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Why banks cause crises (and how to stop them)
Steve Keen
University of Western Sydney
www.debtdeflation.com/blogs
Banks don’t have to cause crises…
• Banks can create money “out of nothing”
– Richard last night; Schumpeter in 1934
• And not cause financial crises
– But they almost always do… Why?
• Versus two popular (but false) beliefs
– Bank lending must cause crises
• Lend $100, expect $105 back—rising debt must lead to crisis
– Banks don’t matter at all
• Bank lending controlled by Central Bank
• Belief that “banks are different” is for “banking mystics”
– “I’m all for including the banking sector in stories where it’s
relevant; but why is it so crucial to a story about debt and
leverage?” (Paul Krugman, 2012)
• Tackling the 1st fallacy
– Consider a pure credit economy, like 19th century “Free Banking”…
Popular Fallacy: Crises inevitable
• 19th century experiment with “pure” private money
– Private banks printed own notes across USA, Australia, Scotland
Popular Fallacy: Crises inevitable
• Simple model:
– Bank prints notes & stores them in “Vault”
– Lends to Firms by transferring $ from Vault to Firm Deposits
– Firm hires workers by transferring $ from Firm to Worker Deposits
– Workers and Banks consume by transferring $ to Firm Deposit
– Bank charges loan interest & pays deposit interest
• Should be unsustainable according to “lend $100, expect $105 back”
– Constant economic activity should need rising debt; or
– Firms’ bank balance should head to zero with constant money stock
• What actually happens?
– Develop model of financial flows using accounting table…
Popular Fallacy: Crises inevitable
Type of Account
Action
Lend
Bank Assets
Vault
Loans
-Loan
Record Loan
Workers
Safe
+Loan
+Interest
Pay Interest
-Interest
Record Payment
+Interest
-Interest
Hire Workers
Deposit Interest
Consume
Record Repayment
Firms
Income
+Loan
Charge Interest
Repay Loan
Bank Liabilities (Deposits)
+Repay
-Wage
+Wage
+DF
+DW
-DF-DW
+CW+CB
-CW
-CB
-Repay
-Repay
Popular Fallacy: Crises inevitable
• Stable stock of money finances stable level of economic activity:
Popular Fallacy: Crises inevitable
• Warning… “Wonkish”…
• Model a system of “Ordinary Differential Equations”:
• With functions substituted for “Repay” etc., it becomes…
FL( t) BV( t)

•
d
B ( t)

d



BV(dtt) V Repay  Loan


RL
V

•
dt



BV( t) FL( t)
d


d


t)  Repay

FL( t) FL(Loan


d
t




V
RL
dt




BS( t) BV( t) FL( t) W D( t) FD( t)  ( s  1) •
d
d

 FL(Dt)F Interest
  Loan
  Repay
  Wage
 
ODEs
ODEsPP11   FDF( tD) ( t)rD FCDB( t) CrW
L
dt dt
B
V
 RL
W
 S 



W
(
t
)
F
(
t
)

(
s

1
)
d


d W ( t) D  C D Wage D

W D(Dt) rD WWD( t) W



W
S
dtd t





B
(
t
)
d


S
d BS( t) Interest  DF  DW  CB


B
(
t
)
r

F
(
t
)

r

F
(
t
)

r

W
(
t
)



