Debtwatch 27 October 08: The Failure of Central Banks

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Just two years ago, Cen­tral Banks appeared tri­umphant. Infla­tion, the scourge of the 1970s and 80s, appeared dead, the finan­cial cri­sis of the Tech Wreck had been con­tained, economies world­wide were boom­ing, and stock mar­kets and house prices were spi­ralling ever upwards.

Then along came the Sub­prime Cri­sis, and we received a rude reminder of why Cen­tral Banks were cre­at­ed in the first place: to ensure that the world would nev­er again expe­ri­ence a Great Depres­sion.

We are not in a Great Depression–not yet anyway–but a key pre-con­di­tion for one has devel­oped right under the noses of Cen­tral Banks: exces­sive pri­vate debt. In fact, debt lev­els today are twice as high as in 1929, which is why this finan­cial cri­sis is caus­ing far more car­nage than 1929 did.

At the time of the Stock Mar­ket Crash of Octo­ber 1929, the US’s debt ratio was 150%; today it is 290%. Aus­trali­a’s ratio was 64%; today, it is 165%. The reg­u­la­tors who were sup­posed to keep us from the jaws of The Beast have instead led us clos­er towards its bel­ly.

Figure One

USA and Australian Debt to Output Ratios 1920-2008

USA and Aus­tralian Debt to Out­put Ratios 1920–2008

This was not, of course, a con­scious deci­sion. It has hap­pened because Cen­tral Banks are run by econ­o­mists, and the dom­i­nant “Neo­clas­si­cal” fac­tion with­in eco­nom­ics ignored the real lessons of the Great Depres­sion.

The false les­son that Neo­clas­si­cal eco­nom­ics preach­es is that the mar­ket econ­o­my is fun­da­men­tal­ly sta­ble, and the Great Depres­sion was caused by the mon­e­tary author­i­ties tight­en­ing cred­it in the after­math to the Stock Mar­ket Crash, rather than loos­en­ing it.

The real les­son of the 1930s is that a cred­it-dri­ven mar­ket econ­o­my is fun­da­men­tal­ly unsta­ble, and a Great Depres­sion occurs when debt-financed spec­u­la­tion results in exces­sive pri­vate debt at the same time as infla­tion is low.

Cen­tral Banks, under the mis­guid­ance of con­ven­tion­al eco­nom­ic the­o­ry, ignored the role of pri­vate debt in the eco­nom­ic sys­tem. They instead rein­ter­pret­ed their charters–which empha­sised full employment–as a man­date to keep infla­tion low.

As the RBA put it in its most recent Annu­al Report, its:

duty … to ensure … the sta­bil­i­ty of the cur­ren­cy… the main­te­nance of full employ­ment … and the eco­nom­ic pros­per­i­ty and wel­fare of the peo­ple of Aus­tralia… has found con­crete expres­sion in the form of a medi­um-term infla­tion tar­get. Mon­e­tary pol­i­cy aims to keep the rate of con­sumer price infla­tion at 2– 3 per cent, on aver­age, over the cycle.” (Annu­al Report 2008, page 5).

With its Neo­clas­si­cal eyes fix­at­ed on the rate of infla­tion, it ignored the expan­sion of pri­vate debt–as did its equiv­a­lents at Cen­tral Banks around the world, as did gov­ern­ment Trea­suries, and as did inter­na­tion­al eco­nom­ic agen­cies. This is why the sud­den col­lapse of the world eco­nom­ic order took econ­o­mists by sur­prise. They were look­ing at their math­e­mat­i­cal mod­els, which ignore pri­vate debt (and indeed mon­ey!), rather than at the real world, where debt is king.

Nowhere was this more obvi­ous than with the OECD–the organ­i­sa­tion whose impri­matur the Aus­tralian Trea­sury seeks. The fol­low­ing are the unabridged open­ing two para­graphs from the Edi­to­r­i­al to the OECD Eco­nom­ic Out­look from May of 2007 (with the real­ly fun­ny bits in bold):

In its Eco­nom­ic Out­look last Autumn, the OECD took the view that the US slow­down was not herald­ing a peri­od of world­wide eco­nom­ic weak­ness, unlike, for instance, in 2001. Rather, a “ smooth”  rebal­anc­ing was to be expect­ed, with Europe tak­ing over the baton from the Unit­ed States in dri­ving OECD growth.

