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Dynamics of the Global Financial Crisis
Steve Keen
UWS
Appalling guidance by neoclassical economists
• OECD World Economic Outlook, June 2007, p. 9:
– “the current economic situation is in many ways
better than what we have experienced in years…
– Our central forecast remains indeed quite benign:
•
•
•
•
•
a soft landing in the United States,
a strong and sustained recovery in Europe,
a solid trajectory in Japan
and buoyant activity in China and India.
In line with recent trends, sustained growth in OECD
economies would be underpinned by strong job
creation and falling unemployment.”
– Jean-Philippe Cotis, Chief Economist
• Crisis began August 9 2007—just 2 months later!
– BNP closes 3 funds with strong subprime exposure…
• Different theory needed to understand crisis:
Minsky’s “Financial Instability Hypothesis”
• Explanation for regular credit-driven cycles & crises:
– Economy in historical time
– 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…
The Euphoric Economy
• Self-fulfilling expectations
– Decline in risk aversion causes increase in investment
• Investment expansion causes economy to grow faster
– Asset prices rise
• speculation on assets profitable
– Increased willingness to lend increases money supply
• Money supply endogenous money, 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
The Assets Boom and Bust
• Eventually:
– 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
• 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...
Crisis and Aftermath
• High Inflation?
– Debts repaid by rising price level
– Economic growth remains low: Stagflation
– Renewal of cycle once debt levels reduced
• Low Inflation?
– Debts cannot be repaid
– Bankruptcy affects even non-speculative businesses
– Economic activity remains suppressed: a Depression
• Big Government?
– Anti-cyclical spending enables debts to be repaid
– Renewal of cycle once debt levels reduced
Crisis and Aftermath
• Modelling Minsky
– Extension of Goodwin’s Growth Cycle to include debt
• 3 “stylised facts”
– Wages share grows if wage rises exceed productivity
– Employment rises if growth exceeds productivity +
population increase
– Bank lend money to finance investment
• Dynamics
– Borrow money to finance investment during a boom
• Repay some of it during a slump
– Debt to income levels ratchets up through series of
booms/busts
– Eventually one boom where debt accumulation passes
“point of no return”…
Modelling Minsky & Endogenous Money…
• Just one
problem…
Capital
Output
Productivity
l
/
r
Employment
Population
l
/
r
Employment Rate
Graphs
Investment
Profit
Output
+
+
Wages
Interest
0.03
r
Profit
Debt
134
Output
l
/
r
Initial_Population
Debt
Debt/Output
750000
7.5
500000
5.0
250000
2.5
0
0
0
*
50
100
Time (Years)
150
0
50
100
Time (Years)
150
The Global Debt Bubbles
• Worse than the 1920s…
US Debt to GDP Ratios
200
180
450
400
350
Household
Plus Business
Plus Financial
Plus Government
160
Debt to GDP Ratio
Dec. '05
Crisis Begins
140
120
Percent
300
100
250
80
200
60
150
40
100
20
50
0
1920
0
1955
1930
1940
1950
1960
1970
1980
1990
2000
1960
1965
1970
1975
1980
1985
1990
1995
2000
2005
2010
2010
Australia's Long Term Debt to GDP Ratio
• Model’s main missing
ingredient:
– Ponzi Investing
200
150
100
50
0
1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010
Ponzi Finance
• Difference between model debt/output pattern:
Debt to Output Ratio
12
10
Ratio
8
6
4
2
0
0
20
40
60
80
100
Years
• And actual pattern:
200
180
160
Debt to GDP Ratio
Dec. '05
Crisis Begins
140
120
100
80
60
40
20
0
1955
1960
1965
1970
1975
1980
1985
1990
1995
2000
2005
2010
• Absence of “Ponzi Finance” in
base model
– All borrowing leads to
growth in productive
capacity in model
• In Minsky’s theory (and in
reality!), much of borrowing
simply finances speculation on
asset prices
– No addition to productive
capacity
– But addition to debt!