S
L L
D D
D D

B
ddtt


Yes, it’s complicated!
But if you understood
previous table, you
understand this
Realistic parameter values
(workers share of output
roughly 70%, Loan rate 5%, 7
years to repay loans, etc.)
can derive equilibrium
incomes…
Popular Fallacy: Crises inevitable
• With $100m in circulation, incomes settle down to:
Income
Gross
Wages
228.687 p.a.
Profits
98.009 p.a.
Interest
4.667 p.a.
Sum
331.362 p.a.
• Incomes exceed loan level by factor of 3!
• $100m in cash turns over several times a year
– Generates incomes out of which interest is paid
• Popular “can’t repay loan” fallacy a stock/flow confusion
– Loan: $—Stock
– Incomes: $/Year—Flow
• Borrow $100, generate $300 p.a. in turnover, pay $200 p.a. in costs, pay
$5 p.a. in interest from $100 profit—no big deal
• Now the 2nd Neoclassical fallacy
Neoclassical Economic Fallacy—Banks don’t matter
• Krugman on Keen:
– Minsky and Methodology (Wonkish):
• “Keen then goes on to assert that lending is, by definition (at
least as I understand it), an addition to aggregate demand.
• I guess I don’t get that at all.
• If I decide to cut back on my spending and stash the funds in a
bank, which lends them out to someone else, this doesn’t have to
represent a net increase in demand…”
– Banking Mysticism
• “… banking is where left and right meet. Both the Austrians and
the self-proclaimed true Minskyites view banks as institutions
that are somehow outside the rules that apply to the rest of the
economy, as having unique powers for good and/or evil…
• Banks don’t create demand out of thin air any more than anyone
does by choosing to spend more; and banks are just one channel
linking lenders to borrowers.”
Neoclassical Economic Fallacy—Banks don’t matter
• Patient lends to Impatient
•
•
•
•
Patient’s spending power goes down
Impatient’s spending power goes up
No change in aggregate demand
Banks mere intermediaries (ignored in analysis)
Neoclassical Economic Fallacy—Banks don’t matter
• The real world: Entrepreneur (or speculator) approaches bank for loan
• Bank grants loan &
creates deposit
simultaneously
• Alan Holmes, Senior V-P,
New York Fed
• “In the real world, banks
extend credit, creating
deposits in the process,
and look for the reserves
later.” (1969)
• New loan puts additional spending power into circulation
• Aggregate demand exceeds demand from income alone
• Neoclassical macro wrong to ignore change in debt
Neoclassical Economic Fallacy—Banks don’t matter
• Neoclassicals ignorant of own literature:
– Kydland & Prescott: Credit money leads base money
• “There is no evidence that either the monetary base or M1 leads
the cycle, although some economists still believe this monetary
myth…
• The difference of M2-M1 leads the cycle by even more than M2,
with the lead being about three quarters…” (1990, p. 4)
– Fama & French: change in debt finances investment
• “The source of financing most correlated with investment is longterm debt. The correlation between It and dLTDt is 0.79….
• debt plays a key role in accommodating year-by-year variation in
investment.” (1999, p. 1954)
• So debt & endogenous increase in demand do matter
– Rising debt main source of investment finance (good) and
speculative finance (bad)
• But neoclassical models ignore banks, debt & money completely!
– Not to mention fallacies in own models
The absurd foundations of Neoclassical macro
• “The preferred model has a single representative consumer
optimizing over infinite time with perfect foresight or rational
expectations, in an environment that realizes the resulting plans more
or less flawlessly through perfectly competitive forward-looking
markets for goods and labor, and perfectly flexible prices and wages.
• How could anyone expect a sensible short-to-medium-run
macroeconomics to come out of that set-up?... (Solow 2003, p. 1)
• ‘The simpler sort of RBC model that I have been using for expository
purposes has had little or no empirical success…
• As a result, some of the freer spirits [i.e., Woodford, Krugman,
Bernanke, Blanchard] in the RBC school have begun to loosen up the
basic framework by allowing for 'imperfections' in the labor market,
and even in the capital market…
• The model then sounds better and fits the data better. This is not
surprising: these imperfections were chosen by intelligent economists to
make the models work better...” (Solow 2001, p. 26)
