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 http://www.treasury.gov.au/contentitem.asp?NavId=016&ContentID=235):
“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)
and
“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:
- Firms borrow to invest during booms;
- Workers’ capacity to secure wages rises is affected by the rate of employment; and
- Banks lend money to finance investment;
and four very simple “stylised facts”:
- Wages share of output will rise if wage rises exceed productivity;
- The employment rate will rise if the rate of growth exceeds the sum of population and productivity growth;
- The debt to GDP ratio will rise if investment exceeds profits; and
- 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
END OF COMMENTARY
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.
Nice writing. You are on my RSS reader now so I can read more from you down the road.
Allen Taylor
Steve
Congratulations on an extremely well put together descriptive. Concise, clear while remaining instructive.
Many possible states, and the models need to be able to reach any particular state.
I prefer the original ” in the long run, we are all dead “, but clearly the equilibrium models are not enough, since dis-equilibrium has existed often enough.
And it is clear that a feedback model that allows for all types of behaviour, including speculative borrowing, is necessary. I believe that the vast majority of currency trading in Australian dollars is speculative / non-trade related. Clearly, equilibrium models can’t cope with such dynamics.
I don’t think that you need to argue for 40% declines in housing and it would be a tragedy to see a Gerard Hendersen cheering your long walk to the Blue Mountains when it is your framework and analysis that ought to be adopted, regardless of which actual state eventuates.
All the best writing such articles.
I’m still looking forward to your Climate Change addendum. The debt speculation aspects are fairly common sense to me. However, I am not well informed on the effect of rising real costs within feedback systems.
Again, thanks for your wonderful contributions. It is pleasing to even see someone writing this stuff, a relief that not *every* inmate in the economic asylum deserves to be certified !
Furball
I distrust forecasts of complex dynamic systems made using simple models, and you’ve certainly given me every reason to distrust TRYM. Your model is better, but the question is how much?
If I read it correctly, low interest rates, Keynesian stimulus and nationalisation of debt may be exactly the wrong medicine. Can the model show what can happen, or perhaps show the path that Japan took?
Thatk you for the explaination of the method that neo-classical economists use to make prediction of economic growth. I had felt that they were not very accurate, but never found any description of the way they were generated so I could understand why they were wrong.
Your modelling is brilliant. I have had a sort of vague high level understanding of what you are modelling here, but I would never have the time or expertise to turn it into anything useful. I am very happy to finally find someone that has done it, and excited about seeing the results.
One thing that I think you are overlooking is just how much potential there is for the debt cycle to restart, in Australia at least. I know you say that 165% of GDP is very high, but that is not a reason in of itself for the cycle to enter the depression phase. The US is at over 300%. Why so high for them and so low for us? Or put differently, what’s special about 165% of GDP ?
The reason I ask is that it seems to me that there is still alot of scope for the Australian government to start taking over from where the consumer has left off. If we are in a recession/depression then governments will start issuing debt. The likely outcome to my mind is that we will stumble along the Japanese model of replacing private debt with government debt.
Hi Dyork,
I agree; there’s nowhere near enough sophistication in my model to trust it completely–as one might a weather forecast. But there is enough in it to imply that it is a far better guide to the overall behaviour of the economy than any neoclassical model.
On what to do, no the model isn’t sophisticated enough to say; I would need to add the capacity to vary interest rates, abolish speculative debt arbitrarily at some point and see what happens, etc. But between the model and the data, I think the only prospect for getting out of this crisis involves substantial debt reduction–something that will only be on the agenda once all the usual neoclassical remedies have been tried and failed.
And swio,
Thanks; there’s a lot more to be added before I’d hold my head up at a party of meteorologists though!
On why is 165% the limit; again, this is somewhat arbitrary. It is 100% higher than debt was at the start of the Great Depression, and 80% higher than when the 1890s Depression began, so that’s enough of a sign from history that it will probably prove to be the turning point…
We wouldn’t have got to this level of debt without state (Central Bank) intervention, in my opinion. Greenspan’s rescues, and those locally, just emboldened a continued expansion of debt.
