation of the overwhelming majority of the money supply in circulation.• “By far the largest role in creating broad money is played by the banking sector.. When banks make loans they create additional deposits for those that have borrowed.”(Bank of England, 2007) Ryan-Collins et al. (2011) Where does money come from?, New Economics Foundation Berry et al. (2007) Interpreting movements in Broad Money, Bank of England Quarterly Bulletin 2007 Q3 Emanuele Campiglio – Giovanni Bernardo – New Economics Foundation

The role of banking• Krugman and Keen differ in the way they look at debt and banking.• As far as we understand, Krugman looks at banks essentially as intermediaries, moving money from where there is an excess of savings to where credit is needed.• This is a crucial role of banks, but that’s not all: banks are able to indipendently create new credit and allocate it in the economy, thus significantly influencing its shape. Ryan-Collins et al. (2011) Where does money come from?, New Economics Foundation Emanuele Campiglio – Giovanni Bernardo – New Economics Foundation

Our Contribution (2)• Our model explicitly includes the mechanisms through which banks create new money supply. We will here present a simplified version of the model that assumes no credit rationing, but if you want to have a taste of the overall structure you can read the presentation we gave at the Ecological Economics conference in Rio de Janeiro last June.• Our numerical simulations show that, in the simple model we present here, no growth can take place without the creation of credit by banks, the net change in the level of debt being the the crucial 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. Emanuele Campiglio – Giovanni Bernardo – New Economics Foundation

But enough with words: Let’s look at the model• nef has developed a consistent macro framework using system dynamics that we use for a variety of research questions.• The overall structure of the model is pictured below: Aggregate macroeconomic framework Sectoral accounts are connected to an macro “core unit” where demand, Production Demand Employment supply, investment and employment dynamics are modelled. Sectoral accounts Every agent in the economy is modelled using a double-entry Non Banks Central Gilt House financial Govern book-keeping representation in Bank sellers holds ment order to ensure consistency in firms the model.• We will here present a simplified version of our macro “core unit”, abstracting from the sectoral accounts. Emanuele Campiglio – Giovanni Bernardo – New Economics Foundation

A word on system dynamics• The model is built employing system dynamics, a methodology used to study the behaviour of complex systems and based on the explicit representation of feedback loops. Its basic units are: – Stocks and Flows (basically, differential equations) – Connectors (parameters or simultaneous equations)See this simple examplewhere Population is a stock,new born and deaths areflows affecting the level ofthe stock, and the rest ofvariables are exogenousparameters or defined bysimultaneous equations. Emanuele Campiglio – Giovanni Bernardo – New Economics Foundation

Output, inventories and sales Inventories Output SalesFirst of all, imagine the production ofoutput as a flow of goods and service Goods and services leave thethat enters a stock of inventories. Inventories stock once they areImagine this as firms producing and sold.then storing their production in We will for now assume thatwarehouses. supply is not an issue: everything that is demanded Output is produced according to some is available to be purchased. production function. We are currently using This is made to focus on the a standard Cobb-Douglas function of demand side dynamics. We physical capital and labour, but the will relax this assumption functional form is not relevant for the point later on. we want to make here. Emanuele Campiglio – Giovanni Bernardo – New Economics Foundation

Wages and Profits Planned Wages (W) Consumption (CP) Workers then plan their Sales are distributed among consumption on the basis workers and firms in the of their wages. For form of wages and profits.. simplicity, we assumeSales (S) that workers want to ..That is, in our model Sales consume their entire are always equal to Income. wage, without saving nor asking for loans. Profits (Π) Emanuele Campiglio – Giovanni Bernardo – New Economics Foundation

What happens to Profits? Profits (Π) Net Planned Profits (ΠN) Investments (IP)For simplicity, assume thatfirms pay no interests onloans, but just have torepay a portion of the debt Debt Creditalready contracted. Profitsless the repayment of debt Repayment (DR) Creation (CC)are equal to Net Profits. Net Profits are then entirely invested in new physical capital. If Therefore, Planned Investments are equal firms desire to invest more than to Profits plus Net Credit Creation, where their net profits they need to ask Net Credit Creation is equal to Credit banks for new loans. Creation less Debt Repayment. Emanuele Campiglio – Giovanni Bernardo – New Economics Foundation

Planned Aggregate Expenditure Wages Planned Consumption Finally, Planned Aggregate Expenditure PlannedSales is equal to Planned Consumption plus Aggregate Planned Investments. Expenditure Planned Profits Investments Planned Aggregate Expenditure represents the amount that agents today plan to spend tomorrow. Net Credit Creation Emanuele Campiglio – Giovanni Bernardo – New Economics Foundation