The absurd foundations of Neoclassical macro
• “the main argument for this modeling strategy has been a more
aesthetic one:
• its virtue is said to be that it is compatible with general equilibrium
theory, and thus it is superior to ad hoc descriptive models that are not
related to ‘deep’ structural parameters.
• The preferred nickname for this class of models is ‘DSGE’ (dynamic
stochastic general equilibrium). I think that this argument is
fundamentally misconceived…
• The cover story about ‘microfoundations’ can in no way justify recourse
to the narrow representative-agent construct...” (2007, p. 8)
• Solow’s critique noted the “SMD” conditions (Sonnenschein–Mantel–
Debreu)
– These invalidate “microfoundations” macroeconomics
• Even invalidate “supply & demand” in single market!
The absurd foundations of Neoclassical macro
• SMD theorem:
– “we prove that every polynomial … is an excess demand function
for a specified commodity in some n commodity economy… every
continuous real-valued function is approximately an excess demand
function.” (Sonnenschein 1972 , pp. 549-550)
• Market demand curves do not obey the "Law of Demand"
• Even if summing "well behaved" individual demand curves
P
Crusoe
P
q
•
•
•
•
Friday
P
q
Market
Q
Can’t even treat single market demand curve as “scaled up consumer”
Yet Neoclassicals model entire macroeconomy as scaled-up individual
Their advice on macroeconomy—and banks, debt & money—is useless
Back to why banks don’t have to cause crises, but do…
Why bank cause crises
• Bank income depends on how much debt they create
– Main way to create more is to finance investment or speculation
Bank income if...
25
Base Case
Recycle * 2
Repay / 2
Invest * 2
22.5
Interest income p.a.
20
17.5
15
12.5
10
7.5
5
2.5
0
0
1
2
3
4
5
6
7
www.debtdeflation.com/blogs
8
9
10
Why bank cause crises
• Best way to encourage debt is to finance speculation on asset prices
– Australian households, for example:
100
14
• Bank lending
Personal
PersonalDebt
Debt
actually causes
Mortgage Debt
asset price rises
80
• Positive feedback
loop that caused
12
both boom of
60
“Great
Moderation” and
this crisis
40
• We need
10
monetary
20
analysis of
capitalism…
80
1990
1990 1992
1992 1994
1994 1996
1996 1998
1998 2000
2000 2002
2002 2004
2004 2006
2006 2008
2008 2010
2010 2012
2012 2014
2014
A strictly monetary view of aggregate demand
• Two sources of monetary demand
– Income (Wages + Profits)
– Borrowing (Change in Debt)
• Two categories of supply
– Goods & Services (Consumer + Investment Goods/Services)
– Net new financial assets
• Schumpeter:
– Incomes mainly spent on consumption
– Change in debt main source of funds for investment
• Minsky: Change in debt also finances Ponzi behavior
d
Wages  Profits  D  Consumption  Investment  NetFIRE
dt
Walras-Schumpeter-Minsky Law
• Aggregate Demand = Income + Change in Debt
• Aggregate Supply = Good & Services + Net Asset Turnover
d
Y  D  GDP  NetFIRE
dt
• Implications for macro & finance: NetFIRE  P  Q  T
A
A
A
– Change in debt a factor in level of employment, output
– Debt acceleration drives change in GDP & asset prices
2
d
d
d
d
Y  2 D  GDP   PA  QA  TA 
dt
dt
dt
dt
• Change in debt explains crisis (& “Great Moderation” before it)
• Accelerating debt explains why asset bubbles must burst
Aggregate debt overview
• Private debt far more important than government debt:
US Debt to GDP
320
300
280
• Only the Great
Depression
compares to now
• & “Roaring
Twenties” to “The
Great Moderation”
Private
Public
260
Percent of GDP
240
220
200
180
160
140
120
100
80
60
40
20
0
1920
1930
1940
1950
1960
1970
1980
www.debtdeflation.com/blogs
1990
2000
2010
2020
Change in Debt & Aggregate Demand
• Today—compared to Then
US
USAggregate
Aggregate Demand
Demand 1920-1940
1980-2012
US $ million p.a.
US $ million p.a.
7
1.9
120000
10
7
115000
1.8
10
7
110000
1.7
10
7
105000
1.6
10
1000007
1.510
950007
1.410
900007
1.385000
10
7
1.280000
10
7
1.175000
10
7
170000
10
6
965000
10
600006
810
550006
710
500006
645000
10
6
540000
10
6
435000
10
Nominal GDP
+Change in Private Debt
+Change in Public Debt
Nominal GDP
+Change in Private Debt
+Change in Public Debt
6
330000
10
1980
1920 1982 1922
1984 1986
19241988 1990
1926 1992 1928
1994 199619301998 2000
1932 2002 1934
2004 20061936
2008 2010
1938 2012 1940
2014
www.debtdeflation.com/blogs
www.debtdeflation.com/blogs