Recent devel­op­ments have broad­ly con­firmed this prog­no­sis. Indeed, the cur­rent eco­nom­ic sit­u­a­tion is in many ways bet­ter than what we have expe­ri­enced in years. Against that back­ground, we have stuck to the rebal­anc­ing sce­nario. 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.”

Yeah, right. Just three months lat­er, the finan­cial cri­sis began.

It should by now be painful­ly obvi­ous that con­ven­tion­al eco­nom­ics can­not be relied upon to explain where we are, how we got here, where we might end up, and what might work to avoid the worst con­se­quences. To under­stand it, we have to go back to the econ­o­mist who got it right, but was ignored by the eco­nom­ics pro­fes­sion: Irv­ing Fish­er.

The Debt-Deflation Theory of Great Depressions

Fish­er had been an aca­d­e­m­ic cheer­leader for the finan­cial bub­ble of the Roar­ing Twenties–his main claim to fame one can find on the Inter­net is that he uttered the fate­ful pre­dic­tion that “Stock prices have reached what looks like a per­ma­nent­ly high plateau” the week before the Stock Mar­ket Crash of 1929.

Four years on, chas­tened and effec­tive­ly bank­rupt­ed, he reflect­ed that a Great Depres­sion ensued when too much debt was accom­pa­nied by falling prices. He chris­tened the phe­nom­e­non a “debt-defla­tion”.

A key aspect of Fish­er’s rea­son­ing was that, though econ­o­mists of his time mod­elled the econ­o­my as if it were per­ma­nent­ly in equi­lib­ri­um, the real econ­o­my would always be in dis­e­qui­lib­ri­um. As he put it, even if the econ­o­my did tend towards equi­lib­ri­um:

new dis­tur­bances are, human­ly speak­ing, sure to occur, so that, in actu­al fact, any vari­able is almost always above or below the ide­al equi­lib­ri­um”

He also argued that the forces that gave rise to a Depres­sion were innate­ly dis­e­qui­lib­ri­um in nature. The two key fac­tors that caused a Depres­sion, he argued, were exces­sive debt and falling prices. Though oth­er fac­tors might lead to a cri­sis (such as over­con­fi­dence or exces­sive spec­u­la­tion), debt and defla­tion were the two key forces that turned a gar­den-vari­ety down­turn into a Depres­sion. As he very poignant­ly put it (since he him­self was a vic­tim):

over-invest­ment and over-spec­u­la­tion are often impor­tant; but they would have far less seri­ous results were they not con­duct­ed with bor­rowed mon­ey. That is, over-indebt­ed­ness may lend impor­tance to over-invest­ment or to over-spec­u­la­tion. The same is true as to over-con­fi­dence. I fan­cy that over-con­fi­dence sel­dom does any great harm except when, as, and if, it beguiles its vic­tims into debt.”

Fish­er then laid out the sequence of events that fol­lows when a finan­cial cri­sis ensues in the con­text of exces­sive debt and low infla­tion:

(1) Debt liq­ui­da­tion leads to dis­tress sell­ing and to

(2) Con­trac­tion of deposit cur­ren­cy, as bank loans are paid off, and to a slow­ing down of veloc­i­ty of cir­cu­la­tion. This con­trac­tion of deposits and of their veloc­i­ty, pre­cip­i­tat­ed by dis­tress sell­ing, caus­es

(3) A fall in the lev­el of prices, in oth­er words, a swelling of the dol­lar. Assum­ing, as above stat­ed, that this fall of prices is not inter­fered with by refla­tion or oth­er­wise, there must be

(4) A still greater fall in the net worths of busi­ness, pre­cip­i­tat­ing bank­rupt­cies and

(5) A like fall in prof­its, which in a “cap­i­tal­is­tic,” that is, a pri­vate-prof­it soci­ety, leads the con­cerns which are run­ning at a loss to make

(6) A reduc­tion in out­put, in trade and in employ­ment of labor. These loss­es, bank­rupt­cies, and unem­ploy­ment, lead to

(7) Pes­simism and loss of con­fi­dence, which in turn lead to

(8) Hoard­ing and slow­ing down still more the veloc­i­ty of cir­cu­la­tion. The above eight changes cause

(9) Com­pli­cat­ed dis­tur­bances in the rates of inter­est, in par­tic­u­lar, a fall in the nom­i­nal, or mon­ey, rates and a rise in the real, or com­mod­i­ty, rates of inter­est.” 