The USA got to a higher level because it is the centre of the global financial system, and had the reserve currency effect in its favour as well, and (with apologies to Joseph Heller) “scam” is American for “patriotic”.
I agree that the first step in the attempt to get out of the crisis will involve the state issuing debt. We will then most likely end up in the Japanese situation, of a long run debt impairment of economic activity.
How do we know that we are at the tipping point where debt overwhelms the economy and we enter a multi-year depression?
How do we know that this isn’t just another “ratcheting up” event, like the early 80s and early 90s?
What is the criteria that determines whether this will be multi-month recession or a multi-year depression?
carbonsink
I am thinking the same. But I think the answer is that the weak yen, and the carry trade that followed in Japan, in the US because of Reserve currency status, will materialize as a new round of commodity price inflation and stagflation like in the seventies, I really don’t think Joe Bull can stand 0 % interest rates any more than the Japanese could as they created huge distortions everywhere with their free money policy, I think we are going back into the carry trades with the USD and Yen.
Other people such as Soros, have seen the POST war era as a superbubble, ending with the US dollar loosing reserve status. It’s clear to me that he don’t believe in deflation from looking at his portfolio, it’s geared towards inflation.
Another thing I have thought is that the bubble in Japan, was at a much more severe level in terms of psychology, than the US bubble as fear spread that Japanese companies were taking over the world, a small district in Tokyo worth more than the state of California. I think the bubble itself was created because of foreign investment during the bear market for US bonds lasting from 1950-1982, then, after the US bond market entered a bull phase, Japan engaged on a debt binge as they let their currency strengthen, company profits increased as inflation peaked, but foreign investment, and the building of infrastructure, and other real activity came to a halt, and the real boom for Japan ended already in 1982 or so I think.
Steve, brilliant work and thanks. I’ve been reading a lot lately on Austrian Economics (von Mises, Hayek, Rothbard) who incorporate debt expansion in their Austrian Theory of the Business Cycle. The debt is brought about be articifically low IR from the fed, and leads consumers to over-consumer, and business to over-invest in production. The recession is simply the capital liquidation of these malinvestments (cash, plant, equipment and HR). One frustrating thing with ATBC is it is ‘economics without numbers’, a praxilogical approach. Your work looks Austrian, but with numbers to substantiate. Is this right?
Lastly, would I be correct to say the reason we had artifically low IR, is that central banks keep printing money, some of which is used to by government bonds…thereby driving down rates? I read that lots of the US Feds alphabet soup of bailout funds (in trillions) is buying US Treasuries which is why yields are at 0.02%. And the USD is soaring as international bond players mimic in a momentum play. Thoughts?
Steve, brilliant work and thanks. I’ve been reading a lot lately on Austrian Economics (von Mises, Hayek, Rothbard) who incorporate debt expansion in their Austrian Theory of the Business Cycle. The debt is brought about be articifically low IR from the fed, and leads consumers to over-consumer, and business to over-invest in production. The recession is simply the capital liquidation of these malinvestments (cash, plant, equipment and HR). One frustrating thing with ATBC is it is ‘economics without numbers’, a praxilogical approach. Your work looks Austrian, but with numbers to substantiate. Is this right?
Lastly, would I be correct to say the reason we had artifically low IR, is that central banks keep printing money, some of which is used to by government bonds…thereby driving down rates? I read that lots of the US Feds alphabet soup of bailout funds (in trillions) is buying US Treasuries which is why yields are at 0.02%. And the USD is soaring as international bond players mimic in a momentum play. Thoughts?
Thanks again, Mark
Regarding your model including (for the first time) the effect of Ponzi-style investing – could this be just the tip of a positive feedback system due to the market being self-aware?
Every investor knows that in a growing market you can make money by picking winners – investing for capital growth, as you have noted. Every investor also has theories of how best to weather a bear market. As does every government and central bank – the current vogue of spending our way out of crisis being a prime example.
It seems to me that any “playing the market” or manipulating the market – benevolently or not – is a whole new set of inputs that follow a whole new set of rules, outside of the simplistic economic models that you’re debunking. As soon as we think we understand the economy and try to outsmart it, we’re changing the economy. If the perturbations are small, they are lost in the inertia of the classic economy – the business of making and doing stuff (which may well tend toward equilibrium in the long term).