• Modelled by introducing Ponzi
Capital component:
Ponzi Finance
Capital
Output
Plot
Speculative to Productive Debt
Output
6
5
Cyclical Growth
2000
4
1000
3
2
0
0
20
40
Time (Years)
60
WageShare
Output
1
0
0
10
20
30
40
Time (Years)
50
60
Cyclical Growth
Wages share of output
Employment Rate
1.0
Debt
Ratios
On
DebtInModel
1.
On
Ponzi
1.
.5
Plot
0
0
Debt to Output Ratios
20
40
Time (Years)
60
6
5
Cyclical Growth
Employment
• Honouring
irresponsibly
created debt will
lock us into a
permanent slump…
• Implies can’t
overcome crisis
without debt
reduction
– Via deliberate
inflation; or
– Widespread
debt moratoria
• Problem too big to
“paper over”
Investment
4
1.1
1.0
3
.9
2
.8
1
.7
0
.6
EmploymentRate
Wages
+
Profit
+
.8
*
1
Employment
InterestRate
TotalDebt
Total Debt
Productive
Speculative
Ponzi model
pattern closer to
actual data
0
0
10
+
+
20
30
40
Time (Years)
Productive
Debt
Speculative
Debt
Profit
Investment
RateOfGrowth
50
60
The problem
• Debt/GDP twice as
bad as prior to
Great Depression
– USA
• 1929: 150%
• 2008: 290%
– Australia
• 1929: 64%
• 2008: 165%
• Common across
OECD:
• Position probably
far worse once
impact of
derivatives, off
balance sheet
SIVs, etc. included
Prospects
• Government deficit spending justified
– Cash flow to private sector assists debt repayment
• But scale of problem will overwhelm financial rescue
– Spending sum of GDP + Change in Debt
• Last year GDP $1,080bn; change in debt $259bn
• Change in debt≈20% aggregate demand
– Even debt stabilisation means drastic drop in demand
• Debt stabilisation $259bn cut to spending
• Debt reduction to say 75% GDP (triple 60s level)
– $100bn/year cut in demand for next 10 years?
– Government spending can’t counteract this
• Witness Japan:
Omens
Japan Debt to GDP Ratios
• Japan’s “Bubble Economy”
Government
Private
crisis a precursor to
Private
Aggregate Debt
Subprime Crisis
– Debt-financed
speculative bubble
– Burst end-1989
– Two decades later,
still in low level
Depression
– Government debt far
higher, private debt
• Can’t “pump prime” way out of
debt crisis this big…
slightly lower…
• Simply swaps public debt for
• But economy still
private
mired in economic
– Debt should never have been
slump
300
200
130
120
150
Percent
200
110
100
100
100
50
90
0
80
1970
1975
1980
1985
1990
1995
2000
2005
issued in the first place
2010
Solutions?
• Only solutions involve drastic cut in Debt/GDP ratio
– Deliberate Inflation?
– Debt moratoria?
• Post-crisis reforms
– Palliative reforms (Glass-Steagall Act, etc.) will be
“reformed” away once they cause prolonged stability
– Long term success only if possibility of profitable
asset price speculation virtually eliminated
• Alter nature of share ownership
• Alter property valuation
• Re-assign risk from borrowers to lenders
• And think differently about the economy in future…
– Less ideology (left or right!) and more knowledge…
Alternative economic theory needed too!
• Economic theory in part got us into this mess
– Ignoring role of money & debt
– Fetish on equilibrium when economy far from it
– Naïve view of role of finance markets
• “Efficient Market Hypothesis”…
– Insane view of rationality
• rationality as ability to predict the future!
• Didn’t see this crisis coming…
• Can you trust conventional (neoclassical) theory to
– Know what comes next?
– Get us out of it?
• Alternative theories of economics needed
– Some exist but are underdeveloped
– Best is Minsky’s Financial Instability Hypothesis
Don’t get fooled again…
• Some other alternatives
– Post-Keynesian economics
• http://www.levy.org/
• http://cas.umkc.edu/econ/
– Evolutionary economics
• http://www.themeister.co.uk/economics/evolu
tionary_economics.htm
• http://www.business.aau.dk/evolution/
– Complex systems analysis & “Econophysics”
• Physicists doing economics
– http://www.unifr.ch/econophysics/
• For more information & analysis: