Debt­Watch No 29 Decem­ber 2008

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What’s Really Going On? or…

Why Did I See it Com­ing and “They” Didn’t?

Part 2: The Mod­els

But this long run is a mis­lead­ing guide to cur­rent affairs. In the long run we are all dead. Econ­o­mists set them­selves too easy, too use­less a task if in tem­pes­tu­ous sea­sons they can only tell us that when the storm is long past the ocean is flat again.” (Keynes, A Tract on Mon­e­tary Reform, 1924)

In last month’s Debt­watch, I explained why the data side of why the “Finan­cial Insta­bil­ity Hypoth­e­sis” enabled me to pre­dict this cri­sis, long before con­ven­tional “neo­clas­si­cal” econ­o­mists had any idea it was approach­ing.

This month I explain why the mod­els neo­clas­si­cal econ­o­mists build are hope­lessly inadequate–as mod­els of the econ­omy in gen­eral, as guides to what is likely to hap­pen in the future, and as sources of pol­icy rec­om­men­da­tions to end this cri­sis.

In par­tic­u­lar, the Aus­tralian Treasury’s pre­dic­tion that Aus­tralia will avoid reces­sion sim­ply can­not be trusted.

Neoclassical Models: Crisis? What Crisis?

The focus of neo­clas­si­cal econ­o­mists on mis­lead­ing indi­ca­tors is com­pounded by the mod­els they build, which–as well as omit­ting cru­cial data like the debt to GDP ratio–are con­gen­i­tally inca­pable of iden­ti­fy­ing seri­ous turn­ing points in the econ­omy.

This are sev­eral rea­sons for this, but first and fore­most is their belief that the econ­omy is fun­da­men­tally sta­ble, and will always return to a long-run equi­lib­rium growth path after any shock. The mod­els they con­struct have this expec­ta­tion of a return to long-term growth paths after any short term diver­gence from trend “hard wired” into their results.

An instance of this for the Aus­tralian Treasury’s macro­eco­nomic model (TRYM) is shown in Fig­ure One, which shows the impact on busi­ness invest­ment in the model of a sim­u­lated mon­e­tary shock in 2010. The shock ini­tially pushes busi­ness invest­ment above the long term trend, to which it then returns after eight years.

This is not a pre­dic­tion by the model as such, but a prod­uct of its struc­ture, which assumes that the econ­omy will always return to a sup­ply-side dri­ven equi­lib­rium in a rel­a­tively short time frame.

Figure One

TRYM’s sup­ply-side behav­iour is deter­mined sim­ply by the assump­tion that, in the long run, the econ­omy will return to an equi­lib­rium rate of growth, given by the sum of assumed trends in pop­u­la­tion growth and labour pro­duc­tiv­ity, at an assumed equi­lib­rium rate of unem­ploy­ment called “NAIRU” (“Non-Accel­er­at­ing Infla­tion Rate of Unem­ploy­ment”). As the Treasury’s doc­u­men­ta­tion of TRYM puts it (see

The model could be described as broadly new Key­ne­sian in its dynamic struc­ture but with an equi­li­brat­ing long run.  Activ­ity is demand deter­mined in the short run but sup­ply deter­mined in the long run… The model will even­tu­ally return to a sup­ply deter­mined equi­lib­rium growth path in the absence of demand or other shocks.” (THE MACROECONOMICS OF THE TRYM MODEL OF THE AUSTRALIAN ECONOMY, p. 6; empha­sis added)


the aggre­gate sup­ply curve is ver­ti­cal in the long term at a level of employ­ment and pro­duc­tion con­sis­tent with the NAIRU. (Or more pre­cisely the econ­omy grows along a steady state growth path con­sis­tent with the NAIRU.)” [AN INTRODUCTION TO THE TRYM MODEL APPLICATIONS AND LIMITATIONS p. 6]

Neo­clas­si­cal mod­els like TRYM are thus vari­able in the present–and have some capac­ity to pre­dict the very short term, if their guesses about the size of any shock are rea­son­ably accu­rate. But they are anchored to some point in the (not too dis­tant) future when it is assumed that “equi­lib­rium” will once again apply, and they are there­fore use­less as guides in the medium term.

