A mathematician looks at economics and is baffled by what he sees.

A foundational principle of modern economics is that the creation of credit leads to economic growth. That precept underlies need for quantitative easing, and it is central to the question of what role monetary policy can and should play in stimulating a faster recovery from the Great Recession. It is also the subject of a debate between one of the world’s most prominent economic scholars, Paul Krugman, and a feisty Australian economist, Steve Keen.

Krugman is an unusually public figure for an academic. The Nobel Prize-winner and Princeton professor is also a widely-read New York Times columnist and prolific blogger, with the gift – unusual for someone in so wonky a profession – of clear and persuasive prose. He has earned a large and passionate audience, among them both ardent acolytes and rabid detractors. Krugman represents the mainstream of neoclassical economics, which believes that a combination of central bank monetary policy and government fiscal policy can moderate the business cycle.
 
Among the dissidents is Keen, the author of a provocative book, Debunking Economics. By his own admission, Keen is proudly out of the mainstream, but also able (“because of impediments like academic tenure,” he says in his book) to challenge it without fatal retribution. Keen thinks central bank controls are not as effective as Krugman believes, because private banks can create money in the form of debt through a process that is beyond the central bank’s control. Because of that, the economy will regularly experience “financial instability,” as advocated by Keynes’s disciple Hyman Minsky.

 The debate in the blogosphere between those in the Krugman camp and those in the Keen camp has generated more heat than light; but the core of the debate is whether or not private banks can create money “out of thin air” to their heart’s content, by extending credit – leaving the central bank with no choice but to sanction this money creation.

Read it at Advisor Persectives
An Attack on Paul Krugman
By Michael Edesess
May 15, 2012
(h/t paul in the comments)

...there are really two aspects to the debate. The first is the general charge that all of neoclassical economic theory is bankrupt because it is enthralled with equilibrium, and therefore it cannot model or understand the dynamic evolutionary economic process. That is to say, the essential nature of the economy is to be indisequilibrium, so theories obsessed with equilibrium cannot model it. 

This charge seems wholly valid to me. In answer to the mainstream’s deficiencies, Keen said in my interview with him, “I want to eliminate the neoclassical mainstream and replace it with a Schumpeterian dynamic growth evolutionary mainstream.”Schumpeter, you’ll recall, was the economist who coined the term “creative destruction” to characterize the capitalist economic process – a term beloved by nearly all economists, but of which it is difficult to find any trace in mainstream economic models. Says Keen, “Creative destruction doesn’t involve equilibrium, so they leave it out completely. It’s about how investment comes in pulses and waves … so you get an inherent explanation for the cyclicality of capitalism out of Schumpeter.” 

The second aspect is a chicken-and-egg problem: Do banks take in deposits and then lend, or do they loan first, then use the proceeds of the loan to create deposits? It is not merely a chicken-and-egg question – those, like Keen, who say banks can create money out of thin air also say that the central bank must condone, willy-nilly, this so-called “endogenous” money creation. Krugman, on the other hand, says the central bank can control the process. That is, he believes money is created only “exogenously” by the central bank. Keen is a disciple of Hyman Minsky, who was a disciple of John Maynard Keynes but also of Schumpeter. Minsky believed that this process of banks creating money, in the form of debt, would inevitably lead to frequent financial bubbles and crises. 

Judging from how much feverish blogging there has been surrounding the Keen-Krugman battle alone, this is a thorny question to resolve one way or the other. The amazing thing is that, in this debate, one side or the other will present what appears to be a very simple proof that they are right – and yet the other side is not persuaded in the least.

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I am particularly baffled by these debates, because my background is in pure mathematics. Economics pretends to be mathematics, but it is not mathematics. There is a major difference. No mathematician uses a term in a formula, or a statement of a theorem, unless that term has first been defined with excruciating precision. Hence, there is no question of what the term means, let alone any debate that is carried on only because two disputants have different concepts of the meaning of their terms. As a result, a very simple proof of something will invariably persuade the other side. The cost of this, however, is that mathematics is strictly limited in what it can define and prove. 

In economics, it is completely different. Terms are used in formulas without ever having been precisely defined. Economists may think they’ve defined them, but they should try reading some real mathematics to see what a precise definition truly is. The economists, I think, leave the work of definition to be inferred from the way the terms are used in the formulas. This, to me, is weird – but I suppose it could work, and it does work sometimes, but more often it leads to ridiculous debates that leave matters of real importance unexamined.

That seems to be the case in the Keen-Krugman faceoff. The most central terms – inflation and GDP – are so riddled with measurement problems that they are almost arbitrary fictions, a reality with which no one ever grapples. There is never so much as a nod to the fact that a large body of intelligent people believe that economic growth, by mathematical necessity, cannot continue forever, or even for long – yet efforts to define clearly enough what “economic growth” means in order to close the gap with this external (and sometimes internal) body of thought are rarely seen in debates among economists.

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The source of all the confusion, in my view, is the idea that if you can’t measure something and model it mathematically, it has no meaning. There is too much mathematics used and expected in economics, and too much of it is of poor quality and distorts the ideas it is meant to undergird. Keen agrees. “If you’re actually aware of the limitations of mathematics, you say, ‘Well, this is a guide, but I could have missed something,’” he told me. “So there’s more modesty in a proper non-equilibrium dynamic modeling approach than you’ll ever get out of neoclassical equilibrium modeling.”