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Reconciling Krugman and Keen
An analysis of the relation between debt and
    aggregate demand using nef model

            Emanuele Campiglio
             Giovanni Bernardo
               New Economics Foundation
                        London
                      23/07/2012
Outline

1.   Introduction: the Keen – Krugman debate
2.   The relation between debt and aggregate demand
3.   Our contribution to the debate
4.   The theoretical model
5.   Scenario simulations
6.   A step further: the supply side
7.   Conclusions


             Emanuele Campiglio – Giovanni Bernardo – New Economics Foundation
Introduction:
                 the two contenders
Paul Krugman, everybody knows him. Nobel Prize for
economics in 2008 for his work on trade and
international   economics.       Prolific   political
commentator, 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 example
where Population is a
stock, new born and deaths
are flows affecting the level
of the stock, and the rest of
variables are exogenous
parameters or defined by
simultaneous equations.


                   Emanuele Campiglio – Giovanni Bernardo – New Economics Foundation
Output,
                   inventories and sales
                                          Inventories
            Output                                                               Sales



First of all, imagine the production of
output as a flow of goods and service          Goods and services leave the
that enters a stock of inventories.            Inventories stock once they are
Imagine this as firms producing and            sold.
then storing their production in                        We will for now assume that
warehouses.                                             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 assume
Sales (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 that
firms pay no interests on
loans, but just have to
repay a portion of the debt            Debt                                        Credit
already contracted. Profits
less 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                                  Planned
Sales         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
                              Expenditure
Planned Aggregate Expenditure become Realized
Expenditure only in the following period. That is, Realized
Expenditures at time t are equal to Planned Expenditures at
time t-1.
                    Time t                                     Time t+1



                 Planned                                   Realized
                Aggregate                                 Aggregate
               Expenditure                               Expenditure

Remember that for the moment we are assuming that everything is demanded
can be found on the market, so everything that firms plan to spend (either
coming 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 t
Inventories 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 other
Inventories t+1                        variables are determined, including the
                   Sales t+1           new Planned Aggregate Expenditure.
                                       At time t+2 the Planned Expenditure
                                       become Realized Expenditure, and
Plus,         planned
                                       so on..
consumption at time t
becomes consumption
at t+1 and planned             Wages t+1                              Planned
investments at time t                                              Consumption t+1
become investments at
t+1.
Realized Consumption                                                                                Net
and Investments then     Profits t+1                                    Planned                    Credit
affect other model                                                   Investments t+1             Creation t+1
sectors, not shown
here.
                          Emanuele Campiglio – Giovanni Bernardo – New Economics Foundation
In analytical terms:
The model can be described by
the following equations:                                    Where:
                                                            S : Sales
1)    St = ERt                                              ER : Realized Expenditure
2)    Wt=α St                                               W : Wages
                                                            Π : Profits
3)    Πt=St-Wt                                              CP : Planned Consumption
4)    CPt=Wt                                                IP : Planned Investments
5)    IPt= Πt+ΔDt                                           D : Debt
                                                            CC : Credit Creation
6)    Dt+1 = Dt+CCt-DRt                                     DR : Debt Repayment
7)    DRt=Dt/r                                              EP : Planned Expenditure
                                                            and
8)    CCt=η(Πt-DRt)                                         α : Labor Share
9)    EPt=CPt+IPt                                           r : Debt Repayment Time
10)   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) = 0.7

Emanuele 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 Credit
Expenditure 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 if
Expenditure 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 t
Output 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 t
Output 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 constraint
170                                                                                     •   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 of
150
                                                                                            inventories is being depleted.
                                                                                        •   When Inventories run out, demand
140                                                                                         (Attempted Expenditure) can’t be
                                                                                            satisfied. Income ( = Realized
130
                                                                                            Expenditure) decreases.
                                                                                        •   Planned Expenditure also go
                                                                                            down, as Desired Investments
120                                                                                         become lower than Profits, thus
                                                                                            leading to a negative Net Credit
110                                                                                         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 conclusions
The 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, and
in 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

