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Private debt to GDP ratios Debt-financed demand percent of aggregate demand 300 275 USA Australia 20 15 225 200 10 175 5 Percent Years (percent of GDP) 250 25 150 125 100 0 0 5 Great Depression including Government Great Recession including Government 10 75 50 15 25 20 0 1870 1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010 2020 Flow of Funds Table L1+Census Data; RBA Table D02 25 0 1 2 3 4 5 6 7 8 9 10 11 12 Years since peak rate of growth of debt (mid-1928 & Dec. 2007 resp.) Why credit money doesn’t have to crash And why it always does Steve Keen University of Western Sydney Debunking Economics www.debtdeflation.com/blogs www.debunkingeconomics.com 13 The Great Moderation to The Great Recession • Everything was going SO well… The Great Moderation.. and Great Recession 15 2008.5 Percent 10 10 5 0 0 Unemployment Inflation 5 1975 1980 1985 1990 1995 Year 2000 2005 2010 2015 What the hell happened? • A debt bubble burst… USA Private Debt to GDP 320 2008.5 300 280 260 Percent of GDP 240 220 • Should that 175 matter? • Not according to conventional “neoclassical” economics… 200 180 160 140 120 100 80 60 40 20 0 1920 1930 1940 1950 1960 1970 Year 1980 1990 2000 2010 2020 Credit Money Myths • Neoclassical economics – Debt not a problem because loans = savings • “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).” (Bernanke 2000, p. 24) • Populist (& many non-neoclassical economists) – Inevitable problem because interest can’t be paid • “The existence of monetary profits at the macroeconomic level has always been a conundrum … not only are firms unable to create profits, they also cannot raise sufficient funds to cover the payment of interest.” (Rochon 2005, p. 125) Neoclassical myth: “Deposits create loans” • Creation process: – Government creates Base Money (e.g., welfare cheque) – Public puts BM in bank account – Bank keeps fraction (RR%: “reserve requirement”) – Lends rest: MB*(1-RR%) – Borrower deposits loan in another bank… – Iterative process generates BM/RR dollars • Banks as – Passive amplifiers of government money creation – Mere intermediaries between savers & borrowers • Loan transfers money from saver to borrower – Private Debt has minimal macroeconomic effect • Only if borrower has higher propensity to spend Reality: Endogenous money • Banks create credit money “out of nothing” – “In the real world banks extend credit, creating deposits in the process, and look for the reserves later” (Moore (1979, p. 539)—quoting Fed economist) – “There is no evidence that … the monetary base … leads the cycle, although some economists still believe this monetary myth…, if anything, the monetary base lags the cycle slightly… – The difference of M2-M1 leads the cycle by even more than M2 with the lead being about three quarters." (Kydland & Prescott 1990, p. 14) • So credit money created “ab initio” by banks • And that doesn’t have to be a problem… Model of credit money • Pure credit money system: bank issues own notes – Like 19th century free banking in USA – No Central Bank • Private bank formed by elite • Notes “backed” by own wealth • Lends to local businesses… • How did it work? • Stylised model with 5 accounts • “Vault”—where bank stores its wealth • “Safe”—for spending, payment & receipt of interest • “Loans”—ledger recording who owes bank how much • “Firms”—deposit account for firms • “Workers”—deposit account for workers • System starts with Notes (say $1 million) in Vault 19th century free banking: Stage 1 • • • • • • • • $1 million in Vault, all other accounts zero… Bank loans transfer notes from Vault to Firms Bank records loans in its Loans ledger Bank charges interest on loans Firm pays interest which Bank deposits in its Safe Bank records payment of interest on Loans ledger Bank pays deposit interest to Firm End result at this point: • Over time, Vault emptied of Notes • Notes pass via Firms back to Banks’ Safe: 19th century free banking: Stage 1 • Modelled using new software package QED – “Quesnay Economic Dynamics” QED 19th century free banking: Stage 2 • • • • • Closing the system: workers, factories & consumption Firms pay wages to Workers Bank pays workers interest on deposits Workers and Bankers consume End result at this point: System sustainable • Firms make profits • Workers earn wages, Banks earn interest Non-Neoclassical myth: “Interest can’t be repaid” • Common belief in Post-Keynesian economics & populist views of money: No it isn’t – Interest