Discussing “Can we avoid another financial crisis?”

from WEA Commentaries

My first book since Debunking Economics has just been released in the UK, and will come out in May in the USA. Can we avoid another financial crisis? is a brief (140 page, 25,000 word) explanation for the lay reader of how the 2008 crisis was caused by factors that mainstream economics ignores—fundamentally, the levels of private debt and credit-based demand—and why other countries that avoided a crisis in 2008 are likely to suffer a similar crisis in the near future.

My argument is based in equal measure on my interpretation and model of Hyman Minsky’s Financial Instability Hypothesis (though my book is equation-free), and my analysis of the role of endogenous money—which I now prefer to call “Bank Originated Money and Debt” or BOMD—in causing both economic booms and slumps. The book relies upon the statistical work of the BIS, which since 2014 has started publishing detailed databases on private debt, government debt, house prices, and recently consumer prices. This has made it possible for me to analyse the debt and credit dynamics of 43 countries to identify which have had a crisis, and which are likely to have one in the future.

There are two new insights developed in the book that are new for people who are otherwise familiar with my analysis: that a realistic macroeconomics can be derived directly from macroeconomics itself; and that a rough guide to whether a country is likely to experience a financial crisis can be derived from the BIS data.

Methodology: derive macro from macro  

Incorporating energy into production functions

from Steve Keen

In my last post on my Debtwatch blog, I finished by saying that the Physiocrats were the only School of economics to properly consider the role of energy in production. They ascribed it solely to agriculture exploiting the free energy of the Sun, and specifically to land, which absorbed this free energy and stored it in agricultural products. As Richard Cantillon put it in 1730:

The Land is the Source or Matter from whence all Wealth is produced. The Labour of man is the Form which produces it: and Wealth in itself is nothing but the Maintenance, Conveniencies, and Superfluities of Life. (Cantillon, Essai sur la Nature du Commerce in Général (Essay on the Nature of Trade in General)

Quesnay’s famous but neglected “Tableau Economique” therefore described the agricultural sector as “the productive sector” and manufacturing as “sterile”—see Figure 1.

CERN Discovers New Particle Called The FERIR

from Steve Keen

CERN has just announced the discovery of a new particle, called the “FERIR”.

This is not a fundamental particle of matter like the Higgs Boson, but an invention of economists. CERN in this instance stands not for the famous particle accelerator straddling the French and Swiss borders, but for an economic research lab at MIT—whose initials are coincidentally the same as those of its far more famous cousin.

Despite its relative anonymity, MIT’s CERN is far more important than its physical namesake. The latter merely informs us about the fundamental nature of the universe. MIT’s CERN, on the other hand, shapes our lives today, because the discoveries it makes dramatically affect economic policy.

CERN, which in this case stands for “Crazy Economic Rationalizations for aNomalies”, has discovered many important sub-economic particles in the past, with its most famous discovery to date being the NAIRU, or “Non-Accelerating Inflation Rate of Unemployment”. Today’s newly discovered particle, the FERIR, or “Full Employment Real Interest Rate”, is the anti-particle of the NAIRU. 

The seven countries most vulnerable to a debt crisis (10 graphs)

from Steve Keen

For decades, some of the most important data about market economies was simply unavailable: the level of private debt. You could get government debt data easily, but (with the outstanding exception of the USA—and also Australia) it was hard to come by.

That has been remedied by the Bank of International Settlements, which now publishes a quarterly series on debt—government & private—for over 40 countries. This data lets me identify the seven countries that, on my analysis, are most likely to suffer a debt crisis in the next 1-3 years. They are, in order of likely severity: China, Australia, Sweden, Hong Kong (though it might deserve first billing), Korea, Canada, and Norway.

