Steve Keen on Private Debt, Money Creation and Debt Jubilees

Steve Keen, an economist with a background as a potential professional tennis player, holds a unique perspective on economics, particularly his admiration for Karl Marx's economic insights, despite personally opposing Marxism. He is known for his ability to identify both the strengths and weaknesses in Marx's theories, even pinpointing the exact moment where Marx's logic diverged. Keen is recognized for accurately predicting the 2008 financial crisis, though he did not personally profit from this foresight as he avoids the stock market.

The Flawed Understanding of Debt and Money Creation

Keen argues that mainstream economists consistently misunderstand how economies function, particularly regarding debt and money creation. He believes that economic textbooks are fundamentally flawed in their depiction of these processes.

The Core Misconception: Banks as Intermediaries

The central misunderstanding, according to Keen, is the belief that banks merely act as intermediaries, lending out existing deposits. This view, he contends, leads to an incorrect understanding of the economy. Instead, banks create money ex nihilo (out of thin air) when they issue loans. This means that private debt, not government debt, is the crucial factor to monitor for understanding economic cycles.

Government Debt vs. Private Debt

Keen challenges the common warnings about government debt, such as those issued by the Government Accountability Office (GAO). While he agrees that a crisis is coming, he asserts it will be a private debt crisis, not a government debt crisis.

He explains that when the government creates money (through deficit spending), it directly contributes to GDP growth. His mental model for GDP is:

GDP = Amount of Money in the System × Velocity of Money

In this model, government debt injects money into the system, thereby increasing GDP. Therefore, he argues, it is illogical to claim that government debt growth is inherently problematic, as it is a function of growing GDP.

The GAO's Flawed Projections

Keen criticizes the GAO's projections, which show government debt growing exponentially and becoming unsustainable. He points out that these models are ahistorical, as historical data shows fluctuations in debt-to-GDP ratios, not continuous upward trends. He also highlights that these projections are based on a flawed understanding of money creation, which is taught in universities and perpetuated by mainstream economists.

Double-Entry Bookkeeping and the Reality of Money Creation

Keen emphasizes the importance of understanding double-entry bookkeeping to grasp how banks truly operate. He explains that every financial claim is both an asset and a liability. When debt is created, both an asset and a liability come into existence. Conversely, when debt is paid off, both the asset and liability disappear, meaning the money ceases to exist.

This concept is crucial because if money is destroyed when debt is repaid, then paying off debt reduces the amount of money in the system, which in turn slows GDP.

The Bank of England's Confirmation

Keen notes that his long-held critique of mainstream economics was validated in 2014 when the Bank of England published a report titled "Money Creation in the Modern Economy." This report explicitly stated that banks do not simply act as intermediaries lending out deposits, nor do they multiply central bank money. It criticized the "loanable funds" and "money multiplier" models commonly used by economists as incorrect.

The Impact of Private Debt on the Economy

Keen argues that ignoring private debt leads to a fundamental misunderstanding of macroeconomic dynamics. He demonstrates a strong correlation between private credit and unemployment:

• As private debt increases: People have more money, leading to increased spending, which allows companies to employ more people.
• As private debt decreases: People have less money, leading to reduced spending, which forces companies to hire fewer people.

This relationship suggests that private debt creation is a primary driver of economic activity and employment.

The Role of Interest Rates and Psychological Factors

While Keen acknowledges the impact of interest rates on borrowing, he tends to downplay their role in his simplified models. He believes that higher interest rates make borrowing more expensive, leading to less borrowing, as seen in the housing market. However, he also recognizes the psychological aspect, citing Japan's prolonged economic stagnation due to a collective aversion to debt after its 1989 bubble burst, despite low interest rates.

The Concept of Debt Jubilees

Keen proposes the idea of "debt jubilees" as a mechanism to manage the economic system. He suggests that government debt should be allowed to grow indefinitely, as it injects money into the system and boosts GDP. However, to prevent the system from becoming unsustainable due to ever-increasing interest payments, he advocates for periodic debt jubilees.

One specific proposal involves giving every citizen a substantial check (e.g., $100,000) with strict conditions: it must be used to pay off existing debt or invested in companies that then pay down their debt. This, he argues, would inject equity into companies and stimulate the economy.

The Dangers of Unconstrained Debt and Inflation

The discussion also touches upon the complexities and potential pitfalls of such a system. While injecting money can stimulate the economy, it can also lead to inflation if not managed carefully. The example of the COVID-19 pandemic is used to illustrate this:

• 2008 Financial Crisis: The bailout injected money into an economy with "slack demand," leading to economic recovery without significant inflation.
• COVID-19 Pandemic: A massive injection of money, coupled with supply chain disruptions and reduced production, led to a 30% jump in prices, demonstrating that more money chasing fewer goods results in inflation.

The psychological impact of debt jubilees is also considered. If people know their debts will be periodically cleared, it could lead to reckless spending and a "moral hazard," where individuals take on excessive debt without fear of consequences, further exacerbating inflation and economic instability.

Conclusion

Steve Keen's central argument is that mainstream economics fundamentally misunderstands money creation and the role of private debt. He contends that banks create money when they lend, and this private debt is a critical driver of GDP and employment. Ignoring this reality, as mainstream economists do, leads to flawed economic models and policy recommendations. While his ideas, particularly debt jubilees, present complex challenges and potential risks like inflation and moral hazard, they offer a different framework for understanding and managing modern economies.