can’t be repaid because loan less than loan + interest; and firms can’t make monetary profits: • “The existence of monetary profits at the macroeconomic level has always been a conundrum for theoreticians of the monetary circuit… not only are firms unable to create profits, they also cannot raise sufficient funds to cover the payment of interest. In other words, how can M become M`?” (Rochon 2005, p. 125) – Wrong! – Confusion of stock (size of loan in $) with flow (turnover of economic activity in $/year) Non-Neoclassical myth: “Interest can’t be repaid” • System is stable if accounts can stabilise • Vault empties over time: all bank assets Loans to Firms • Accounts do stabilise • What’s happening? • After the vault empties… Non-Neoclassical myth: “Interest can’t be repaid” Add up columns • Long run dynamics in final 8 rows of table: • System stable if sum of flows in each column equal zero Flow conditions for stability of all accounts except Vault Account Outflows Inflows Loans Interest charged Interest paid Firms Interest on Loans + Wages Deposit Interest + Consumption Safe Deposit interest + Consumption Interest on Loans Workers Consumption Wages + Deposit Interest • Vault stabilises too if loan repayment equals rate of loans: 19th century free banking: Stage 3 • Firm repays loan which Bank puts back in Vault • Bank records repayment on Loan ledger • Sustainable system • Bank assets now unlent Notes in Vault plus Loans to Firms • Incomes for all classes • Wages $310.47 p.a. • Net Interest $3.72 • Profit? 217.33 p.a. (shown later) • Final step: new money QED • In 19th century: notes • In 20th century: credit Money creation in pure credit economy • 19th century: add new notes to vault Money creation in pure credit economy • 20th century: simultaneously issue loan and deposit Money creation in pure credit economy • System not inherently unstable – Firms can pay interest & make a profit – Debt can remain low & constant relative to GDP – Rising debt also necessary for expanding economy… • “If income is to grow, the financial markets … must generate an aggregate demand that, aside from brief intervals, is ever rising. • For real aggregate demand to be increasing, … it is necessary that current spending plans, summed over all sectors, be greater than current received income… • It follows that over a period during which economic growth takes place, at least some sectors finance a part of their spending by emitting debt or selling assets.” (Minsky 1982, p. 6; emphasis added) Money creation in pure credit economy • Schumpeter on same issue: growing debt adds demand beyond that generated by sales of goods & services • Debt essential for entrepreneurial function – Entrepreneur often has idea but no money – Needs purchasing power before has goods to sell – Gets purchasing power via loan from bank – Entrepreneurial demand thus not financed by “circular flow of commodities” but by new bank credit – Since entrepreneurial activities essential feature of growing economy, in real life “total credit must be greater than it could be if there were only fully covered credit. The credit structure projects not only beyond the existing gold basis, but also beyond the existing commodity basis.” (Schumpeter 1934, p. 101) Money creation in pure credit economy • But incentive to instability exists: – Bank income rises if • New money issued more rapidly • Debt repaid more slowly (or not at all) Money creation in pure credit economy • Same result in modern banking; bank income rises if – Bank reserves circulated more rapidly – Loans paid off more slowly – New loans created more rapidly Money creation in our real economy • • • • Banks have inherent bias to create debt Borrowers control whether that bias is expressed Income based borrowing—inherently limited The “Solution”: lend to finance Ponzi Schemes – Potential borrower expects asset price to rise – Borrows money to buy asset – Drives price of asset up – Rise entices other borrowers into market • Positive feedback from leverage to prices causes asset price bubble • Scheme “works until it fails”: – Rising debt-financed spending boosts economy – Requires acceleration in debt to continue forever… The Facts on Debt • 2 obvious US debt bubbles in last century USA Private Debt to GDP 320 2008.5 300 280 260 Percent of GDP 240 220 200 180 175 160 140 120 100 80 60 40 20 0 1920 1930 1940 1950 1960 1970 Year 1980 1990 2000 2010 2020 Debt and Aggregate Demand • Conventional “exogenous money” economics – Debt has