I’ve detailed the logic behind my argument too many times to count, and I won’t repeat it here (if you want to check it out, try this Forbes post on Krugman, this one on money, this one on the Fed, or this one on our dysfunctional monetary system). The bottom line is that private sector expenditure in an economy can be measured as the sum of GDP plus the change in credit, and crises occur when (a) the ratio of private debt to GDP is large; (b) growing quickly compared to GDP. When the growth of credit falls—as it eventually must, as growing debt servicing exhausts the funds available to finance it, new borrowers baulk at entry costs to house purchases, and numerous euphoric and Ponzi-based debt-financed schemes fail—then the change in credit falls, and can go negative, thus reducing demand rather than adding to it. 

Get ready for an Australian recession by 2017

from Steve Keen

For the last 25 years, Australian politicians of both Liberal and Labor hue have been able to brag that, under their stewardship, Australia has avoided a recession. Those bragging rights are about to come to an end. During the life of the next Parliament — and probably by 2017 — Australia will fall into a prolonged recession.

Whichever party is in opposition at the time will blame the incumbent, but in reality this recession has been set up by the sidestep both parties have used to avoid downturns for the past quarter century: whenever a crisis has loomed, they’ve avoided recession by encouraging the private sector to borrow and spend.

The end product of that is starkly evident in a new database on private and government debt published by the Bank of International Settlements. Australia’s most famous recession sidestep was during the GFC, when it was one of only two countries in the OECD to avoid experiencing two consecutive quarters of negative GDP growth (the other country was South Korea). Since then, the private sectors of the advanced countries have collectively de-levered, reducing their debt levels from about 170 to 160 per cent of GDP. Australia, in stark contrast, has levered up. Our private debt to GDP ratio is now more than 20 per cent higher than when the GFC began, and more than 50 per cent higher than in the USA (see Figure 1).

Tilting at windmills: The Faustian folly of quantitative easing

from Steve Keen

As I explained in my last post, banks can’t “lend out reserves” under any circumstances, which undermines a major rationale that Central Bank economists gave for undertaking Quantitative Easing in the first place. Consequently, the hope that Bernanke expressed in 2009 is “To Dream The Impossible Dream”:

To dream the impossible dream
To fight the unbeatable foe
To bear with unbearable sorrow
To run where the brave dare not go

But without the poetry:

Large increases in bank reserves brought about through central bank loans or purchases of securities are a characteristic feature of the unconventional policy approach known as quantitative easing. The idea behind quantitative easing is to provide banks with substantial excess liquidity in the hope that they will choose to use some part of that liquidity to make loans or buy other assets. (Bernanke 2009, “The Federal Reserve’s Balance Sheet: An Update”

What a folly this was—almost. The one out that Bernanke gives himself from pure delusional babble is the phrase “or buy other assets”—because that’s the one thing that banks can actually do with the excess reserves that QE has generated.

Hey Joe, banks can’t lend out reserves

from Steve Keen

I began another post critical of Joe Stiglitz’s analysis with the caveat that I like Joe. I’ll add to that that I respect his intellect too, both because he’s very bright—you don’t win a Nobel Prize (even in Economics!) without being very bright—and because compared to some other winners, he is very capable of thinking beyond the limitations of the mainstream.

But there are some mainstream concepts that are so deeply embedded in even highly intelligent, flexible thinkers like Joe, that they continue thinking in terms of them, when a bit of really serious thought would show that the concepts are in fact nonsense.

Some of these are so deeply embedded in the psyche of economists that they even permeate the alternate economic universe I work in—known as Post Keynesian Economics (even here I’m a bit of a maverick). I attended a presentation by a non-mainstream colleague recently, and while she was critical of the mainstream, she also seemed to agree with Joe on the same topic: that private banks can lend their excess reserves to the public.

1. THEY. CAN’T.

Here’s Joe on this subject recently in Project Syndicate, in an article entitled “What’s Holding Back the World Economy?”:

Our dysfunctional monetary system (3 graphs)

from Steve Keen

The great tragedy of the global economic malaise is that it is caused by a shortage of something that is essentially costless to produce: money.

Both banks and governments can produce money at physically trivial costs. Banks create money by creating a loan, and the establishment costs of a loan are miniscule compared to the value of the money created by it—of the order of $3 for every $100 created.