But when a good portion of the economy is made up of people fiddling with the economy for fun and profit, not doing anything productive, then the positive feedback systems can take over. Positive market sentiment causing growth. Stock markets plunging on rumours that the stock market might plunge. Bank runs. Phenomena that build on themselves.
I’m no economist – just a curious engineer who thinks control systems theory is fascinating – but it seems to me that there’s more “fiddling” money in the market now than ever before. It’s little wonder that simple models that don’t include such factors are failing to predict current events.
I tend to think that the non-productive fiddling of the market is a factor that will increase over time, with the increasing availability of information.
Who knows how to model large step-change inputs like governments dropping a bluntly-targetted US$1 trillion into the debt market?
Re the Austrian approach:
There are some aspects of the Austrian school that I like–notably their focus on non-equilibrium arguments–but generally I see them being too much “neoclassical-lite” to be worthwhile.
I reject their (subjectivist, utility-based) theory of value–which is why they are incapable of giving quantitative expression to their theories (and proud of it, as it happens), their theory of production (which is subject to the same critique that withers the neoclassical model), and their theory of money (which sees money as under state control simply because we have fiat money).
But because I work in out of equilibrium analysis, and emphasise the role of credit and uncertainty, there are certainly commonalities between my approach and theirs.
However fundamentally I come from a different perspective on the theories of value, money, and production. That’s a pretty big difference in the world of economics.
re self aware markets and consequent strategies. I would think this was easy to model as automatic strategies for dumping or buying are public knowledge. Simlarly with government dumping money. Of course the model just keeps getting more complex. In my old field – neuroscience, particularly computational neuroscience – the models can get so complex that the map becomes the territory and understanding the model is just as hard as understanding what is modelled (ie the models become useless).
The trick is getting a model that is complex enough to explain the phenomena and no more so. Not a trick really – more a combination of luck, hard work and brilliance.
Steve,
I have perhaps three concerns with your model
1. The lack of a foreign sector (and a distinction between foreign debt and domestic debt is in my view very important)
2. The lack of ecological constraints. (I am currently reading Herman Daly)
3. The lack of institutional detail (Here I am inclined to think such simple models inevitably exclude too much important institutional detail and that eventually we need to use object oriented simulations looking at what individual players are doing. How else for instance can you capture the assymetricality that comes from bankrupcy and limited liability?)
Looking at the chart of debt & GDP I notice that the peaks in the 70s and 80s were also larger because of higher rates of inflation not just base effects.
As for policy, my own view is that the correct remedy in the case of debt deflation, is you need REAL helicopter money (citizens income financed by printing money) to reduce debt, combined with positive real interest rates (so you can have both savings and real consumption) to repair household sector balance sheets. The business sector is to an extent protected by limited liability, it will quickly reorganise and production will recover is real demand is strong enough. The big problem is though that everybody will be trying to devalue their currencies at the same time, so the international reallignment that needs to occur (with asian countries consuming more and western – at least anglo-saxon
countries producing more) is made more difficult. I find this the great paradox at the moment, short term effects seem to be moving major prices (especially exchange rates) in the wrong direction from a long term perspective. I think we need radical international financial reform in order to ultimately solve the problems.
Steve,
when I can address a question about the choices made in this model, it seems to me that although you have added “speculative” investment to the model, I’m not sure I know exactly what that means. I guess it means investment made not expecting to earn dividends but based on expectations about asset prices. So to model it correctly (and to include balance sheet constraints in the model, which I think you need in order to properly model debt effects), you need some asset price model – probably with some sort of momentum expectations effects included. As you haven’t given us the entire model specification in mathematical terms, what exactly have you done here?
And isn’t one of the most important effects in recent times the reduction of household savings rates and the increase in debt taken on to finance consumption. Why is this missing?
“Steve, brilliant work and thanks. I’ve been reading a lot lately on Austrian Economics (von Mises, Hayek, Rothbard) who incorporate debt expansion in their Austrian Theory of the Business Cycle.”