They are also use­less for long term pre­dic­tion because the model’s long run equi­lib­rium is unaf­fected by the short term dis­tur­bance: if the fig­ure assumed for the NAIRU in the model remains unchanged, along with the esti­mates for pop­u­la­tion and pro­duc­tiv­ity growth, then the model will aver­age the rate of growth those assump­tions imply, regard­less of how severe a shock the short-term dis­tur­bance causes.

In the case of the RBA’s main model, this is a real growth rate of 3.25 per­cent per annum (see Tables 7 & 8 of RDP2005-11)–so the econ­omy is assumed to con­verge to a tran­quil future path after any dis­tur­bance, with no residue from the shock itself (apart from a change in the price level for per­ma­nent increases in the money sup­ply).

Iron­i­cally, this means that mod­els like TRYM pro­duce medium term pre­dic­tions of an accel­er­a­tion in growth after the impact of a shock like this finan­cial crisis–otherwise the model could not get back to its “long run equi­lib­rium growth path”.

There was thus no prospect that Neo­clas­si­cal mod­els could pre­dict the cri­sis, and their guid­ance on what will happen–with or with­out pol­icy intervention–are irrel­e­vant.  Unlike these mod­els, the actual econ­omy does not have a point of bal­ance in the future to which it is teth­ered. It is there­fore no won­der that these mod­els gave no warn­ing of the impend­ing crisis–indeed the won­der would be if they had done so!

This is why sup­pos­edly author­i­ta­tive bod­ies like the OECD could claim “our cen­tral fore­cast remains indeed quite benign” just two months before all hell broke loose (as noted in my last Debt­watch). If eco­nomic data have been appar­ently tran­quil, these mod­els will pre­dict tran­quil­ity ahead; if the data have been depressed, they will pre­dict a bit of a down­turn, fol­lowed by a return to equi­lib­rium some years hence.

Nei­ther pre­dic­tion is worth a pinch of salt.

To have any hope of pre­dict­ing the future using an eco­nomic model, it has to be one with gen­uine dynamics–not a model that sim­ply assumes that “when the storm is long past the ocean is flat again”, as Keynes satir­i­cally remarked. Such a model has to spec­ify what it sees as the main causal fac­tors in the econ­omy, and then let those fac­tors inter­act. The medium and long term out­comes are thus a prod­uct of the inter­ac­tion of the causal vari­ables in the model, just as the short term is.

Mod­els of this nature are com­mon­place out­side eco­nom­ics, and sci­en­tists, math­e­mati­cians and engi­neers have designed an impres­sive range and vari­ety of com­puter sim­u­la­tion pro­grams to sup­port this gen­uinely dynamic approach to mod­el­ling.

I devel­oped such a model of Minsky’s Finan­cial Insta­bil­ity Hypoth­e­sis in the early 1990s.

A Minsky Model: Finance and Economic Breakdown

The basic prin­ci­ples in Minsky’s finan­cial insta­bil­ity hypoth­e­sis are extremely sim­ple. A cap­i­tal­ist econ­omy is nec­es­sarly cycli­cal. Dur­ing a boom, investors will take on debt to finance invest­ment, but because the econ­omy is cycli­cal, they will later find them­selves in a reces­sion when they have to repay that debt.

There­fore their repay­ments don’t quite can­cel all the extra debt, and debt lev­els tend to ratchet up over time. These debt cycles with an over­all sec­u­lar trend towards increas­ing debt can lead to an ulti­mate cri­sis where the debt over­whelms the economy–a Depres­sion.