Governments create money by running a deficit—by spending more on the public than they get back from the public in taxes. As inefficient as government might be, that process too costs a tiny amount, compared to the amount of money generated by the deficit itself.

But despite how easy the money creation process is, in the aftermath to the 2008 crisis, both banks and governments are doing a lousy job of producing the money the public needs, for two very different reasons.

Banks aren’t creating money now because they created too much of it in the past. The booms that preceded the crisis were fuelled by a wave of bank-debt-financed speculation on some useful products (the telecommunications infrastructure of the internet, the DotCom firms that survived the DotCom bubble) and much rubbish (the Liar Loans that are the focus of The Big Short). That lending drove private debt levels to an all-time high across the OECD: the average private debt level is now of the order of 150% of GDP, whereas it was around 60% of GDP in the “Golden Age of Capitalism” during the 1950s and 1960s—see Figure 1.

The unnatural rate of interest (ultra-wonkish)

from Steve Keen

Paul Krugman’s latest column—“Check Out Our Low, Low (Natural) Rates” (which he didn’t flag as “Wonkish”, even though it is so in spades)—noted that the “natural real rate of interest” was falling, and that this justified the low interest rate set by the Federal Reserve.

And this made me think about Karl Marx.

Why? Because the “natural real rate of interest” is an unobservable entity—in that it’s not a rate you’ll find charged by any bank, but a rate that has to be statistically derived. But more importantly, it is a fantasy: there is no such thing. However it is required as part of a theory in which the economy returns to equilibrium after it is hit by an “exogenous shock”. So Neoclassical economists—meaning both “New Classicals” and “New Keynesians”, as the two fractious clans in this economic tribe call themselves—have to go in search of this phantom.

Why China had to crash: Part 2

from Steve Keen                          Why China had to crash: Part 1

One thing my 28 years as a card-carrying economist have taught me is that conventional economic theory is the best guide to what is likely to happen in the economy.

Read whatever it advises or predicts, and then advise or expect the opposite. You (almost) can’t go wrong.

Nowhere is this more obvious than in its strident assurances that the value of shares is unaffected by the level of debt taken on, either by the firms themselves or by the speculators who have purchased them. This theory, known as the “Modigliani-Miller theorem”, asserted that since a debt-free company could be purchased by a highly levered speculator, or a debt-laden company could be purchased by a debt-free speculator, therefore (under the usual host of Neoclassical “simplifying assumptions”, which are better described as fantasies) the level of leverage of neither firm nor speculator had any impact on a firm’s value—and hence its share price. The sole determinant of the share price, it argued, was the rationally discounted value of the firm’s expected future cash flows.

Why China had to crash: Part 1

from Steve Keen

In this post I consider the economy in general: I’ll cover asset markets in particular in the next column, but you’ll need to understand today’s post to comprehend the stock and property market dynamics at play. Having said that, the Shanghai Index fell another 7.5% on Tuesday, after losing 8.5% on Monday, and is now down over 45% from its peak—so I’ll try to write the stock-market-specific post by tomorrow. In this post I’ll show, very simply, why a slowdown in the rate of growth of private debt will cause a crisis, if both the level and the rate of change of debt are high at the time of the slowdown.

Is the UK facing another financial crisis? (3 graphs)

from Steve Keen

Taken at face value, David Cameron’s warning this week about risks in the global economy sounds like it might be wonderfully prescient. Here’s the country’s economic chauffeur, carefully checking his instrument gauges, and sure enough, sees the same signs today that should have given us warning of the crisis of 2007-08. Time to apply the brakes.

There’s only one problem: the economic dashboard that Cameron relies upon did not warn of the crisis before it happened. Instead, that dashboard advised Cameron and other leaders around the world that everything was looking rosy, and that going full throttle was entirely safe.