After the Crash of 1929, when busi­ness debt was dom­i­nant, many firms found them­selves with debt repay­ment com­mit­ments that they could­n’t meet out of cash flow. They under­took “ dis­tress sell­ing”  to try to raise the mon­ey they need­ed— and because every­one dropped their prices, prices fell across the board. Even firms that man­aged to pay their debts down in nom­i­nal terms found that their rev­enues fell even more than their debt, lead­ing to “ Fish­er’s Para­dox”  that:

the more debtors pay, the more they owe. The more the eco­nom­ic boat tips, the more it tends to tip. It is not tend­ing to right itself, but is cap­siz­ing.”

That phe­nom­e­non is strik­ing­ly obvi­ous in the his­tor­i­cal data, which shows the rate of infla­tion falling from triv­ial lev­els (of between 0.5% and 1% p.a.) to minus 10% p.a. between 1931 and 1933.

Figure Two

Inflation Rates 1920-40 USA and Australia

Infla­tion Rates 1920–40 USA and Aus­tralia

Eco­nom­ic growth also came to a shud­der­ing halt as the ensu­ing cred­it crunch cut spend­ing lev­els, and as cash-strapped busi­ness­es sacked their work­force. That decline is also evi­dent in the data, with the rate of real eco­nom­ic growth falling from 6% before the crash to minus 8% after it–and as low as minus 13% in 1932.

Figure Three

Rate of Economic Growth 1920-40, USA and Australia

Rate of Eco­nom­ic Growth 1920–40, USA and Aus­tralia

The decline in both out­put and prices meant that the debt to GDP ratio con­tin­ued to rise after the Stock Mar­ket Crash of 1929–even though cred­it was tight, and any­one who was in debt was try­ing to reduce it. Notice on Fig­ure One that debt ratios con­tin­ued to rise until 1932–from 150% to 215% of GDP in Amer­i­ca, and from 64% to 77% of GDP in Aus­tralia.

The effect of this decline on employ­ment was so severe that it has remained etched into human­i­ty’s psy­che. When the Stock Mar­ket began its col­lapse, the lev­el of unem­ploy­ment in Amer­i­ca, as record­ed by the Nation­al Bureau of Eco­nom­ic Research, was 0.04%–one 25th of one per­cent. Three years lat­er, it reached 25%. Aus­trali­a’s unem­ploy­ment rate blew out too, from a high­er ini­tial lev­el of 9% to a peak of 20% in 1932. The world had sud­den­ly moved from The Great Gats­by to They Shoot Hors­es, Don’t They?

Figure Four

Unemployment Rates 1920-40, USA and Australia

Unem­ploy­ment Rates 1920–40, USA and Aus­tralia

This calami­ty, which eco­nom­ic the­o­ry said could not hap­pen, both dis­cred­it­ed con­ven­tion­al eco­nom­ic thought, and gave cre­dence to the then unfash­ion­able views of John May­nard Keynes (Fish­er, with his rep­u­ta­tion in tat­ters after his false assur­ances that noth­ing was amiss in 1929, was large­ly ignored–even though Fish­er’s expla­na­tion of how Depres­sions occur was supe­ri­or to Key­nes’s). When the world emerged from the World War that fol­lowed the Great Depres­sion, so-called Key­ne­sian Eco­nom­ics dom­i­nat­ed the pro­fes­sion, and the once supreme Neo­clas­si­cals were ignored.

How­ev­er, one of the most prophet­ic obser­va­tions that Keynes ever made con­cerned the like­li­hood that his new ideas would fail to be tru­ly accept­ed by the eco­nom­ics pro­fes­sion. In the Pref­ace to his Gen­er­al The­o­ry of Employ­ment, Mon­ey and Wages, Keynes observed that:

The ideas which are here expressed so labo­ri­ous­ly are extreme­ly sim­ple and should be obvi­ous. The dif­fi­cul­ty lies, not in the new ideas, but in escap­ing from the old ones, which ram­i­fy, for those brought up as most of us have been, into every cor­ner of our minds.”