minor macroeconomic effects • Redistributes money from lender to borrower • “Absent implausibly large differences in marginal spending propensities among the groups, it was suggested, pure redistributions should have no significant macroeconomic effects.” (Bernanke 2000, p. 24) • Realistic “endogenous money” economics – Increasing debt expands aggregate spending – Aggregate demand equals GDP plus change in debt • Spent on all markets—goods + existing assets – Volatile “change in Debt” component dominates economy as debt grows relative to income Debt and Aggregate Demand • Crisis manifestation of deleveraging US Aggregate Demand GDP 1990-2010 7 210 7 1.810 7 1.610 $ million 7 1.410 GDP alone GDP+Change in Debt + Government 18 Crisis by deleveraging 7 1.210 7 110 6 810 6 610 But notice recent turnaround 6 410 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 Years since 1990 Debt and Aggregate Demand • Correlation with unemployment Correlation US debt-financed demand & unemployment 30 Percent change p.a. 24 18 Debt-financed Inc. Gov Unemployment Crisis by deleveraging 0 1 2 3 12 4 6 5 0 06 6 7 12 8 18 9 But notice recent turnaround 24 30 36 1975 1979 1983 1987 1991 1995 Year 1999 2003 2007 10 11 2011 2015 Percent unemployed (inverted) 36 Acceleration in Debt & Change in Employment • Since AD = GDP +DD – DAD = DGDP +DDD – Changes in aggregate demand • & hence changes in employment – Correlated not with change in debt (DD) • But with acceleration/deceleration in debt (DDD) • Defining “credit impulse” (Biggs, Meyer & Pick) as ChangeInChangeInDebt GDP • Empirically, credit—ignored by neoclassical economics—is the key driver of the economy... Change in Debt & Change in Employment • Correlation with change in employment Acceleration of private debt & change in employment, USA Crisis begins 10 2008 5 0 Percent p.a. 0 5 10 15 20 USA stalled crisis by slowdown in deleveraging 25 30 1955 Acceleration of private debt Change in Private Employment 1960 1965 1970 1975 1980 1985 Year 1990 1995 2000 2005 2010 2015 Change in Debt & Change in Employment • Summing up: Credit drives the economy • Acceleration in debt precedes change in GDP Credit Impulse Correlations in the USA 0.8 0 Employment GDP Correlation 0.6 0.4 0.2 0 0.2 20 10 0 10 Lag in months 20 • Doesn’t have to drive it “over the cliff” • But always does • Why? • The temptation of Ponzi Finance • Putting it all together... 30 Finance and Economic Breakdown • Economy is – Inherently cyclical • Waves of innovation/destruction (Schumpeter) • Struggles over income distribution (Marx, Goodwin) • Complex & aperiodic (Lorenz, Mandelbrot, Prigogine) – Inherently monetary • Moore, Graziani – Inherently afflicted by uncertainty • Keynes (not IS-LM!) • Given nature of capital assets – Banks’ desire to create debt leads to financial crises • The Financial Instability Hypothesis: Minsky Minsky’s “Financial Instability Hypothesis” • Economy in historical time – Both ignored by conventional “neoclassical” economics) • Debt-induced recession in recent past • Firms and banks conservative re debt/equity, assets • Only conservative projects are funded – Recovery means most projects succeed • Firms and banks revise risk premiums – Accepted debt/equity ratio rises – Assets revalued upwards… • “Stability is destabilising” – Period of tranquility causes expectations to rise… • Self-fulfilling expectations – Decline in risk aversion causes increase in investment – Investment expansion causes economy to grow faster The Euphoric Economy • Asset prices rise: speculation on assets profitable • Increased willingness to lend increases money supply – Money supply endogenous , not under RBA control • Riskier investments enabled, asset speculation rises • The emergence of “Ponzi” (Bond, Skase…) financiers – Cash flow less than debt servicing costs – Profit by selling assets on rising market – Interest-rate insensitive demand for finance • Rising debt levels & interest rates lead to crisis – Rising rates make conservative projects speculative – Non-Ponzi investors sell assets to service debts – Entry of new sellers floods asset markets – Rising trend of asset prices falters or reverses The Assets Boom and Bust • Ponzi financiers go bankrupt: – Can no longer sell assets for a profit – Debt servicing on assets far exceeds cash flows • Asset prices collapse, increasing debt/equity ratios • Endogenous expansion of money supply reverses • Investment evaporates; economic growth slows • Economy enters a debt-induced recession – Back where we started... • Process repeats once debt levels fall – But starts from higher debt to GDP level • Eventually final crisis where debt burden overwhelms economy Modelling Minsky • Modelled by – Introducing nonlinear functions • Capitalist desire to invest • Debt repayment rate • Money relending rate – Endogenous money creation via “line of credit” • Firm investment desire funded by increased deposit • Simultaneous increase in debt – Modelling production & price formation • Also growth in population & labor productivity Modelling Minsky: Financial side • New Godley Table “Line of credit”: money & debt created at same time • Exponential functions for expectations under uncertainty: • Given uncertain future, investors assume that “the present is a much more serviceable guide to the future than a candid examination of past experience would show it to have been hitherto” (Keynes 1936, p. 214) Modelling Minsky: behavioural components • Functions for wage setting (workers), investment (firms), loan repayment (firms) and money relending (banks) 20 50 20 Loan repayment Money relending 40 10 5 15 30 Years 15 Percent of GDP Percent change in money wages Loan Repayment and Money relending Investment & Profit Rate Wages and Employment Rate 10 20 5 10 0 5 90 92 94 96 Employment Rate 98 100 0 5 0 Profit Rate % 5 10 0 10 5 0 Rate of Profit • Purpose of functions not to generate cycles • System already inherently cyclical (Goodwin) • But to constrain cycles to realistic levels 5 10 Modelling Minsky: Production Relations • Capital K determines output Y via the accelerator: K 1/3 Accelerator Y • Y determines employment L via productivity a: Y l r 1 a Labour Productivity / L • L determines employment rate l via population N: L l r 100 N Population / l • l determines rate of change of wages w via Phillips Curve + .96 "NAIRU" 10 WageResponse * PhillipsCurve • (Linear Phillips curve for now) dw/dt • Integral of w determines W (given initial value) 1 Initial Wage dw/dt + 1/S + Integrator w L * W • Y-W determines profits P and thus Investment I… Y W + - Pi I dK/dt • Closes the loop: 1 Initial Capital dK /dt + 1/S + Integrator Modelling Minsky: Inherent cycles • Model generates cycles (but no growth since no population growth or technical change yet)…: K 1/3 Accelerator l r 1 a Labour Productivity 1 Population .96 "NAIRU" + 10 WageResponse L / • Cycles caused by essential nonlinearity: • Wage rate times employment Goodwin's cyclical growth model 1.50 / Employment Wages 1.25 l 1.00 .75 PhillipsCurve * dw/dt .50 1 Initial Wage Y l r N Y w L + 1/S + Integrator + - * 0 2 4 6 Time (Years) W Goodwin's cyclical growth model 1.3 Pi I 1.2 dK/dt + 1/S + Integrator Wages 1.1 3 Initial Capital 8 1.0 .9 .8 .7 .9 .95 1 Employment 10 • Behavioural nonlinearities not needed for cycles; • Instead, restrain values 1.05 to realistic levels Modelling Minsky: Wage dynamics • Phillips curve much maligned in economics – But used by almost all schools of thought • Also misunderstood: three factors, not just one: – 1. Level of unemployment (highly nonlinear relationship) – 2. Rate of change of unemployment – 3. Rate of change of retail prices “operating through cost of living adjustments in wage rates.” (Phillips 1958 p. 283-4) • All 3 factors included in this model: Employ Rate of Rate of change of Inflation ment employment 1change d of 1 d wages W Ph g P depends W dt on… P dt Modelling Minsky: Price dynamics • Physical Output (Q) = Labor times L labor productivity a • Labor = Money flow of wages divided by money wage W • Flow of wages = worker share of output during turnover period tS (time from outlays to receipts) • Money Demand = Annual flow of wages plus profits – = Money in Firms divided by turnover tS . • Physical Demand = Money Physicaldemand divided by Price level Physical • In equilibrium, of physical supply = physical demand supply flowdemand 1 s FDe 1 FDe Qe a De tS W t S Pe • Solving for equilibrium price: Pe 1 W 1 s a Convergence over time • As a dynamic process: d 1 1 W P P dt tP 1 s a Modelling Minsky: The full system Financial Sector • In scary equations… d BC( t) dt d BPL( t) dt FL( t) t RL r( t) BC( t) t LC r( t) BC( 0) rL FL( t) rD FD( t) rD W D( t ) BC( t) FL( t) BPL( t ) BPL( 0) tB d FL( t) dt t LC r( t) d FD( t) dt BC( t ) FL( t ) BPL( t) W D( t ) W ( t) Yr( t) rD FD( t) rL FL( t) PC( t) Yr( t ) Inv r( t) t LC r( t ) t RL r( t ) tB tW a( t ) d W D( t) dt t RL r( t ) PC( t) Yr( t) Inv r( t ) rD W D( t) W D( t) tW BC0 W ( t) Yr( t ) BPL0 FL( 