The Austrian theory is rooted in equilibrium analysis — their basic argument is that credit expansion by banks artificially lowers the rate of interest below its equilibrium value (which is what the “natural rate” means).
Given that the Austrian’s usually deny that equilibrium is a meaningful concept or can even exist, why should it become so when discussing the credit market?
Equally, no one forces the banks to act like they do. They could have 100% reserves, but they do not. Instead they, well, act like capitalists and seek to make profits — surprise!
So I’m not sure how a theory which is based equilibrium theory and on banks not acting like capitalists can be of much use in understanding any real economy. And, unsurprisingly, in the 1930s von Hayek was defeated by the critiques of Sraffa and Kaldor.
In terms of credit expansion, Marx also noted that this happened, as did Minsky, and they provided a more realistic understanding on why this happened — in response to events in the economy and a desire to make money. And it would be silly to expects in a free market to act otherwise…
So credit expansion is caused by the boom, it does not cause it although, of course, it can heighten the boom and deepen the bust.
for more discussion: http://anarchism.pageabode.com/afaq/secC8.html
Iain
Interest rate cut of 125 basis and down to 2%. Huge call there although you are not alone but almost.
Care to say why?
And to be fair I will have a crack at tomorrows interest rate cut and I will pick 100 basis
Hi Steve,
First off, I want to congratulate you on a series of fascinating and insightful articles, keep up the good work!
As for economic modeling…
One thing that has always struck me about mainstream economic models is that they act as though the economy somehow exists apart from the natural environment and biology, society, psychology, and politics. At best, these seem to be reduced down by way of economic determinism, or at worst are altogether ignored or dismissed as ‘distortions.’
Instead of other disciplines – both in the hard sciences and the social sciences – having the products of their research incorporated into economic models, we often have situations where a social or natural phenomena can clearly be demonstrated in another field, and even become orthodoxy, yet economic models continue to incorporate either different assumptions, or assumptions which few experts in a given field would subscribe to. And long many term economic models seem to treat either as irrelevancy or distortion the very significant long-term shifts that can take place in a society over a period of time.
For example, we’ve had an increase in per capita household debt over recent decades, and it seems to be an ongoing trend (unless or until we hit debt deflation). Very well.
But who are the people who have been taking up this debt? Who are they by gender? Age bracket? Socio-economic status? Ethno-religious background? Geographic location? Or is it across the board? What have they been purchasing with this debt and why? If some groups in society are more likely to borrow than others, what impact do demographic shifts have in the take-up rate of debt in a given society? I think it would be far more telling to see what people who fit into various demographics are doing in a society, rather than what an undifferentiated mass of ‘rational consumers benevolently pursuing their own self interest’ would do. And this is where, I think, research from other disciplines – such as sociology or anthropology – could make a real contribution.
Related to this point, Clive Hamilton, in his book “Affluenza,” describes the growing pressure on people in our increasingly consumerist society to acquire material goods in the in vain and elusive pursuit of happiness. Should we try to somehow measure the level of ‘affluenza’ in our society over time, and then compare it to the level of debt growth in our society? Should we be examining what happens to this pressure during and after a recession? What is the economic impact of this, and how should such economic impact be factored in to economic models?
Another author, Robert Putnam, wrote a book called “Bowling Alone” that there has been a measurable decline in American community groups and organisations, and an inversely proportional growth in a number of social maladies. Again, should we be looking at correlations between community group participation and the level of debt people take on? What happens to community participation in periods of strong economic growth, and during recessions? Again, what is the economic impact of this, and how should such economic impact be factored in to economic models?
On the topic of community groups, Mark Lyons wrote an insightful book a few years ago called “Third Sector,” which argued that – aside from the public sector and corporate sector, there is a ‘third sector’ or ‘community sector’ of the economy (consisting of co-operatives, nonprofits, mutuals, associations, clubs, churches, etc.). Yet all too often economic analysis breaks down the economy into a ‘public sector’ and ‘private sector; seemingly neglecting a whole class of organisations that create jobs, and are engaged in a range of economic activities. Again, I think such organisations need to be systematically included in economic models.
