Broadcast on March 11 2009 by ABC Radio National Big Ideas
A blog member has kindly produced a transcript of the off-the-cuff talk I gave at this forum. I’ve made minor corrections to the punctuation below, but the text is otherwise as delivered on the night without speaking notes–so there are some grammatical slips. For those who want to listen to this alone–without also listening to Bernie Fraser beforehand–here is a link to the MP3 of my talk.
I might start with when I started issuing the warnings. That was in December of 2005. I’d started researching what I’d call the debt deflation theory of great depressions in my PhD, working on the advances done by a guy called Hyman Minsky, who’s somebody who the economic students in the back row should definitely start looking up as soon as they get back to the library. Because answering one of the questions Bernie posed, “Who saw this coming?”, the only answer is Hyman Minsky in the most recent history, and before him, Irving Fischer during the Great Depression.
Those two men, and the theoretical history they are part of, really gives us a far better explanation of what we’ve got ourselves into. Indeed if they’d been heeded, we wouldn’t be having this meeting.
So, I think one of the reasons we’re having the crisis now is not entirely caused by the economics profession; but I believe by the direction economics took after the second world war and was amplified after the period of stagflation in the 1970’s is a major contributor to the scale of the crisis we’re in and why I don’t believe policy makers have any idea of how to get us out of it. In fact what I think we’re going to have to wait on is basically the current set of policy makers abandoning all hope and certainly the political leaders abandoning hope in them before we’re going to see any sort of change around out of this crisis.
Now as to how bad it’s going to get — you have to know what caused it in the first place to have any idea there. And this is again why you tend to get, “I don’t know” type answers from most economists—and that goes right up to and including people like Joseph Stiglitz and Paul Krugman.
The reason they don’t know is that their economic theory is the wrong one. They’ve got a model of how the economy operates and it’s got no relevance to the real world, you’re not going to understand what’s happening in the real world when somebody asks you a question about it. So I, for some years, have been arguing that economic theory as it’s being taught in universities and as is commonly believed, is an utterly fallacious view of how the world operates. I published a book called Debunking Economics to make that case back in 2001. And the reason that economists can’t understand what’s happening in the economy is, and I know this is going to sound ludicrous to anybody who hasn’t actually studied economics, is that economists convinced themselves when they were about 18 years old that neither money nor debt matter.
Now, if you start from that mental position, how are you going to understand the real world in which we have manifestly clear now money and debt are crucial.
Now the reason they have their particular mythology inculcated into them is that early in their first year courses, back when I did economics, and now in second year because the courses have been dumbed down so much in the last 30 years, they learned what’s called the money illusion. And they get shown a model which has a proposition made that you can separate a consumer’s taste from their income. And then consumers are all supposed to know exactly what they desire in any particular combination of relative prices. And if you say, well let’s say we double all relative prices and double your income what combination are you going to choose? And the student does the mental exercise or the mathematical or graphical one and says, “Well, duh, the same combination.”
Being naive enough not to have credit cards at that stage, certainly when I was going through University, most of the students accept this and go on to believe that it isn’t absolute prices and money that matter but it’s relative prices. And they end up building mathematical models of how the economy operates that leave out of the equations, out of their variables, both debt and money.
Then along comes the real world, after 40 years of that and I’m sorry suddenly you realize your models don’t make any sense whatsoever. So a model that does make sense is Minsky’s. And it comes out of the work of Irving Fischer originally.
And the argument that Minsky made was that we live in an uncertain world and the mathematical world that economists swallow when they are at University—which is largely known as neoclassical economics—teaches them that you don’t need to know absolute prices, you only need to know relative ones. That all transactions are relative, that absolute magnitudes don’t matter and that credit can be forgotten about.
Well, it can’t in the real world. And that’s the lesson Irving Fisher learned the very hard way in the 1920’s and early 1930’s.
Minsky put it together quite effectively to say, “In the uncertain world with financial obligations, absolute prices are the links between the debts you accumulated in the past and your capacity to service them now.” And if you have a world where you borrow money to finance activity, and that’s the world we live in, then those absolute prices are crucial and so to is the level of debt.