This is not an inevitable out­come of Minsky’s the­ory, but he empha­sises that since mar­ket economies have expe­ri­enced Depres­sions in the past, to be valid a model of the econ­omy must…

make great depres­sions one of the pos­si­ble states in which our type of cap­i­tal­is­te­con­omy can find itself”  (Min­sky, 1982, Infla­tion, Reces­sion and Eco­nomic Pol­icy, p. xi)

In the model I devel­oped in 1993, under some cir­cum­stances, the econ­omy could taper to equi­lib­rium; but under oth­ers, a series of debt-dri­ven finan­cial cycles would lead to an even­tual cri­sis where debt over­whelmed the econ­omy. The fol­low­ing graph­ics set out the model in flow­chart for­mat. It can also be sum­marised in three very sim­ple propo­si­tions:

  1. Firms bor­row to invest dur­ing booms;
  2. Work­ers’ capac­ity to secure wages rises is affected by the rate of employ­ment; and
  3. Banks lend money to finance invest­ment;

and four very sim­ple “stylised facts”:

  1. Wages share of out­put will rise if wage rises exceed pro­duc­tiv­ity;
  2. The employ­ment rate will rise if the rate of growth exceeds the sum of pop­u­la­tion  and pro­duc­tiv­ity growth;
  3. The debt to GDP ratio will rise if invest­ment exceeds prof­its; and
  4. an increased rate of eco­nomic growth will reduce the debt to GDP ratio.

As a flow­chart, the model is as shown in Fig­ure Two (the blue boxes con­tain math­e­mat­i­cal sub-sys­tems).

The sim­u­la­tion below and in Fig­ure Three are with no debt in the model–in which case the model gen­er­ates sim­ple cycli­cal growth.

Figure Two

Fig­ure Three explodes the “Graph” sub­sys­tem of the model. The same set of graphs is used in sub­se­quent Fig­ures to dis­play the behav­iour of the more com­plete mod­els, where debt and Ponzi invest­ing are added.

Figure Three

When the debt switch” is flicked to include bor­row­ing to finance pro­duc­tive invest­ment only–so all bor­rowed money leads to an increase in the capac­ity to pro­duce output–then one of two sit­u­a­tions will apply.

Fig­ure Four shows the first such sit­u­a­tion: when the model begins close to its equi­lib­rium val­ues, it con­tin­ues to con­verge towards it. Employ­ment and income dis­tri­b­u­tion (prox­ied here by the wages share of out­put) taper to equi­lib­rium val­ues, as does the debt to out­put ratio (which is neg­a­tive, imply­ing pos­i­tive net finan­cial assets for firms).

Figure Four

How­ever, if the sys­tem starts fur­ther away from equi­lib­rium, then the system’s behav­iour is rather like that described by Fisher in his Debt Defla­tion The­ory of Great Depres­sions:

There may be equi­lib­rium which, though sta­ble, is so del­i­cately poised that, after depar­ture from it beyond cer­tain lim­its, insta­bil­ity ensues, just as, at first, a stick may bend under strain, ready all the time to bend back, until a cer­tain point is reached, when it breaks.

This sim­ile prob­a­bly applies when a debtor gets “ broke,” or when the break­ing of many debtors con­sti­tutes a “ crash,”  after which there is no com­ing back to the orig­i­nal equi­lib­rium.

To take another sim­ile, such a dis­as­ter is some­what like the “ cap­siz­ing”  of a ship which, under ordi­nary con­di­tions, is always near sta­ble equi­lib­rium but which, after being tipped beyond a cer­tain angle, has no longer this ten­dency to return to equi­lib­rium, but, instead, a ten­dency to depart fur­ther from it.” (Fisher, 1933)

With this far from equi­lib­rium start­ing point, the sys­tem goes through a series of cycles in which the debt to out­put ratio ratch­ets up, as Min­sky sur­mised, until such time that the next boom leads to such an accu­mu­la­tion of debt that it can­not be repaid–debt ser­vice con­sumes all avail­able revenues–and the econ­omy falls into a per­ma­nent slump.