On politics, it’s interesting to note that, where once we had a field called ‘political economy,’ we now have two separate disciplines of ‘politics’ / ‘political science,’ and ‘economics.’ But can – or should – the two areas really be separated from one another? Or should economic models incorporate what happens – or at least attempt to incorporate what happens – in the political sphere of a society? Similarly, should grassroots political movements be seen as being a reaction within the political economy of our society to certain events and conditions, rather than merely a distortion to markets?
Finally, there’s the natural environment and biology. And yet, with the exception of a handful of largely neglected theories on ‘natural capitalism,’ and some neo-Georgists who broaden their definition of ‘land’ to include all natural resources (see http://www.earthsharing.org.au/ for an example), the natural environment has long been neglected by economic models and economic theories. Far too often, we see ‘wealth’ appear as if out of thin air, neglecting the fact that all wealth is created by labour and capital acting on natural resources, that such natural resources form part of an ecosystem, and that many natural resources (particularly the oil that our economy is based on) is very much finite. What should be the base of our economic theory is, again, relegated to the economic sidelines. So is any research that improves our understanding of our ecosystem.
In all these examples, areas that should be central to economic models and analysis are instead cast off to the sidelines. And it’s to our detriment overall. Good work in challenging these outmoded models.
Anarcho,
What a treasure trove your site is. Rarely have I found such a penetrating analysis of neoclassicism’s intellectual bankruptcy. Using the works of Paul Ormerod, Steve Keen, Mark Blaug, Edward Herman, Nicholas Kaldor, Joseph McCauley, etc, it shows where neoclassicism falls flat.
I find it interesting that some political parties on the left (social libertarians, anarchists, etc) have started to pick up the fact that neoclassicism and Marxism are not very useful economic theories and that something should replace them. On the right, Austrianism tends to take hold in some quarters.
Given time, hopefully reform of economic theory will happen sooner rather than later.
Hi Steve,
In your analysis of private debt, how do you take into account the introduction of compulsory Superannuation, and the effect that had on the attitude of savings and debt repayments.
From your graph there appears to be a marked ramp up in private debt levels in Australia from the mid 1980′s, which co-incides with the introduction of compulsory super.
To many it has been more prudent to salary sacrifice into super, than to pay out mortgage debt, simple by reason of the tax advantages.
In my own case, I have significant private debt, but in super I have sufficient assets to cover the principle of the debt.
I know this is not the case for the USA and some other countries, but I wonder if your graphs/charts take this into account.
Thanks once again Steve,
The National Bureau of Economic Research today announced that the U.S. economy entered into recession in December 2007.
It is the first official recession since 2001.
According to NBER’s way of calculating these things, the economy had been expanding for 73 months, since November 2001, before it entered recession in December.
I hate to criticise the eminent economists who sit on NBER’s Business Cycle Dating Committee, the body which makes the official recession calls, but their analysis is statistical nonsense.
They don’t know the difference between productive activity and overhead, and thus haven’t a clue about the real state of the economy.
The U.S. economy has been in continuous decline, measured in physical terms, since the 1967-1968 period.
That’s four decades of recession, which has escalated in recent years to a full-blown depression.
There has been no economic expansion at all — the tumour has grown, but not the patient.
Further, the NBER dates the start of the recession some five months after the global financial system collapsed, setting off a chain-reaction collapse of financial institutions, businesses and households, and leading to the biggest financial bailout in history, with much larger explosions yet to come.
All NBER really showed with its too little, too late announcement, is that it is totally irrelevant.
- RJW
Richard J Wood said: “The U.S. economy has been in continuous decline, measured in physical terms, since the 1967-1968 period.”
Interesting claim, but exactly what physical measures are you using? The quantity of physical resources consumed has grown during that period, hasn’t it?
I have a basic question about the CPI, I know in the US their CPI calculation excludes three of the highest-priced budget items energy, food and the price of your home. Does the Australian CPI calculation have similar significant exclusions that may cause it to underestimate inflation?
Question to Steve, a while ago you mentioned you would comment in your newsletter about what you felt was wrong with going back to a “Gold Standard” I was wondering if you have written that yet piece yet?
- Ernie.