As the level of debt rises, you have an increasing need to devote part of your current monetary income to servicing those monetary charges. And if you have debt and you’re trying to repay it, then the little mathematical model the student use that got shoved down their throats in first year before they are mature enough to bite the hand of the lecturer that’s feeding it to them, don’t work.
Because if you do double all prices and double incomes you do not get back to the same situation because it’s a non-linear process of repaying your debt.
You might get 1.73 times as much consumption. You might get 2.03, 2.07. You can’t say. So the argument that says you don’t need to worry about absolute prices is false as soon as you allow the existence of a world which debt exists and in which people have some need to pay their debt off over time.
So that mental construct that academic and then ultimately reserve bank economists use is on entirely the wrong track and it’s why they missed this whole process happening.
Now Minsky argues that the world you’ve got to look at is the one which is modeled from the point of view, not of the barter economy, which is the mental model that economists adopt in first year and don’t realize they’ve done it, but a Wall Street model. He said that in the Wall Street world it’s a world of credit driven systems with financial obligations being absolutely paramount, an uncertain future and people trying to speculate and invest to make money.
In that world they will borrow money, in a particular stage of the trade cycle. And here come two more terms that don’t turn up in conventional economic thinking: history and time.
Now I don’t need to ask the economics students here, “Have you studied economic history?” because I know the answer to the question—they haven’t. Economic history is abolished from most university courses around the world. So students don’t actually learn history when they are doing economics.
And I have often see people who haven’t had the misfortune of having an education in economics, saying, “Haven’t central bankers learned about this stuff? Don’t they apply the lessons of history of the 1930s and the 1890s? The 1870s?” For those who actually know their history, the answer is no they don’t. They don’t study economic history. Well, that’s one thing they’d better change.
They also don’t study the history of their own discipline. So they have no idea where the ideas come from. I’m proud to say that the University of Western Sydney, where I teach, is the only university in the country with a compulsory course in the history of economic thought.
And history itself is not part of economic theory, nor is time. Again, most economic models work on what’s called comparative statics. Or what they laughingly call general equilibrium. And all these ideas leave out of existence the very function of time.
So, Minsky starts from history and time. And he says, let’s imagine a time in history where there was a previous financial crisis. And you’re all thinking that must be 1990, maybe the younger ones are thinking 2000. So, 1990–1991 we had a financial crisis in the past. Bernie was part of that experience and remembers it well. And as a result of that crisis, everybody is conservative about the amount of debt they are going to consider taking on. That applies both to lenders and borrowers.
Because everybody is conservative, the only projects that are put forward for funding are projects that actually are likely to have a cash flow that’s going to exceed their financial commitments. And because the economy has recovered from that crisis, however that might have happened, most of those projects succeed. Because they succeed, everybody thinks, “Ah, we were too conservative last time around. If we’d actually borrowed more money, been more leveraged, we would have made a larger profit.” So, as a result of that, people start to relax their risk premiums so they become more adventurous.
As Minsky put it, quite classically, “Stability, in a world with an uncertain future, and complex financial instruments, is destabilizing.” So the experience of a period of stable growth, leads to rising expectations, and sets off the next bubble. When the next bubble begins, you suddenly have a period of self-fufilling expectations for awhile –where that high level of investment and a larger growth in the money supply, which is not under the control of the reserve bank, but caused by the willingness of borrowers to take on debt. That expansion of the money supply drives the big economic activity and makes it profitable once more to speculate on asset prices. You then get caught in another bubble for awhile where partly positive feed back systems are good which boosts investment and spending and improve confidence, that illusive word, rise and cause a boom in the real economy to take place. But you also have a boom in the artificial economy –the speculative world. And that often comes to dominate the real world. I remember one, Robert Holmes a Court I think, one of the classic speculators from the end of the last bubble, saying he didn’t like to invest in real projects because he could only expect a rate of return of only 5 or 10 percent and he was much happier with 20.
A twenty percent rate of return is a recipe for catastrophe in the future. It can’t be sustained.