The OECD’s Economic Outlook, published in May 2007, stated that its “central forecast remains indeed quite benign” as it predicted “a strong and sustained recovery in Europe”. Some dashboard that turned out to be.

Motor skills

Politicians are fond of car analogies when talking about the economy, because

The revolt of (part of) the top 1% of the top 1%

from Steve Keen

What are your preconceptions about the author of a book with the title The Next Economic Disaster: Why It’s Coming and How to Avoid It? Academic? Leftist? Anti-capitalist? Anti-banker certainly?

Prepare to drop them all, because the author is none of the above. Taking the last first, the majority of his career has been in banking — and as a founder and CEO.

To put it in his own words:

An open letter to Brussels

from Steve Keen

The European Stability and Growth Pact is based on the principle that stability and growth are enhanced when government deficits are either minimised or eliminated. I want you to dispassionately consider an argument that reaches a different conclusion. It may sound like something you have heard before from others and already dismissed. But bear with me.

When considered from a strictly monetary point of view, an economy can be regarded as having five major sectors: households, firms, the government, the banks, and the external sector. To focus on money flows, I will diverge from mainstream economic theory by treating households as consisting exclusively of workers, while I will combine firms and their owners into the firm sector, and do likewise with banks and their owners. I also treat the central bank as part of the government sector, and I ignore capital and income flows between nations in this simple exposition.

Neither households nor firms can produce money, while the other three sectors are potential sources of money. As is now well known (though this fact is still contested by academic economists), banks create money by making loans:

Whenever a bank makes a loan, it simultaneously creates a matching deposit in the borrower’s bank account, thereby creating new money. (Bank of England Quarterly Report 2014 Q1, Money creation in the modern economy.)

Governments can also create money by running a deficit (if it is financed by the central bank, or by bonds sold to banks in return for excess reserves). Money can also be created by running a balance of payments surplus (which in this simple exposition is exclusively a balance of trade surplus).

In order to simplify my argument, I will assume that

Why Europe’s austerity experiment is doomed to fail (7 graphs)

from Steve Keen

I’ve spent the past two weeks in Europe, with speaking engagements in Italy, Greece and Austria. This was my first visit to Greece, and my first chance to get an admittedly superficial tourist’s view of what a country with Great Depression levels of unemployment looks like.

It didn’t look like anything in particular until the drive from Athens, Greece’s capital and largest city, to Thessaloniki, its second largest. Then it struck me: the roads were near empty — as the toll booth shown in Figure 1 illustrates. My host Nikos reckons he has done a million kilometers over the years on this 500km drive, and he confirmed that roads which were now virtually empty were once full of cars, and especially trucks — that mobile sign of a thriving economy.

Figure 1: A toll booth on Greece’s main highway at about 5pm: no vehicles in either direction

This is a very different manifestation of economic stagnation than the mental picture I had of it from the historical record of the Great Depression, when the overwhelming impression was of crowds: crowds lined up at soup kitchens, crowds outside dole offices. Today, the 28 per cent of Greek’s workforce that is unemployed is mainly at home (if they have homes), and surviving on electronically transmitted dole payments. The social organisation of the unemployed that marked the Great Depression is not apparent today — though the political shifts are beginning.

Taking stock of Wall Street’s boom (1)

from Steve Keen

If the US economy was performing as well as the US stockmarket, even Walmart workers would be breaking out the champagne.

Since 2009, the S&P has risen over 250 per cent in nominal terms, and almost 230 per cent in inflation adjusted terms. In nominal figures, it is at its highest value ever, though when you adjust for inflation, it is still 10 per cent below its peak in 2000 (see Figure 1).

The $64 question is: will it keep on going up?

Figure 1: The S&P 500 before and after inflation

There are good reasons for the stockmarket index rising over time in inflation-adjusted terms. These include sound ones like the reinvestment of earnings (think Berkshire Hathaway),  but also misleading ones like survivor bias.

