Talk to the Fabian Forum: The Global Financial Crisis: How bad will it get?

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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.

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About Steve Keen

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