So, you get this bubble going on and then out of that bubble come people like those speculators: the Bonds, the Skases and so on of the 1990s, the “Fast Eddies” of the most recent period, who only make money because asset prices are rising. They buy assets on a rising market, they pay amounts of money for those assets which are beyond debt servicing of the debt exceeds cash flow from the businesses.
The only way they can get out of trouble is by re-leveraging later for a larger level of debt or selling the asset on a rising market which is what they do. Now, of course, ultimately that momentum has to break down because even though asset prices are rising, debt is rising faster. And that is the thing which as been left out of reserve bank visions around the world, including Australia. Debt rises faster than the asset prices rise, the servicing costs rise faster. Ultimately, you may have a boom coming out of that as we did back in the 1970s and the 1990s, that changes income relativities as well, and that can shock the system internally and turn it around. So that wage demands get to be higher than people anticipated, raw material prices go through the roof and undercut profitability, and so on. You then reach a crisis. The asset bubble bursts, and you are back where you started again in a debt induced recession.
Now that’s the process we’ve been going through in the Western economies since the mid ’60s. The first major financial was 1966. If you go back and take a look at the Dow Jones then and see the collapse that happened then, it was at that stage that the biggest stock market crash since 1929. I recommend going and look at Robert Schiller’s home page where Robert has done an excellent job of assembling long term data series on asset prices, particularly share markets and houses in America. And you will see that bubble in price to earnings ratio where the earnings are over a ten year period. And that price to earnings ration points out two major bubbles in the past, the 1929 bubble and the 1966. We are now well above that level and so is the driving factor which is the level of debt.
Now to give you an idea of how much debt has grown during this whole process, again what Minsky talked about was the tendency for the ratio of debt to income ratio to ratchet up over time. The reason for that is that you borrow money during a boom and you have to repay it during a slump. You don’t quite have the cash flows you thought you would to service the debt, so when you’ve got it down to a reasonable level, it’s not quite back to as low a level as before the last bubble began.
So, you get a series of ratcheting up of the level of debt. And the more you overlay speculative lending, where you borrow money not to invest in real projects, but to gamble on asset prices, the more you drive that level up. That’s certainly been the case in the Australian situation, and the American. If we go back to 1945, the ratio of debt to GDP was roughly 45%. So, it owed less than half a year’s income to pay all it’s debts off if it ever wanted to do that. It now owes 290% of it’s GDP. That’s not factoring in the obvious nettable outcome of all the monstrous derivatives that have been pumped around the system. The most irresponsible of them in this most recent crisis is something we’ve never seen in history before. For those who want to see how bad that is and go to the Bank of International Settlements page and look for the data there on over-the-counter transactions derivatives. You’ll see that as of July 2008, there was $683 trillion worth of outstanding derivative contracts out there. Now, when that gets netted out we’re going to see a fairly substantial increase in even that astronomical level of debt.
Putting 290% of GDP in context, in terms of debt levels, that is 60% higher than the peak debt reached during the Great Depression in America and about 120% higher than it reached when the Depression began. The reason the ratio was that high during the Great Depression was because the level of debt caused a period of deflation. And that deflation and collapsing output meant that even though Americans reduced their nominal debt levels from 1929 to 1932, their indebtedness relative to their income rose from about 175% of GDP to 235% of GDP. Now, we’re starting this crisis at 290% of GDP.
In that sense I’m saying that debt is the actual cause of the disease and and the cause in the American case is pretty close to 1.5 to 2 times as bad as the Great Depression. So, I think it’s going to be… we’ll be lucky to come out of things as well as the Great Depression. We’ll certainly come out worse than 1990. People who believe we’re going to stop at less than double digit rates of unemployment are, I think, deluding themselves. And that’s unfortunately what economists normally do.
We also have deflation hitting us. In 1930–1931 the rate of falling prices in American was roughly 10% per annum. The maximum rate of fall of prices in any particular month occurred in 1932 or 1933 and it was about 2%. The second largest rate of fall in consumer prices in recorded history was in November of last year. Already. So there’s all sorts of signals that this could be a worse crisis than the Great Depression.