Paul Krugman, the champion of inertia

from Steve Keen

In his latest blog, Paul Krugman slings off at non-mainstream economists — and the students at Manchester University campaigning for change to the economics curriculum — for wanting fundamental change in economics. The status quo is fine, he reckons: move along folks, nothing to see here. Says Krugman in his latest post, Frustrations of the Heterodox:

“Here’s the story they tell themselves: the failure of economists to predict the global economic crisis (and the poor policy response thereto), plus the surge in inequality, show the failure of conventional economic analysis. So it’s time to dethrone the whole thing — basically, the whole edifice dating back to Samuelson’s 1948 textbook — and give other schools of thought equal time.

“Unfortunately for the heterodox (and arguably for the world), this gets the story of what actually happened almost completely wrong.

How not to win an economic argument

from Steve Keen

A critique of a yet-to-be-published paper of mine (“Loanable Funds, Endogenous Money and Aggregate Demand”, forthcoming in the Review of Keynesian Economics later this year; the link is to a partial blog post of that paper) by non-mainstream economist Tom Palley reminds me of one of my favourite ripostes by a politician, back in the days before spin doctors stopped them saying anything offensive — or indeed anything interesting.

As Sir Robert Menzies, former Australian prime minister and leader of the conservative Liberal Party, was giving a campaign speech in 1954, a heckler called out “Mr Menzies, I wouldn’t vote for you if you were the Archangel Gabriel”. Menzies shot back: “Madam, if I were the Archangel Gabriel, you would not be in my constituency.”

So it is with Tom’s critique. He criticises me for a whole range of things that I didn’t discuss, that he thinks I should have discussed, and for techniques I used that he thinks I shouldn’t have used. But Tom wasn’t in my intended audience for this paper — and not because he “wouldn’t be in my constituency”, but because he is. We have our differences, but we’re generally on the same side on the topic of this paper — and I didn’t write it for people who agree with me, but for those who don’t on two key issues: the role of banks, debt and money in the economy, and the role of the change in debt in aggregate demand.

Modeling financial instability

from Steve Keen

This paper will be published in a forthcoming book on the crisis edited by Malliaris, Shaw and Shefrin. In what follows, I derive a corrected formula for the role of the change in debt in aggregate demand, which is that ex-post aggregate demand equals ex-ante income plus the circulation of new debt, where the latter term is the velocity of money times the ex-post creation of new debt.

The PDF is available here: Keen2014ModelingFinancialInstability. The Minsky models used in this paper are here in a ZIP file. The latest version of Minsky can be downloaded from here.

• Introduction

Literally no-one disputes that the financial sector was the cause of the post-2007 economic crisis: disputation instead centers on the causal mechanisms. I follow Fisher (Fisher 1933) and Minsky (Minsky 1980) in assigning key roles to the growth and contraction of aggregate private debt (Keen 1995; Keen 2000), but this perspective is rejected by New Keynesian economists on the a priori basis that private debts are “pure redistributions” that “should have no significant macro-economic effects” (Bernanke 2000p. 24), and as a corollary to the oft-repeated truism that “one person’s debt is another person’s asset” (Krugman 2012c, p. 43).

My analysis also follows the Post Keynesian tradition of

Economics’ odd couple highlights a Nobel folly

from Steve Keen

I would love to be in the audience watching the body language at this year’s “Nobel” ceremony for economics. Robert Shiller, who is far too polite a person to make it obvious, will nonetheless at least fidget as he listens to Eugene Fama’s speech, since Fama continues to dispute that bubbles in asset prices can even be defined. Shiller, in contrast, first came to public prominence with his warnings in the early 2000s that the stock and housing markets in the States were displaying signs of “irrational exuberance”.

Fama came to prominence within economics – though not in the wider body politic – in the 1970s with his PhD research that argued that asset markets were “efficient” not just a first order (getting the actual values right) but even to a second order (picking the turning points in valuation as well).

How can two such diametrically opposed views receive the Nobel Prize in one year? The equivalent in physics would be to award the prize to one research team that proved that the Higgs Boson existed, and another that proved it didn’t.