0) FL0 FD( 0) FD0 W D( 0) a( t ) W D0 Physical output, labour and price systems Level of output Employment L( t ) Yr( t) Rate of real economic growth g( t) d W ( t) dt Rate of change of prices Rate of change of capital stock L( 0) a( t ) PC( t) Yr( t ) W ( t) L( t) rL FL( t) rD FD( t) r( 0) ( t) [ g( t) ( ) ] Inv r( t) v W ( ( t) ) Ph ( ( t ) ) [ [ g ( t) ( ) ] ] d PC( t) dt d Kr( t) dt Rates of growth of population and productivity v PC( t) Yr( t) d ( t) dt Rate of employment Yr( 0) Yr0 v r( t) Rate of Profit Rate of change of wages Kr( t) Yr( t) 1 t Pc PC( t) W ( t) W ( t) 1 1 t a( t) ( 1 s ) P ( t) C Pc a( t ) ( 1 s ) Kr( t) g ( t) d a( t ) dt a( t ) d N ( t) dt N ( t) N ( 0) N0 L0 r0 ( 0) 0 g ( 0) g0 W ( 0) W0 PC( 0) PC0 Kr( 0) Kr0 a( 0) a0 Modelling Minsky: The full system • In less scary QED format: QED Modelling Minsky: The outcome • Model generates Great Moderation & Great Recession – Not yet calibrated on data yet qualitatively similar… Great Moderation to Great since Recession US Inflation and Unemployment 1970 16 15 Inflation Inflation Unemployment Unemployment 14 U-6 Measure 12 Percent Percent p.a. 10 10 8 5 6 4 0 2 0 Inflation Unemployment U-6 Measure 0 52 78 803082 84 92 94 70 96 9880 100 102 108 110 110 70 74 7620 0 72 10 4086 88 50 90 60 90104 106 100 Year Year Modelling Minsky: The outcome • The full picture from QED Modelling Minsky: The outcome • The full picture from QED Modelling Minsky: The insights • Private debt causes both boom and crisis • Workers pay for debt through reduced share of income: Income Distribution • Reduced volatility with Workers Capitalists rising debt a sign of Bankers • Not increased stability (“The Great Moderation”— Bernanke 2004) • But “Calm before the storm” (Keen 1995) 110 100 90 Percent of GDP 80 70 60 50 40 30 20 10 0 10 0 20 40 Year 60 How does “Now” compare to “Then”? • Debt-financed proportion of aggregate DDebt demand:GDP DDebt Debt-financed demand percent of aggregate demand 25 20 15 Percent 10 5 0 0 5 Great Depression including Government Great Recession including Government 10 15 20 25 0 1 2 3 4 5 6 7 8 9 10 11 12 Years since peak rate of growth of debt (mid-1928 & Dec. 2007 resp.) 13 Where to from here? • 3 factors determine debt impact on economy – Level (relative to GDP) • Like distance between start and destination • How long before journey is over – Rate of change • Like speed of travel to destination • Affects aggregate demand – Rate of change of rate of change • Like acceleration/deceleration • Whether you’re getting there more quickly or not • Affects rate of change of aggregate demand – Are things improving or getting worse right now? Where to from here?: Level • It’s a long way from the top if you’ve sold your soul... USA Private Debt to GDP 320 300 280 260 The NBER thinks the recession ended here! Percent of GDP 240 220 200 180 160 140 120 100 80 60 40 20 0 1920 1930 1940 1950 1960 1970 Year 1980 • Almost 100% of GDP reduction to get to pre-Great Depression level • Speculative 175 debt still present • 200% to get back to 50s level 75 • Only productive debt 2010 2020 • Decade with aggregate demand below GDP 2009.5 1990 2000 Where to from here?: Rate of change • Deleveraging impact equivalent to Great Depression level Velocity of debt & unemployment 25 0 2009.5 Debt-financed demand Unemployment (inverted) Percent of aggregate demand 20 15 10 5 5 0 0 5 10 15 20 25 30 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 Year • Debt reducing at Great Depression rate • Levelling out implies sustained slump • “Turning Japanese” U-3 measure of unemployment 30 Where to from here?: Acceleration • We’re slowing down... Acceleration of debt & change in employment 2009.5 10 Rate of change of new debt p.a. 5 0 5 10 15 20 0 0 The acceleration effect might be why the NBER thinks the recession ended here! 25 30 1955 10 20 Acceleration of debt Rate of change of employment 1960 1965 1970 1975 1980 1985 Year 1990 1995 2000 2005 2010 Rate of change of private employment p.a. 10 30 2015 • Less scary than accelerating fall (rising on quarterly data) • But still not enough to increase employment • Susceptible to future acceleration in fall • Much of rise driven by return to Ponzi investing Where to from here? • 2 most persistent debt metrics remain negative – Level of debt to GDP – Rate of change • Most volatile currently positive – Deceleration of deleveraging has boosted economy • Learning complicated dynamics of debt the hard way • History implies crisis has many years to run…