Figure Five

I have com­mented fre­quently that econ­o­mists are pris­on­ers of their models–rather than see­ing the econ­omy, they see their model of it. Though I dif­fer from the neo­clas­si­cal main­stream in the type of model I see, on this front I was not very dif­fer­ent. I there­fore expected to find a pat­tern like that shown for the debt to out­put ratio in Fig­ure Five in the Aus­tralian data, when I pre­pared an expert wit­ness case for the NSW Legal Aid in Decem­ber 2005: a grad­ual hump-like increase in debt to out­put ratios.

Instead what I saw was the pat­tern shown in Fig­ure Six.

Figure Six

That was an almost purely expo­nen­tial increase in the debt to GDP ratio over time–disturbed only by the growth and burst­ing of two obvi­ous super-bub­bles (one in the early 1970s that was asso­ci­ated with the demise of the Whit­lam gov­ern­ment, and the other that drove Keating’s “reces­sion we had to have” in the early 1990s).

It was obvi­ous that a key aspect of Minsky’s the­ory that my model omit­ted had to be intro­duced: Ponzi invest­ing, in which indi­vid­u­als take out debt to spec­u­late on asset prices, but don’t actu­ally build any assets in the process. I intro­duced this into the model by adding a spec­u­la­tive debt com­po­nent, where bor­row­ing for spec­u­la­tion rose when­ever the rate of growth exceeded a min­i­mum level. With that mod­i­fi­ca­tion, the pat­tern shown in Fig­ure Seven resulted.

Figure Seven

This model gen­er­ates a gen­er­ally expo­nen­tial increase in debt lev­els, with super-bub­bles in spec­u­la­tive bor­row­ing occur­ring reg­u­larly, and bor­row­ing to finance spec­u­la­tion grad­u­ally accel­er­ates to ulti­mately dwarf bor­row­ing for pro­duc­tive invest­ment.

At some point the debt bur­den becomes too great for the econ­omy to finance, and debt accu­mu­lates faster than it is repaid, lead­ing to a sec­u­lar cri­sis and not merely a finan­cial cycle. Guided both by Minsky’s hypoth­e­sis and my math­e­mat­i­cal mod­els, I felt that we were at such a sec­u­lar turn­ing point in the real world when I saw the data in Fig­ure Six (three years ago, in Decem­ber 2005).

I feared that Australia–and prob­a­bly the rest of the world–was in for a seri­ous debt-induced down­turn. Know­ing that there was lit­tle if any like­li­hood that this dan­ger would be per­ceived by the neo­clas­si­cally-trained econ­o­mists who dom­i­nate Trea­suries and Cen­tral Banks (and Uni­ver­sity Eco­nom­ics Depart­ments) around the world. I decided to go pub­lic with my analy­sis

This was more than con­firmed when RBA Deputy Gov­er­nor Ric Bat­tellino pub­lished a graph show­ing Australia’s long term debt to GDP ratio dur­ing a speech in Sep­tem­ber 2007 (see Fig­ure 8, which is aug­mented to include esti­mates of non-bank credit prior to 1953). 

Figure Eight

The model I’ve out­lined above is extremely sim­ple, and would need to be sub­stan­tially embell­ished to cap­ture the main dynam­ics of a mar­ket econ­omy. But it is already streets ahead of neo­clas­si­cal mod­els by not mak­ing an arti­fi­cial dis­tinc­tion between the short and long term. To para­phrase Keynes, “in the long run we are still in the short run”.

Avoiding Recession?

The Aus­tralian Gov­ern­ment is almost unique amongst OECD nations in pre­dict­ing pos­i­tive growth dur­ing 2009. Indeed, only ten coun­tries are hold­ing out for pos­i­tive real growth next year in the OECD’s recent Eco­nomic Out­look are Aus­tralia (1.7%), the Czech Repub­lic (2.7%), Greece (1.9%), Korea (2.7%), Mex­ico (0.4%), Nor­way (1.3%), Poland (3%), the Slo­vak Repub­lic (4%), Swe­den (0%), and Turkey (1.6%) (see Fig­ure Nine, taken from the OECD Eco­nomic Out­look No. 84 for Novem­ber 2008, p. 82). The other nine­teen coun­tries all expect to record neg­a­tive growth.