Realized ExpenditurePlanned Aggregate Expenditure become RealizedExpenditure only in the following period. That is, RealizedExpenditures at time t are equal to Planned Expenditures attime t-1. Time t Time t+1 Planned Realized Aggregate Aggregate Expenditure ExpenditureRemember that for the moment we are assuming that everything is demandedcan be found on the market, so everything that firms plan to spend (eithercoming from profits or new credit) is actually spent on something. Emanuele Campiglio – Giovanni Bernardo – New Economics Foundation

The overall picture (time t) Realized Aggregate Expenditure t+1 Expenditure t Planned Aggregate All this happens during the same Expenditure tInventories t period (time t) Sales t At time t+1 the Planned Expenditure become Realized Expenditure. Wages t Planned Consumption t Planned Net Profits t Investments t Credit Creation t Emanuele Campiglio – Giovanni Bernardo – New Economics Foundation

The overall picture (time t+1) Realized Aggregate Expenditure t+1 t+2 Planned Aggregate Expenditure t+1 In the same period (t+1) all the otherInventories t+1 variables are determined, including the Sales t+1 new Planned Aggregate Expenditure. At time t+2 the Planned Expenditure become Realized Expenditure, andPlus, planned so on..consumption at time tbecomes consumptionat t+1 and planned Wages t+1 Plannedinvestments at time t Consumption t+1become investments att+1.Realized Consumption Netand Investments then Profits t+1 Planned Creditaffect other model Investments t+1 Creation t+1sectors, not shownhere. Emanuele Campiglio – Giovanni Bernardo – New Economics Foundation

In analytical terms:The model can be described bythe following equations: Where: S : Sales1) St = ERt ER : Realized Expenditure2) Wt=α St W : Wages Π : Profits3) Πt=St-Wt CP : Planned Consumption4) CPt=Wt IP : Planned Investments5) IPt= Πt+ΔDt D : Debt CC : Credit Creation6) Dt+1 = Dt+CCt-DRt DR : Debt Repayment7) DRt=Dt/r EP : Planned Expenditure and8) CCt=η(Πt-DRt) α : Labor Share9) EPt=CPt+IPt r : Debt Repayment Time10) ERt+1=EPt η : Propensity to Invest Emanuele Campiglio – Giovanni Bernardo – New Economics Foundation

Some scenarios On the left, you can see how this reduced version of our model looks on the system dynamics software we’re using, Stella. For the first run, we set: • Initial Realized Expenditure: 100 • Initial level of debt = 0 • Infinite inventories (remember assumption: all demand is satisfied) • Eta (η) = 1.4 • Debt repayment time (r) = 5 • Alpha (α) = 0.7Emanuele Campiglio – Giovanni Bernardo – New Economics Foundation

1. Controlled growth 180 14 • Realized Expenditure is always equal to Income 170 12 (and to Sales of course). 160 • Planned Expenditure is 10 higher than Income.Expenditure and income 150 • The difference between Net credi creation 8 Planned Expenditure and 140 Income is equal to Net 6 Credit Creation (right Y- 130 axis). 120 4 • In this case Net Credit Creation converges to 2 110 zero in the long-term as debt and its repayment 100 0 become larger. 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 • Income (and the whole Realized Expenditures Planned Expenditures economy) grows until Income Net Credit Creation reaching a plateau. Emanuele Campiglio – Giovanni Bernardo – New Economics Foundation

2. Exponential growth 800 500 • Change of parameters: 450 700 o Eta = 2; 400 o r= 10. 600 350 • In this case the expansion of Net CreditExpenditure and income 500 Net credi creation 300 Creation (Credit 400 250 Creation growing at a faster pace than Debt 200 300 Repayment) allows for 150 exponential growth. 200 100 • But still the same 100 applies: 50 o Realized Expenditure = Income; 0 0 o Planned Expenditure > Income 0 1 2 3 4 5 6 7 8 9 10 o Planned Expenditure – Income Realized Expenditures Planned Expenditures = Net Credit Creation. Income Net Credit Creation Emanuele Campiglio – Giovanni Bernardo – New Economics Foundation

3. No growth 150 10 • What happens when eta = 140 8 1, that is firms invest just 130 6 their net profits and therefore no new credit is 120 4 created?Expenditure and income • The economy doesn’t grow! Net credi creation 110 2 100 0 • Recalling the Minsky quote: For real aggregate demand 90 -2 to be increasing, it is 80 -4 necessary that current spending plans be greater 70 -6 than current received income 60 -8 and that some market technique exist by which 50 -10 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 aggregate spending in excess of aggregate Realized Expenditures Planned Expenditures anticipated income can be Income Net Credit Creation financed.” Emanuele Campiglio – Giovanni Bernardo – New Economics Foundation