Acceleration in Debt & Change in Employment
• Now (compared to then)
20
15
10
3
15
10
7.5
2
10
5
5
1
5
0
2.5
00
0
5
5
00
1
 2.5
 10
 10
2
5
 15
 15
3
 7.5
 20
 20
4
 10
 25
Credit Acceleration
Employment Change
 12.5
5
 30
 15
6
1920
1922
1924
1926
1928
1930
1932200220042006
1934
1936
1938
1940
1980198219841986
198819901992
1994199619982000
200820102012
2014
www.debtdeflation.com/blogs
Change in 100 minus unemployment rate p.a.
Change in 100 minus unemployment rate p.a.
Private Debt Acceleration p.a. as percent of GDP
Credit Acceleration & Employment Change (Corr=0.76)
(Corr=0.69)
Acceleration in Debt & Change in Dow Jones
• Now (compared to then)
20
200
100
15
150
75
10
100
50
5
50
25
00
0
5
50
 25
 10
 50
100
 15
150
 75
 20
200
 100
 25
Credit Acceleration
DJIA Change
250
 125
300
 30
 150
1920 1988
192219901924
1928 1998
193020001932
1936 2008
1938
1942
1986
1992 1926
1994 1996
2002 1934
2004 2006
2010 1940
2012 2014
www.debtdeflation.com/blogs
Annual Change Deviation from Trend DJIA Percent
Acceleration
p.a. Percent
of (1
GDP
CreditCredit
Acceleration
p.a. Percent
of GDP
year lag)
(Corr=0.65)
Credit Accelerator & DJIA Deviation from Trend (Corr=0.34)
House Prices deflated by CPI—the long view
• N0 trend; long term average 1890-1995 was 98
Real House Price Index
300
275
250
Index 1890 = 100
225
200
175
Greenspan
Index (2006/04: 262; 2012/01: 173)
Mean 1890-1997 (98)
• “a "bubble" in home prices does not appear likely
• home price declines, were they to occur, likely would not
have substantial macroeconomic implications.”
(Greenspan to Congress, August 2005)
150
125
100
75
50
25
0
1890
1900
1910
1920
1930
1940
1950
1960
1970
1980
www.debtdeflation.com/blogs; Case-Shiller Index
1990
2000
2010
2020
Acceleration in Mortgages & Change in House Prices
7
21
6
18
5
15
4
12
3
9
2
6
1
3
0
00
1
3
2
6
3
9
4
 12
5
6
Mortgage Accelerator
Change in Real House Prices
 15
 18
7
 21
1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014
www.debtdeflation.com/blogs
Percent change in real Case-Shiller Index p.a.
Percent of GDP
Mortgage Acceleration & House Price Movements (Corr=0.78)
What about England?
• Faster your seat belts… on the Roller Coaster of Debt
Total Private Debt
500
UK
USA
• Remedies
left till later
given time
constraints
Percent of GDP
400
300
200
100
0
1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014
www.debtdeflation.com/blogs
What about England? Employment…
Credit Accelerator & Employment Change UK (Corr=0.5)
30
20
2
00
0
 10
 20
2
 30
 40
 50
4
Credit Accelerator
Unemployment Change
 60
6
1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014
www.debtdeflation.com/blogs
Percent change p.a.
Percent of GDP
10
What about England? House Prices…
10
40
8
32
6
24
4
16
2
8
0
00
2
8
4
 16
6
 24
8
 10
1988
Household Credit Accelerator
House Price Change
1990
1992
1994
1996
1998
2000
 32
2002
2004
2006
www.debtdeflation.com/blogs
2008
2010
2012
 40
2014
Percent change p.a.
Percent of GDP
Credit Accelerator & Real House Price Change UK (Corr=0.695)
What about England? Shares…
40
80
30
60
20
40
10
20
00
0
 10
 20
 20
 40
 30
 60
 40
 80
 50
Credit Accelerator
Monthly Change in FTSE
 100
 60
 120
1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014
www.debtdeflation.com/blogs
Percent change p.a.
Percent of GDP
Credit Accelerator & Real FTSE Change (Corr=0.35)
Sources & Remedies
• Accelerating debt THE source of asset price bubbles
• Breaking debt-asset price nexus essential to stop bubbles
• Two modest but fundamental proposals
– “Jubilee Shares”
• Last forever when purchased from firm
• Can be sold on secondary market 7 times
• After 7th sale, last 50 years then expire
– “The Pill”
• Property Income Limited Leverage
– Maximum mortgage (say) 1o times property income
• NO reliance on regulators, fine tuning, etc.
• Negative feedback loop between asset prices & change in debt
• Debt reserved for beneficial investment, not Ponzi Schemes
Remedy for today’s crisis
• “Modern Debt Jubilee”
– “Quantitative easing for the public”
• Cancel irresponsibly created debt without penalizing savers
– Fiat money injection via private bank accounts
• First usage must be debt reduction
• Bank debt necessarily paid down
– Solvency maintained, liquidity challenged
• Bonds reduced in value
• But non-debtor bond-holders receive cash injection
– Minimal damage to aggregate demand, inflation/deflation