These “pre­dic­tions” should be seen for what they are–not so much pre­dic­tions as assump­tions of a class of eco­nomic mod­els that has lit­tle con­nec­tion with the real world. The scale of the down­turn “pre­dicted” for 2009 largely reflects the judg­ments of national Treasuries–including Australia’s–as to how severe a shock the finan­cial cri­sis rep­re­sents.

On that scale, the only coun­try giv­ing this finan­cial cri­sis seri­ous weight is Ice­land, which is esti­mat­ing its dam­age as equiv­a­lent to about 14% of GDP–represented by the change between the growth rate recorded for 2007 and that expected for 2009. Australia’s Trea­sury has appar­ently per­suaded the OECD that this cri­sis will knock only a cou­ple of per­cent off growth.

Figure Nine

Notice also that the OECD expects growth to dra­mat­i­cally improve in 2010–even Ice­land is expected to almost return to pos­i­tive growth for the cal­en­dar year as a whole, while in the 4th quar­ter it is expected to record pos­i­tive growth at an annual rate of 2.6% (see Fig­ure Ten). Aus­tralia is expected to rebound to 3.1% annu­alised growth by the last quar­ter of cal­en­dar year 2010.

Why? Because by that stage into the future, the “long run” in the OECD’s neo­clas­si­cal model of the econ­omy starts to reassert itself, and every econ­omy is pre­dicted to boom away, to erase the impact of the “tem­po­rary” shock of the 2008 finan­cial cri­sis.

I’d love to see the OECD’s pre­dic­tions for Ice­land for 2011 and 2012–they should show mas­sive growth to over­come the impact of the –9.3% fig­ure for next year, and return to the long run equi­lib­rium assump­tion the model makes for Iceland–which is prob­a­bly above 5% p.a. Aus­tralia is also likely to be shown to enjoy a rosy 4% or above rate of growth.

These pre­dic­tions, and those of any other neo­clas­si­cal model–including the Treasury’s TRYM model, and the RBA’s small model–are no more than a state­ment of faith in the long run sta­bil­ity of a mar­ket econ­omy.

I expect that faith will be sorely tested in the com­ing years.

Figure Ten


Comments on the Data

It appears that Australia’s debt to GDP ratio has peaked at 165% of GDP, and it is now start­ing to fall. 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 will be felt. This trend appears in the next two graphs, which show the annual rate of change of debt and GDP, and the con­tri­bu­tion that change in debt makes to aggre­gate demand (which I define as the sum of GDP and the change in debt).

One intrigu­ing aspect of the next two charts is the fact that the rate of growth of debt has fallen over time–from a peak of over 34% year on year for the 1973 bub­ble, to 25% for the 1989 bub­ble, and 17% for the bub­ble that has now peaked in 2008–but the con­tri­bu­tion that ris­ing debt makes to demand has risen–from just over 10% in 1973, to 14% in 1989 and 19.5% in 2008.

This appar­ent para­dox is the result of the increas­ing scale of debt com­pared to GDP. Back in 1972, when the first debt super-bub­ble began, debt was equiv­a­lent to only 33% of GDP–and there­fore a 1/3rd increase in debt, while dra­matic, only increased the ulti­mate debt to GDP ratio by 11%. In mid-1984, when the sec­ond super­bub­ble took off, debt was already 54% of GDP, and there­fore the slower rate of growth of debt resulted in the debt to GDP ratio ris­ing vt 57% by the time the bub­ble burst.

This time round, though debt grew by a max­i­mum of only 17% in one year, the debt super­bub­ble which began in mid 1993 increased the debt to GDP ratio by a stag­ger­ing 109%, from 79% at its com­mence­ment to 165.43% by its peak.

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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