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

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.
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70 Responses to Debtwatch 27 October 08: The Failure of Central Banks

  1. BrightSpark says:

    Hello Outback Oracle.

    Re the conference at the GC.

    The CAD is a good thing because it gives us both the comodities (cargoe) and a line of line of credit to pay for it! But for how long?

    This conference sounds like a religious convention and prayer meeting held by the Chuch of the Cargoe Cult. Now I know where the concept of the “Four Pillars” comes from. The banks are the four pillars of the Great Temple of the Cargoe Gods. At the convention they no doubt prayed for the Pillars, more Cargoe, and Ekargnomic Groath.

    The churches are no doubt choking on the CAD right now, feeling a little weighed down by the need to raise $1Bn per week. They need all of our prayers not just those of the pilgrims at this horses, carts, and fools convention.

  2. j says:


    You’re making the same mistake that a few other economists are making in trying to compare this with 1929 (or 1873 as some have said).

    We don’t have the gold standard/link as that was broken by Nixon in the early 70’s when the French came looking for gold.

    Since that time we have been running paper money which mean the central banks can reflate at will.

    So coming up with a 1929 context isn’t accurate and it just scares the kids.

    the other thing to explain is since when can we avoid a recession so lets have some perspective here.

  3. James of FNQ, I agree with your concerns over negative gearing (and I would add the distortion of the capital gains tax concession). You stated there should be a taxation review – there actually is – submissions are due by 17 October and I’d encourage you to put in a submission with your concerns. The website is

    And to the guys voicing concerns about migration and Australia’s carrying capacity, I find the arguments raised by green groups a little extreme. Various groups are making these suggestions relating to national, state or regional levels. At the Brisbane public meeting of the Senate Select Committee on Housing Affordability, one group suggested a cap on the population of South East Queensland. When a senator asked about having some large scale developments in north Queensland instead, they were strongly opposed and asked the question of whether anyone would want to live there “with the weather and cyclones”. Coming from a four generation North Queensland family, I found it quite hilarious!

    Do you remember the saying “a butterfly flaps its wing…..”? For a start, I don’t think that Australia is anywhere near it’s “carrying capacity”. Secondly, if it somehow were, then how far beyond their’s is Indonesia, Singapore, and all of our neighbours. Because of the interconnectedness of our ecosystem, effects of overpopulation on other land masses will also be felt here. The same goes for global warming (and the subprime crisis!).

    In my view, the best thing for the global climate is for the global population to be spread more evenly. Being a developed country with a (consistently) declining birth rate, I think we can biologically sustain a reasonable level of migration.

    Having said that, with our recent focus on skilled migration, and with the economic turmoil, my guess is that migration will slow for a while. And I agree with earlier comments. Skilled migrants from Asia may well go back permanently or temporarily.

  4. Arnside says:

    Great to read the views of many and to know that I am not Robinson Crusoe.

    In my view Governments can pump prime the system until nothing is left in the coffers. The system will still not be fixed. Why? Because the community has no confidence left in the system. Why? Because the community are sceptics and believe that pump priming is a short term fix.

    What will fix the system? Better regulation of lending practices, elimination of largesse in the form of outlandish remuneration (in all its forms), the elimination of doubtful deals behind closed doors and the removal of the sharks.

    When will this occur? The sooner the better. Probably not until we hit the bottom and experience more pain and actually face the facts.

  5. predictor says:

    Hi Steve,

    my question would be do you have any historical data on what happens to rent prices if house prices are falling, surely supply and demand would start to force rent prices up, so this would stimulate real estate as a good investment again and because your returns would improve your thoughts ???

  6. alan says:

    Many good points in Debtwatch.

    I wonder, further to your points: If the price of residential property were to be included in calculation of the cpi, would that have somehow averted or reduced the debt debacle?

    It would be nice if we collectively actually learn something about debt from this mess.

  7. Predictor, I’ve got an alternative view on rents. I already note quite a range of rental value in the area that I look (where I rent). I would guess that a major issue is that the rental stock is owned by a mix of long term investors, new investors and speculators. Seeing as the bubble produced a very strong spike in prices, my guess is that no more than half of the rental stock was purchased at bubble prices. That means that only half of the owners are being squeezed by costs (esp IRs) and are desperate for every $ of rent.

    We all know that the RE agencies will work to have reasonably level rents. But there will be many long term owners, without financial pressures, that know the value of high quality long term tenants, and will be happy with 10-20% below market rent for them.

    And here’s the kicker. As house prices drop, this disparity will show through even more. People who buy for less and less, again will be less desperate for the rent $s.

