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Steve Keen’s DebtWatch No 23 June 2008

RBA Assis­tant Gov­er­nor Guy Debelle and I spoke at a con­fer­ence on Sub­primes in Ade­laide last month. One aspect of my analy­sis that Guy queried was my empha­sis upon the Debt to GDP ratio. He not­ed that this appeared sus­pect, because it was com­par­ing a stock (the out­stand­ing lev­el of debt) to a flow (annu­al GDP).

It’s a valid point to make. The engi­neer-turned-econ­o­mist Mick­al Kalec­ki once caus­ti­cal­ly observed that “eco­nom­ics is the sci­ence of con­fus­ing stocks with flows”, and I’m a stick­ler myself for not mak­ing that mis­take. So mak­ing a song and dance about a stock to flow com­par­i­son like debt to GDP has to be jus­ti­fied by a sound argu­ment.

The most acces­si­ble argu­ment is an anal­o­gy to glob­al warm­ing. Just as the grow­ing lev­el of C02 in the atmos­phere is evi­dence that the ecosys­tem is not cop­ing with the (rel­a­tive­ly tiny) addi­tion­al vol­ume of car­bon diox­ide human activ­i­ty is adding to the bios­phere, the accu­mu­la­tion of debt rel­a­tive to income is evi­dence that the econ­o­my is not cop­ing with the (rel­a­tive­ly large) vol­ume of debt being gen­er­at­ed by the finan­cial sys­tem to finance spec­u­la­tive pur­chas­es of assets.

There are at least five strong sim­i­lar­i­ties between this eco­log­i­cal issue and the eco­nom­ic one of accu­mu­lat­ing debt:

1. The envi­ron­ment has an estab­lished “car­bon cycle”, by which the emis­sion of car­bon diox­ide into the atmos­phere by ani­mals, etc., is bal­anced by its re-absorb­tion by plants, etc. This process is aug­ment­ed by many oth­er factors–such as the explu­sion of CO2 by volcanoes–and, on a geo­log­i­cal time frame, far from sta­ble; but over the peri­od of human exis­tence, the atmos­pher­ic con­cen­tra­tion was below 300 parts per mil­lion (ppm) until indus­tri­al­i­sa­tion began.
2. The fact that the con­cen­tra­tion has risen from under 300 ppm to over 380 ppm in the past cen­tu­ry shows that the plan­et’s nat­ur­al car­bon-pro­cess­ing cycle is not cop­ing with the extra CO2 added by human indus­tri­al and agri­cul­tur­al activ­i­ty. Glob­al Warm­ing is the most appar­ent man­i­fes­ta­tion of this increased stock of CO2.
3. Even if all human indus­tri­al and agri­cul­tur­al activ­i­ty stopped today, it would take decades for the addi­tion­al CO2 we have added to the atmos­phere to decline to pre-indus­tri­al lev­els. At present, the exist­ing nat­ur­al car­bon cycle is only means to reduce that accu­mu­la­tion, and it could take longer to reduce the build up than it took to accu­mu­late it, since we have dam­aged many of the nat­ur­al “car­bon sinks” in the ecosys­tem.
4. Per­sist­ing with present or high­er lev­els of CO2 will cause the ecosys­tem to under­go both pro­found and uncer­tain change, some aspects of which can be inferred from past geo­log­i­cal data.
5. There are feed­back effects that mean any cli­mate-alter­ing effects of raised CO2 lev­els may be fur­ther ampli­fied. For instance, the rise in tem­per­a­ture has reduced the area of ice in the North Pole, lead­ing to reduced reflec­tion of sun­light (since ice reflects most light while water most­ly absorbs it), and fur­ther increas­ing glob­al tem­per­a­tures.

Sim­i­lar propo­si­tions can be put with respect to debt:

1. The econ­o­my has a nat­ur­al capac­i­ty to process debt. Bor­row­ing by busi­ness­es to finance invest­ment can lead to new prod­ucts whose sale enables the busi­ness­es to make a prof­it and repay debt over time (Schum­peter’s The­o­ry of Eco­nom­ic Devel­op­ment gives per­haps the best expla­na­tion of this “nat­ur­al debt cycle”);
2. The fact that debt lev­els are ris­ing with respect to income is a sign that the eco­nom­ic sys­tem is not cop­ing with the lev­el of debt being gen­er­at­ed today;
3. Even if all bor­row­ing stopped today, it would take decades for the addi­tion­al debt we have accu­mu­lat­ed to be reduced to pre-debt bub­ble lev­els. The only way that debt lev­els can be reduced is if income is redi­rect­ed from either con­sump­tion or invest­ment into debt reduc­tion. This is the key rea­son that the debt to GDP ratio is impor­tant: it tells us how much of income would be need­ed to reduce debt, and how long such a reduc­tion would take. How­ev­er the process of reduc­ing debt will itself reduce income to some degree, since mon­ey that would oth­er­wise have gone into invest­ment will now sim­ply be used to pay down debt levels–and incomes and employ­ment will fall as a result;
4. Per­sist­ing with the lev­el of debt we have now will mean a pro­found­ly dif­fer­ent and uncer­tain eco­nom­ic envi­ron­ment. The pro­por­tion of income need­ed to ser­vice debt will remain at lev­els that have only ever been expe­ri­enced in the past dur­ing Depres­sions.
5. Final­ly, there are feed­back effects in the econ­o­my that can mean debt to GDP ratios fall even when, ulti­mate­ly, bor­row­ers try to reduce their expo­sure to debt. The worst such effects are: direct reduc­tions in invest­ment as retained earn­ings are used to pay down debt rather than invest; indi­rect falls in invest­ment as falls in con­sump­tion reduce cash flow and depress both earn­ings and expec­ta­tions; and falling prices if defla­tion sets in, as it did dur­ing the Great Depres­sion when prices fell as much as 10% per year.

There is also an aca­d­e­m­ic eco­nom­ic argu­ment that can be made about the impor­tance of the debt to GDP ratio, deriv­ing from Min­sky’s “Finan­cial Insta­bil­i­ty Hypoth­e­sis”. In this the­o­ry, a ris­ing ratio is both a pre­dic­tion of the mod­el, and a force lead­ing to greater finan­cial insta­bil­i­ty and pos­si­ble eco­nom­ic break­down in a Depres­sion. But I’ll leave a full dis­cus­sion of this for a future Debt­watch.

Observations on the Data

The most recent data imply that the turn­around in debt to GDP may final­ly be start­ing. The debt to GDP ratio fell last month, from 165.25% of GDP to 165.2%. It’s not a lot, and it may still return to its 44-year long upward trend; but it is the first time in fif­teen years that the ratio has fall­en.

The con­trib­u­tor was an “unex­pect­ed” fall in the rate of growth of busi­ness bor­row­ing (these things always seem to be “unex­pect­ed”). Though it still increased, it grew at a slow­er pace than GDP–as did per­son­al bor­row­ing. The grwoth in mort­gage debt, on the oth­er hand, con­tin­ued to out­strip GDP (see Tables 1 and 2 below for details).

While in one sense this slow­ing down in debt growth is a good thing–in that an unsus­tain­able trend may final­ly be com­ing to an end–it also may presage very tough eco­nom­ic times ahead. One aspect of my focus on the debt to GDP ratio is the con­tri­bu­tion that change in debt then makes to aggre­gate spend­ing. Aggre­gate demand in the econ­o­my, for every­thing from com­modi­ties to net asset trans­fers, is the sum of both income (GDP) plus the change in debt.

In a well func­tion­ing econ­o­my, that should­n’t be much rel­a­tive to GDP itself–and it was­n’t in the 1950s and 1960s. Then, the annu­al change in debt con­tributed no more than 4% of total demand.

But as the debt lev­el ris­es, the change in debt can become an extreme­ly large and volatile com­po­nent of aggre­gate spend­ing. That clear­ly is what hap­pened from 1970 onwards: the annu­al change in debt began to con­tribute sub­stan­tial­ly more than 4% of total demand.

And it was high­ly volatile: notice the slump in its con­tri­bu­tion from over 10% to just 4% in 1973–75 that coin­cid­ed with the col­lapse of the Whit­lam Gov­ern­ment, and the fall from a peak of almost 14% of aggre­gate demand to minus 1.5% dur­ing “the reces­sion we had to have”.

Today, the annu­al change in debt is the source of over 19% of aggre­gate demand. Should that turn around–as it must even to sta­bilise the debt to ratio at its cur­rent his­tor­i­cal­ly unprece­dent­ed level–then demand in the econ­o­my could “unex­pect­ed­ly” evap­o­rate.

The full Debt­watch Report, with all the graph­ics, is avail­able in PDF for­mat here.