So it proved to be. Though call­ing them­selves “Key­ne­sian”, most aca­d­e­m­ic econ­o­mists con­tin­ued to cling to the pre­ced­ing “Neo­clas­si­cal” ideas (espe­cial­ly in the area of micro­eco­nom­ics, which Keynes did not address).

As the expe­ri­ence and the mem­o­ry of the Great Depres­sion reced­ed, aca­d­e­m­ic eco­nom­ics pro­duced a hybrid of Key­nes’s macro­eco­nom­ic ideas graft­ed on top of Neo­clas­si­cal micro­eco­nom­ics that they called “the Key­ne­sian-Neo­clas­si­cal Syn­the­sis”.

Unfor­tu­nate­ly, the ideas were incompatible–and over time, wher­ev­er there was a con­flict, aca­d­e­m­ic eco­nom­ics reject­ed the Key­ne­sian graft, rather than the under­ly­ing Neo­clas­si­cal micro­eco­nom­ics. After fifty years of this, Key­nes’s ideas were com­plete­ly eject­ed from the eco­nom­ic main­stream, the Neo­clas­si­cal belief that the econ­o­my is self-cor­rect­ing became dom­i­nant once more, and econ­o­mists trained in this belief came to dom­i­nate Trea­suries and Cen­tral Banks around the world. They ignored lev­els of pri­vate debt, cham­pi­oned dereg­u­la­tion of finance,  and vir­tu­al­ly encour­aged asset price spec­u­la­tion.

Now we have twice as much debt as caused the Great Depres­sion, and infla­tion so low that, were it not for unprecent­ed fac­tors (the rise of Chi­na, glob­al warm­ing and peak oil), defla­tion would almost be a cer­tain­ty.

Hav­ing thus unlearnt the real lessons of the Great Depres­sion, the eco­nom­ics pro­fes­sion may yet make us relive it.


Comments on the Data

It appears that Aus­trali­a’s debt to GDP ratio has peaked at 165% of GDP. It could still turn up once again if defla­tion takes hold, but for the mean­time, this seems to be the top of the bub­ble.

Now as debt lev­els start to fall–firstly rel­a­tive­ly to GDP and then, ulti­mate­ly, in absolute terms as well–the macro­eco­nom­ic effect of the bub­ble’s burst­ing be felt.

This is because aggre­gate demand is the sum of income plus change in debt. For the last decade, the lat­ter fac­tor has been adding to demand–and aggre­gate sup­ply, asset prices, and our import bill have adjust­ed upwards to suit. But as the change in debt drops and ulti­mate­ly turns neg­a­tive, it will sub­tract from demand–and sup­ply (read employ­ment), asset prices and imports will fol­low it down.

If Aus­tralians decid­ed to reduce their debt to income ratio by 10% each year–to get back to the 25% lev­el that applied back in the 1960s (before this long-term spec­u­la­tive bub­ble took off)–it would take rough­ly 15 years to get there.

Chart One

Monthly change in Debt, Australia

Month­ly change in Debt, Aus­tralia

Chart Two

Contribution to Demand from Change in Debt, Australia

Con­tri­bu­tion to Demand from Change in Debt, Aus­tralia

Table One

Agggregate Debt Summary Australia

Agggre­gate Debt Sum­ma­ry Aus­tralia

Disaggregated Debt Summary, Australia

Dis­ag­gre­gat­ed Debt Sum­ma­ry, Aus­tralia

Australias 1964-2008 Debt Bubble

Aus­trali­a’s 1964–2008 Debt Bub­ble

Australias long term addiction to debt

Aus­trali­a’s long term addic­tion to debt­Trends in Dis­ag­gre­gat­ed Debt, Aus­tralia

Monthly changes in disaggregated debt, Australia

Month­ly changes in dis­ag­gre­gat­ed debt, Aus­tralia

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About Steve Keen

I am Professor of Economics and Head of Economics, History and Politics at Kingston University London, and a long time critic of conventional economic thought. As well as attacking mainstream thought in Debunking Economics, I am also developing an alternative dynamic approach to economic modelling. The key issue I am tackling here is the prospect for a debt-deflation on the back of the enormous private debts accumulated globally, and our very low rate of inflation.