    Moreover, economic turmoil will probably ulter demographics relating to housing – net migration will probably drop and people will “bunch up”. And there may be more supply – deleveraging results in the sale of holiday homes, etc, and the governments finally kick into gear and get more affordable rentals on the market. So less demand and more supply.

    The investors and speculators who bought at the top of the bubble, or near to it, will remain desperate for rental $s – but even worse would be periods without any rent coming in. So they will be forced to compete agressively on rent – with those that don’t need every $ anyway.

    So I expect rent increases to slow soon, and then to fall.

  8. Keith says:

    I appreciate your comments. I’m not sure I’m a ‘greeny’ exactly. My comments were in relation to the hard physical limits within the world and the inability of the dismal science to comprehend and suggest alternatives to the ‘growth dynamic’. Coupled with the human race’s inability to comprehend exponential growth, we virtually guaranteed that not only will we encounter a hard limit one day, but also at maximum velocity.

  9. Peter W says:

    It looks like the cooling pump on the financial nuclear reactor is failing.

    A Minsky moment

    The Aussie dollar is taking up the slack by falling.

    The RBA may have to drop short term interest rates to prop up jobs and the economy

    Inflation will accelerate because of the falling AUD raising import prices

    House prices will decline over the next 5 years but inflation will soften the blow.

    The Case Shiller and the Stapledon index will normalise at 100 (currency adjusted)

  10. Mark W says:


    A really important question. How do we (the public) invest in long-term Aus government debt (treasuries)? Could you advise in your next post?

    Thanks Mark

  11. Hi Mark!

    You can take a look at BUYING BONDS FROM THE RESERVE BANK at the RBA’s web page.

  12. tomt says:

    Mike, now you are talking the ‘real truth’!! We do not need these ‘foreign debt hoodlums’!! We have our own “wealth for toil”!! who needs them?
    Let us abandon the rubbish ‘traders’ and go it alone! The switzerland of Asia! “……..for we are young and Free….”.

  13. Paul Nollen says:

    Hi Steve,

    Is it possible to apply your model to a no growth situation (steady state economy) or even an economy in recession?

    My next major academic work will be a book on debt-deflation. An essential part of this will be an explanation of the creation of money and debt. This paper and presentation explain the basic logic, which contradicts the standard “deposits cause loans” theory of money that dominates conventional economics.unquote.

    Kind Regards


  14. Paul Nollen says:

    Hi Steve

    this seems to me a very good presentation

    Kind regards


  15. James Haughton says:

    The New York Times today has an “interactive presentation” on debt in america called “the debt trap”, including figures over the entire century for household debt and savings levels.

  16. Bazza says:

    Hi Steve, great work. you have a huge following here. Keep exposing the myths. You are our mythbuster that is helping the masses break out of the debt trance.

    quote from above article DebtWatch Oct08
    “With its Neoclassical eyes fixated on the rate of inflation, …….They were looking at their mathematical models, which ignore private debt (and indeed money!), rather than at the real world, where debt is king.”

    The other very important thing missed by most is that there are people involved in buying and selling and all the emotion that goes with it either positive or negative. They fail to take into account the social mood.

  17. Jonmeboy says:

    G’day Steve,
    So you are disappointed that you are going to have to buy gold!? I assume that your disappointment is related to the collapse or failure of all schools of Economic Theory belief systems to which you are tied. Welcome to the world of the Goldsmiths and bullion holders. Very rich families have been buying, holding and controlling gold for centuries and that hasn’t occurred by accident. They have held it tightly and have set the price of it for the past few hundred years. They have emptied the vaults of western Central banks and have taken possession of it through various means, the most obvious being confiscation and by the more nefarious method of the printing press. As you have stated, the area of study called economics, is not a science but at best is a hodgepodge of mathematical theories presented as science but in essence an intellectual attempt at alchemy, through price fixing (Interest).
    Gold functions as money in a far more honest and identifiable manner. It acts as a store of ones labour, it holds its value over time, it is everlasting, transportable, not subject to whimsical creation, (as opposed to the contrived paper derivatives of gold that we use today), is internationally recognised as money and easily assayed for authenticity.
    Most economists have been misled in their search for the holy grail: the search for the credit note that requires no bond by the issuer, a credit note that requires no settlement on presentation to the issuer. A credit note that can be used as payment for goods and services with unending supply. A credit note that having all these traits, still must be seen to have and hold value. You have your wish, you call it money and you expected it to thrive. You must be mad.
    Buy some gold Steve and welcome your disappointment. It’s not a new idea, just a forgotten one.

  18. Clinto says:

    Thank you, always a good read… keeps me on track with my thoughts about why I have not bought in the last couple of years.

    happily waiting for calmer days and corrected prices.

    Clinto the happy gen-X-er.

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