  • 1. Reconciling Krugman and Keen An analysis of the relation between debt and aggregate demand using nef model Emanuele Campiglio Giovanni Bernardo New Economics Foundation London 23/07/2012
  • 2. Outline 1. Introduction: the Keen – Krugman debate 2. The relation between debt and aggregate demand 3. Our contribution to the debate 4. The theoretical model 5. Scenario simulations 6. A step further: the supply side 7. Conclusions Emanuele Campiglio – Giovanni Bernardo – New Economics Foundation
  • 3. Introduction: the two contenders Paul Krugman, everybody knows him. Nobel Prize for economics in 2008 for his work on trade and international economics. Prolific political commentator, 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
  • 4. 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
  • 5. 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
  • 6. 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
  • 7. 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
  • 8. 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
  • 9. 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
  • 10. 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
  • 11. 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
  • 12. 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 example where Population is a stock, new born and deaths are flows affecting the level of the stock, and the rest of variables are exogenous parameters or defined by simultaneous equations. Emanuele Campiglio – Giovanni Bernardo – New Economics Foundation
  • 13. Output, inventories and sales Inventories Output Sales First of all, imagine the production of output as a flow of goods and service Goods and services leave the that enters a stock of inventories. Inventories stock once they are Imagine this as firms producing and sold. then storing their production in We will for now assume that warehouses. 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
  • 14. 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 assume Sales (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
  • 15. What happens to Profits? Profits (Π) Net Planned Profits (ΠN) Investments (IP) For simplicity, assume that firms pay no interests on loans, but just have to repay a portion of the debt Debt Credit already contracted. Profits less 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
  • 16. Planned Aggregate Expenditure Wages Planned Consumption Finally, Planned Aggregate Expenditure Planned Sales 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
  • 17. Realized Expenditure Planned Aggregate Expenditure become Realized Expenditure only in the following period. That is, Realized Expenditures at time t are equal to Planned Expenditures at time t-1. Time t Time t+1 Planned Realized Aggregate Aggregate Expenditure Expenditure Remember that for the moment we are assuming that everything is demanded can be found on the market, so everything that firms plan to spend (either coming from profits or new credit) is actually spent on something. Emanuele Campiglio – Giovanni Bernardo – New Economics Foundation
  • 18. The overall picture (time t) Realized Aggregate Expenditure t+1 Expenditure t Planned Aggregate All this happens during the same Expenditure t Inventories 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
  • 19. 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 other Inventories t+1 variables are determined, including the Sales t+1 new Planned Aggregate Expenditure. At time t+2 the Planned Expenditure become Realized Expenditure, and Plus, planned so on.. consumption at time t becomes consumption at t+1 and planned Wages t+1 Planned investments at time t Consumption t+1 become investments at t+1. Realized Consumption Net and Investments then Profits t+1 Planned Credit affect other model Investments t+1 Creation t+1 sectors, not shown here. Emanuele Campiglio – Giovanni Bernardo – New Economics Foundation
  • 20. In analytical terms: The model can be described by the following equations: Where: S : Sales 1) St = ERt ER : Realized Expenditure 2) Wt=α St W : Wages Π : Profits 3) Πt=St-Wt CP : Planned Consumption 4) CPt=Wt IP : Planned Investments 5) IPt= Πt+ΔDt D : Debt CC : Credit Creation 6) Dt+1 = Dt+CCt-DRt DR : Debt Repayment 7) DRt=Dt/r EP : Planned Expenditure and 8) CCt=η(Πt-DRt) α : Labor Share 9) EPt=CPt+IPt r : Debt Repayment Time 10) ERt+1=EPt η : Propensity to Invest Emanuele Campiglio – Giovanni Bernardo – New Economics Foundation
  • 21. 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) = 0.7 Emanuele Campiglio – Giovanni Bernardo – New Economics Foundation
  • 22. 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
  • 23. 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 Credit Expenditure 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
  • 24. 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
  • 25. 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 if Expenditure 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
  • 26. 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 t Output 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
  • 27. 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 t Output 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
  • 28. 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
  • 29. A supply constraint 170 • 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 of 150 inventories is being depleted. • When Inventories run out, demand 140 (Attempted Expenditure) can’t be satisfied. Income ( = Realized 130 Expenditure) decreases. • Planned Expenditure also go down, as Desired Investments 120 become lower than Profits, thus leading to a negative Net Credit 110 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
  • 30. Some conclusions The 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, and in 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.