Steve Keen Continues in the Wrong Direction

Steve Keen has a new paper out.  Some of this simply restates points he has made before, but it also includes a revision to his controversial claims about the relationship between aggregate demand and debt.

The good news is that his new formulation avoids some of the glaring accounting contradictions of his previous work.  However, I'm disappointed that he appears to have moved even closer to relying on the quantity theory of money as the basis of his explanation for the importance of debt.  His new equation (0.15 in his paper) is essentially:

                                AD_t = Y_t-1 + v_t . ΔD_t

where AD is aggregate demand, Y is income, v is the velocity of circulation and ΔD is the change in bank lending, which Keen equates to the change in the money supply.  By referencing previous period income, rather than current, he avoids some of the problems he faced before and can therefore incorporate the usual convention that AD and Y are equal in any period.

It is perhaps worth noting that for this relationship to hold, velocity needs to be constant.  Otherwise, an additional term needs to be included to reflect the impact of any changes in velocity on the existing money stock.  It is not clear whether Keen disputes this, or whether he simply assumes constant velocity for convenience.

However, to me the bigger point is that, in his attempt to avoid his earlier accounting inconsistencies, Keen has ended up in a position which is essentially just old fashioned monetarism.  I think this is a great shame. 

Part of the problem with this approach is that Keen is forced into making a qualitative distinction between bank lending and non-bank lending.  Central to his analysis is the idea that bank lending creates money and non-bank lending doesn't.

The main difficulty with this approach in the context of a modern monetary economy is the fact that this distinction is very blurred.  It would be one thing if Keen was to specify that what matters as money is the total balance of transaction accounts.  But in fact he has to define it to include all bank deposits including term deposits.  This is because he wants to rely on a close relationship between bank loan volumes and money.  Bank loan volumes are closely related to the volume of bank deposits; the relationship with transaction account balances is much more vague, as bank customers can easily switch between sight and time deposits.

But focussing on total bank deposits as a uniquely important causal factor in aggregate demand is difficult to sustain.  An important part of the story of the crisis was the growth of close substitutes for bank deposits in the form of reverse repo and ABCP with the shadow banking sector.  It is hard to argue away the impact of the lending ultimately funded by this type of asset.

All lending generates new financial assets for end investors, whether that's bank deposits, bonds, money market funds or something else.  It may well be the case that these assets are not all the same in the impact they have on the ongoing savings ratios of the non-financial private sector.  But it is a question of degree.  It is quite wrong to suggest that there is some distinction in the mechanical process by which they arise, which makes some assets count and others not.  If we believe that, we risk overlooking some of the most important implications of developments in financial markets.

The relationship between lending and aggregate demand is a rich and intricate one.  More needs to be done to shed light on it.  Steve Keen started with a good intuition, but he has taken a wrong turning and ended up with a outdated and dubious theory.