Now, how much confidence do I have in policy makers today to get us out of it? None. There are several reasons for that. First of all, the people in charge at the moment did not see this coming. Again, Bernie was talking about how economists were thinking about how they’d abolished the trade cycle.
They actually had a whole debate going in American, particularly American journals, but also English ones, called the Great Moderation. And their description, up to and including the beginning of 2007 of what was happening in the macro economy was a reduction in the volatility in the trade cycle: more consistent growth, less bouts of inflation, more stability. And one of those many foolish economic commentators in the newspapers, for the London Times, had a piece published in the beginning of 2007 called the “Great Moderation” which began with the line, “History will marvel at the stability of our era.” I don’t think he was being ironic. He actually believed it.
Even though I support the stimulus the Rudd government has given, why I don’t think it’s going to work is because of the nature of this particular turn around. We had a cycle in ’73, we had a cycle in ’89, each time the recovery from that cycle involved, not restoration of true stability, but a restarting of the engine of private borrowing. If you go back to 1973 in Australia, I think the debt to GDP ratio then was about 45%. It slumped slightly, and then it took off again. We got to 1983 or ’84, another bubble, a super bubble in debt occurred at that stage, took out debt ratio to about 90%. It slumped to about 85% by ’92-’93, then took off again. It’s now, in Australia’s case, peaked at about 165% of GDP. If you factor in corporate bond issues, it’s about 177% of GDP. That is 7 times the ratio of debt to GDP we had back in the 1960s.
Now, we don’t have to have a period of ever accelerating debt. A lot of fringe thinkers in economics believe that’s the case. Probably the best period of economic performance in Australia’s history was the post war period from 1945 to 1965 even though it includes the credit crunch Bernie talked about a moment ago. Across that whole period, that 20 to 25 year period, the ratio of debt to GDP was stable at about 25% of GDP. Now, at that stage, debt was doing what debt should, and that’s providing working capital to corporations, investment funds for those who don’t have enough retained earnings to do it and a small amount of money for people to buy houses who wanted to own their own houses rather than renting. That’s the legitimate function of the financial system.
In Australia’s case, in mid-1964, the ratio of debt to GDP started to accelerate, and from that stage on, debt was grown 4.2% faster than GDP on average for the next 45 years. Now, that’s unsustainable. I know that, again having some conversations with Reserve Bank staff, their attitude was, and this in print from the current Governor in a hearing before the House of Representatives committee about 3 or 4 years ago, that there’s an inverse relationship between debt servicing and interest rates. So, when interest rates fall, debt will rise. And when interest rate rise, debt will fall.
That’s not at all what happened, unfortunately. A good look at the data shows simply an exponential take off of debt to GDP, independent of what interest rates were doing. If you simply look at the ratio of debt to GDP, and do a regression on that, using an exponential function, you’ll find a correlation between a simple exponential growth of that ratio and the actual data of .9912.
Now, I know most people don’t know what I’m talking about, but I’m saying 99% of the increase in the debt ratio can be explained by simply saying debt grows 4.2% faster than GDP. Now, that is an impossible situation to maintain indefinitely because ultimately your debt is going to be a hundred times your GDP and of course you can’t service that amount no matter what interest rates are. It’s going to have to change direction.
It’s changing direction now. In Australia’s case the level of debt to GDP, is almost 3 times what we had prior to the Great Depression. And there I come to a strong criticism of how our Reserve Banks have behaved. Because they have ignored the actual dynamics of the capitalist economy, because they haven’t understood them, they followed the wrong theories. I might actually add, without knowing that there are alternative theories. Because they’ve done that, they’ve ignored the actual problem as it’s run away from us.
And therefore their decisions have actually encouraged the financial system to get back on the speculative band wagon when they should have been kicking them off it in the first place. If you look at the data, I think it’s fairly convincing if we hadn’t had central banks then in 1987 we would have had a crisis about the same size or smaller than the Great Depression. It would have been attenuated by the scale of government. That would have turned us around. We’ve gone another 20 years and we therefore, I think, face a crisis which is bigger than the Great Depression and of which our managers of the economy have less of an idea of how the economy functions, than we had back in 1929.
It’s going to be a long one. Thank you.