4. Decline 100 0 • If we allow for a 98 -0.5 positive value of initial 96 loans (D0=30), debt -1 repayment can bring 94 income down, even ifExpenditure and income -1.5 eta>1 (new credit is Net credi creation 92 created). In this case 90 -2 eta=1.1. 88 -2.5 • That is, when Net 86 Credit Creation is -3 negative (look at the 84 right Y-axis) Planned 82 -3.5 Expenditures are lower than 80 -4 income, and this 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 brings the economy in Realized Expenditures Planned Expenditures a recession. Income Net Credit Creation Emanuele Campiglio – Giovanni Bernardo – New Economics Foundation

A step further: Supply As we have seen, Planned Realized Aggregate Expenditure at t-1 Aggregate determines Realized Aggregate Expenditure t Expenditure at t. Planned Aggregate Expenditure t-1 Inventories tOutput t Sales t That’s not all. In our macro model Planned Expenditure is also used by firms to decide how many workers they want to hire. Employment t Capital Stock t Together with the Capital Stock (whose dynamics is governed by investments and depreciation) these two factors of It’s reasonable to say that in the model production determine the level of output. supply adapts to demand dynamics. Emanuele Campiglio – Giovanni Bernardo – New Economics Foundation

Some adjustments Attempted But let’s keep it simple and Realized forget about the adjustment of Aggregate production factors for a Expenditure t moment. Planned Aggregate Expenditure t-1 Inventories tOutput t Sales t We rename Realized Aggregate Expenditure as Attempted Aggregate Expenditure. That is, Planned Expenditure at time t-1 is what the economy tries = Realized to spend at time t. If there is enough output, every Expenditure attempted expenditure will be realized; The point that we want to otherwise, just a portion of it. make here is that this representation is also capable Sales, which are still equal to Aggregate Income by of modelling the case in which definition, are now redefined as the minimum in the economy suffers from a between the Attempted Expenditure and Output plus supply bottleneck and it’s not Inventories. This allows us to take into account that possible to satisfy the entire it’s not possible to purchase what hasn’t been demand. produced. Sales are now the Realized Expenditures. Emanuele Campiglio – Giovanni Bernardo – New Economics Foundation

A simple example• For the first 10 periods of the simulation, output is set to be equal to whatever the economy attempts to spend in that period. We are in the same situation as previous simulations, where supply always satisfies demand.• At time 10, we impose a shock: supply is now capable of satisfying just 90% of demand (Attempted Expenditures).• At time 13, the situation goes back to the previous situation: supply is able to satisfy the entire demand again.• All the parameters and initial values are set equal to Scenario n.1 (Controlled growth). The initial value of Inventories is set equal to 30. Emanuele Campiglio – Giovanni Bernardo – New Economics Foundation

A supply constraint170 • The shock imposed to output appears very clearly.160 • For a couple of periods, the economy doesn’t seem to suffer much: this is because the stock of150 inventories is being depleted. • When Inventories run out, demand140 (Attempted Expenditure) can’t be satisfied. Income ( = Realized130 Expenditure) decreases. • Planned Expenditure also go down, as Desired Investments120 become lower than Profits, thus leading to a negative Net Credit110 Creation. • With a lag of one period, also Attempted Expenditure drops.100 • At period 13, when the shock is 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 over, there’s little left to do: the Output Attempted Expenditure economy is stuck in a steady state Planned Expenditure Income (Realized Expenditure) that is lower than the potential one. Emanuele Campiglio – Giovanni Bernardo – New Economics Foundation

Some conclusionsThe model presented here is very simple and characterized by a variety of limiting assumptions: – There are no interest payments; – The demand for loans is completely satisfied by banks; – There is no price dynamics; – etc.Still, we believe it’s capable of grasping some core features of how modern economies work, andin particular the role of debt in influencing aggregate demand. We have also been able to:• Clarify Keen’s analysis by explicitly separating realized and planned expenditures.• Show how Keen and Krugman have different definitions of aggregate demand.• Show through numerical simulations that both Keen and Krugman are right in their own logic: – Realized Expenditure (Krugman’s Aggregate Demand) is equal to Aggregate 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.• 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.• Show how in our simple model no growth can take place without the creation of credit by banks. The net change in the level of debt (Net Credit Creation) is the single most important variable affecting the dynamics of the economy.• Expand the framework to include the supply side of the economy, and show how a production bottleneck could complicate the dynamics.

Thank you!emanuele.campiglio@neweconomics.org www.neweconomics.org

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Reconciling Krugman and Keen using nef model

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