Steve Keen says astronomical private debt means more downside (with charts)

Why Debt-Deflation Causes Depressions
Steve Keen
Debtwatch
March 1, 2010

“Declaring victory at half-time” is a syndrome which afflicts the entire debate over our current economic situation: optimists are of the opinion that the crisis is all over now, while pessimists think it’s only just begun. On this front, as always, I regard history as the best indicator of who may be right. In both 1930 and 1931, the belief was widespread–at least in the financial community–that the Depression was over, and recovery was just around the corner…. [A]t least early on during the Great Depression, people didn’t realise that they were in it. They too, were declaring victory at what turned out to be not even half-time.

Ultimately, the debate over whether we’re in a complete recovery or merely a temporary recess from the GFC will only be resolved by time. But well-informed theory can also give a guide as to what we can expect, and here I regard Hyman Minsky’s Financial Instability Hypothesis and Irving Fisher’s Debt Deflation Theory of Great Depressions as the outstanding guides. However they are complex theories, especially when most economists have been mis-educated by neoclassical economics into ignoring money, debt, and disequilibrium dynamics. So the following numerical example might make it easier to understand their arguments:

• Imagine a country with a nominal GDP of $1,000 billion, which is growing at 10% per annum (real output is growing at 4% p.a. and inflation is 6% p.a.);
• It also has an aggregate private debt level of $1,250 billion which is growing at 20% p.a., so that private debt increases by $250 billion that year;
• Ignoring for the moment the contribution from government deficit spending, total spending in that economy for that year–on all markets, both commodities and assets–is therefore $1,250 billion. 80% of this is financed by incomes (GDP) and 20% is financed by increased debt;
• One year later, the GDP has grown by 10% to $1,100 billion;
• Now imagine that debt stabilises at $1,500 billion, so that the change in debt that year is zero;
• Then total spending in the economy is $1,100 billion, consisting of $1.1 trillion of income-financed spending and no debt-financed spending;
• This is $150 billion less than the previous year;
• Stabilisation of debt levels thus causes a 12% fall in nominal aggregate demand.

What about if debt doesn’t actually stabilise, but instead grows at the same rate as GDP? Then we get the following situation:

• In the first year, total demand is $1,250 billion, consisting of $1,000 billion in income and $250 billion in increased debt;
• In the second year, total demand is also $1,250 billion, consisting of $1,100 billion in income and $150 billion in increased debt;
• Nominal aggregate demand is therefore constant;
• But after inflation, real aggregate demand will have contracted by 6%.

This is the real danger posed by debt: once debt becomes a significant fraction of GDP, and its growth rate substantially exceeds that of GDP, the economy will suffer a recession even if the debt to GDP ratio merely stabilises.

A debt-dependent economy has no choice but to record rising levels of debt to GDP every year to avoid a recession. Unfortunately, this makes a debt-servicing crisis inevitable at some point, especially when a large fraction of the increase in debt is financing Ponzi-speculation on asset prices, since this adds to debt without increasing society’s capacity to finance that debt.

That is why falling debt levels caused the Great Depression, as Irving Fisher argued back in 1933, and the phenomenon is obvious in the empirical data. The next few charts illustrate this argument.

Private debt and GDP levels in the USA from 1920 to 1940:

The change in private debt, added to GDP to show aggregate demand as the sum of GDP plus the change in debt:

Now I calculate the proportion of aggregate demand that is debt-financed, by dividing the change in debt by the sum of GDP plus the change in debt: the formula for is:



The correlation of the fraction of demand that is debt financed (lagged one year since the data is end-of-year annual) with unemployment is minus 0.77.  Roughly speaking, this tells us that when the debt-financed fraction of demand rises, unemployment falls, and the correlation of these two series accounts for 77% of the change in unemployment between 1920 and 1940:

Now let’s repeat the same exercise with the data from 1990 till 2010
Private debt and GDP levels in the USA from 1990 to 2010:

The change in private debt, added to GDP to show aggregate demand as the sum of GDP plus the change in debt:

The correlation of the fraction of demand that is debt financed (unlagged since we now have quarterly data on debt) with unemployment (the correlation coefficient is now minus 0.84):

This is why debt-deflation matters, and it’s also why we are barely at the half-time mark in the GFC. Though government spending has countered the fall in debt-financed spending to some degree, that fall has only hit 40% of the level that applied during the Great Depression, even though debt levels are substantially higher (relative to GDP) than they were back then.
The numerical example given above is, by the way, not too far removed from the empirical data for both Australia and the USA prior to the GFC. In the year before the crisis, Australia’s GDP was roughly A$1.1 trillion, and the increase in debt that year was A$260 billion, which was a 17% increase on the previous year; for the USA the comparable figures were roughly US$14 trillion, a US$4.5 trillion increase in debt, and a peak rate of growth of debt of about 10% p.a.

The example also illustrates why the rate of inflation matters, and why a low rate prior to a debt crisis is a serious danger. If inflation is high when the crisis hits (say 20% p.a.) then most of the decline can be taken by a fall in the rate of consumer price inflation itself. But if the commodity inflation rate is low, then the hit will be taken by asset prices and actual output as well as by a fall in the inflation rate.

The process can be countermanded to some degree by the government running a deficit, which counteracts the fall in aggregate demand caused by private deleveraging. But the government deficit would need to be far higher than current levels to return us to prosperity if nothing is also done about the astronomical level of private debt.

With the deficits that are being contemplated today, I expect the outcome to be that the rest of the OECD will “turn Japanese” and enter a long-running, low level Depression. Actions that limit those deficits–or even worse, force countries in crisis like Greece to impose austerity measures to reduce deficits back to zero–will turn this from a drawn-out Depression into a sudden and deep one.

Of course, at the same time that economic policy makers–misled by neoclassical economics–are imposing austerity programs on national governments, they are trying to restart the private debt binge mechanism that gave us the crisis in the first place.