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Monday, December 7, 2009

Transcript: 330 The Dynamics of Debt with Steve Keen

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Now we have learned that money is not created the way the Fed thinks it is.  We're going into that in more detail on Friday.  Today we're going into the work of Steve Keen on another issue the Fed and its chair do not have on their spreadsheets -- the cause of the Great Financial Crisis.

[The following is basically an abbreviation of Keen's most recent monthly Debtwatch report.  I'm going to dispense with the quote unquotes, but the great majority is Keen's work.]

Steve Keen is associate professor of Economics & Finance at the University of Western Sydney, and author of the popular book Debunking Economics.  His Debtwatch blog is excellent.  And for your iPod download the six episodes of the Debtwatch podcast.  They are dated, but it makes the accuracy and insight all the more impressive today.

Keen first looked at the debt to GDP ratio as he was preparing for testimony on predatory lending.  It opened his eyes.  Australia's relation of debt to growth was exponential.

"I expected that the situation in America would be as bad or worse," he said, "which was confirmed by a quick consultation of the Federal Reserve’s Flow of Funds data. Though not as obviously exponential as in Australia’s case, the correlation with simple compound growth was still 98.8%."

some of the charts are on the blog.  Demandsideblog.blogspot.com.

In 1955, debt was 60 percent of GDP.  In 1970 it reached 100 percent.  A spike the the ratio coincided with the stock market collapse of 1987, when debt to GDP reached 150.  The only real rest in its climb came in the first term of Bill Clinton.  But in 1996 it took off again, reaching 200 percent in 1999 and then 250 percent six years later in 2005.  It peaked in early 2009 at about 295 percent.

"Having driven demand higher every year since the 1990s recession by rising and rising faster than nominal GDP, private debt is now falling and reducing aggregate demand. This is deleveraging at work, and it is the force that governments are trying to resist by boosting their own spending as private spending stagnates."

A look at the historic charts demonstrates that n the U.S. the only challenge to the current ratio was in the 1929-1932 period, when debt to GDP reached 235 percent.  The great part of the damage was done in 1929, when the ratio was only 160.  It was the collapse of GDP, not the rise of debt thereafter that ballooned the ratio.

But this is not even on the Neoclassical charts.  Why?  Let's start an explanation with

Steve Keen's three key neoclassical myths

According to Keen, these suffice to explain why the Fed specifically and the Neoclassical economists in general, do not understand the dynamics of our credit driven society. They believe that:

(1) The nominal money supply doesn’t affect real economic output;

(2) The private sector is rational while the government sector is not; and

(3) That they can model the economy as if it is in equilibrium.

The first myth means that they ignore money and debt in their mathematical models: most neoclassical models are in “real” terms and completely omit both money and debt. So since debt doesn’t even turn up in their models, they are unaware of its influence (even though their statistical units do a very good job of recording the actual level of debt).

The second myth means that they are quite willing to obsess about government debt, but they implicitly believe that private debt has been incurred for sensible reasons so that it can’t cause any problems.

The third myth means that they ignore evidence that indicates that the economy is very far removed from equilibrium, and they misunderstand the effect of crucial variables in the disequilibrium environment in which we actually live.

And Keen challenges Baffled Ben Bernanke as an expert on the Great Depression.

[The following is largely verbatim from Debtwatch 40.]

Ben Bernanke got his current position largely on the basis of his reputation as an expert on the Great Depression. In his Essays on the Great Depression, he explained why most economists ignored Irving Fisher’s theory of how the Depression occurred–which emphasised the importance of debt and deflation:

[now quoting Bernanke]

“...Fisher envisioned a dynamic process in which falling asset and commodity prices created pressure on nominal debtors, forcing them into distress sales of assets, which in turn led to further price declines and financial difficulties. His diagnosis led him to urge President Roosevelt to subordinate exchange-rate considerations to the need for reflation, advice that (ultimately) FDR followed. Fisher’s idea was less influential in academic circles, though, because of the counterargument that debt-deflation represented no more than a redistribution from one group (debtors) to another (creditors). Absent implausibly large differences in marginal spending propensities among the groups, it was suggested, pure redistributions should have no significant macroeconomic effects.” (Bernanke, 1995 p. 17).[1]

Though Bernanke notes that Fisher “envisioned a dynamic process”, his statement of why neoclassical economists ignored his theory is inherently couched in equilibrium terms–it sees debt-deflation as merely redistributing income from one group in society (debtors) to another (creditors).  How can aggregate demand fall so much, if all that is happening is a transfer of income and wealth from one group of consumers to another?

[But] when one thinks in truly dynamic terms, income is not all there is to aggregate demand. [A]ggregate demand is not merely equal to income, but to income plus the change in debt.

During a debt-driven financial bubble–which is the obvious precursor to a debt-deflation–rising levels of debt propel aggregate demand well above what it would otherwise be, leading to a boom in both the real economy and asset markets. But this process also adds to the debt burden on the economy, especially when the debt is used to finance speculation on asset prices rather than to expand production–since this increases the debt burden without adding to productive capacity.

When debt levels rise too high, the process that Fisher described kicks in and economic actors go from willingly expanding their debt levels to actively trying to reduce them. The change in debt then becomes negative, subtracting from aggregate demand–and the boom turns into a bust.

Debt has little impact on demand when the debt to GDP ratio is low–such as in Australia in the 1960s, or the USA from the start of WWII till the early 60s. But whenever the debt to GDP ratio becomes substantial, changes in debt come to dominate economic performance.

It is this effect that eluded Bernanke and his neoclassical brethren, because of their insistence on trying to model the world as if it is always in equilibrium. The debt-driven demand process is obvious when you think dynamically, but if you try to put it into an equilibrium straightjacket–as neoclassical economists did–then you can’t understand it at all.

With such ignorance about the dynamics of debt, academic economists and Central Banks around the world are marching ignorantly forward, according to Keen, hoping that the crisis is behind them, even though the cause of it–excessive levels of private debt–has not been addressed. They are recommending winding back the government stimulus packages in the belief that the economy can now return to normal after the disturbance of the GFC.

In fact “normal” for the last half century has been an unsustainable growth in debt, which has finally reached an apogee from which it will fall. As it falls–by an unwillingness to lend by bankers and to borrow by businesses and households, by deliberate debt reductions, by default and bankruptcy–aggregate demand will be reduced well below aggregate supply. The economy will therefore falter–and only regular government stimuli will revive it.

This however will be a Zombie Capitalism: the private sector’s reductions in debt will counter the public sector’s attempts to stimulate the economy via debt-financed spending. Growth, if it occurs, will not be sufficiently high to prevent growing unemployment, and growth is likely to evaporate as soon as stimulus packages are removed.

The only sensible course is to reduce the debt levels. As Michael Hudson argues, a simple dynamic is now being played out: debts that cannot be repaid, won’t be repaid. The only thing we have to do is work out how that should occur.

Since the lending was irresponsibly extended by the financial sector to support Ponzi Schemes in shares and real estate, it is the lenders rather than the borrowers who should feel the pain–which is the exact opposite of the bailout mentality that dominates governments around the world.

Unfortunately, it will take a sustained period of failures by conventional policy before unconventional policies, like deliberate debt reduction, will gain political traction. Implementing them will require both a dramatic change of mindset and probably also a widespread changing of the political guard.

It will also require the breaking of the hegemony of neoclassical economics over economic thinking, but I doubt that the academic profession, or economists in Central Banks and Treasuries, are up to the task of changing their spots. Change in economics will have to come from the rebels, and from outsiders taking over a discipline that economists themselves have failed.

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