Debtwatch No 34: The Confidence Trick

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And, at this point, con­fi­dence is what it is all about… The first thing is to main­tain some con­fi­dence in our­selves and the prospects for our coun­try over time… Unfor­tu­nate­ly, there is no lever marked ‘con­fi­dence’  that pol­i­cy-mak­ers can take hold of. Our task is very much one of seek­ing to behave, across the board, in ways that will fos­ter, rather than erode, con­fi­dence.  It is such con­fi­dence that, more than any­thing else, will help to dri­ve us along the road to recov­ery.” (Glenn Stevens, April 21st 2009)

I fan­cy that over-con­fi­dence sel­dom does any great harm except when, as, and if, it beguiles its vic­tims into debt.” (Irv­ing Fish­er, 1933)

In his recent speech “The Road To Recov­ery”, Aus­trali­a’s Reserve Bank Gov­er­nor Glenn Stevens used “the C word” 17 times–versus, for exam­ple, 15 uses of the “R” word (“reces­sion”). The mes­sage was clear­ly that, if only we can all be con­fi­dent, then the oth­er “R” word (“recovery”–which received ten men­tions) will sure­ly occur.

Anoth­er promi­nent econ­o­mist who had the same atti­tude at the out­break of a finan­cial cri­sis was Irv­ing Fish­er. Speak­ing to a bankers con­fer­ence just two days before the Great Crash of 1929, Fish­er argued that mar­ket down­turns were caused by a “lunatic fringe”. Once they had exit­ed, the bull mar­ket of the pre­ced­ing years would resume:

There is a cer­tain lunatic fringe in the stock mar­ket, and there always will be when­ev­er there is any suc­cess­ful bear move­ment going on… they will put the stocks up above what they should be and, when fright­ened, … will imme­di­ate­ly want to sell out… when it is final­ly rid of the lunatic fringe, the stock mar­ket will nev­er go back to 50 per cent of its present lev­el…

We shall not see very much fur­ther, if any, reces­sion in the stock mar­ket, but rather … a resump­tion of the bull mar­ket, not as rapid­ly as it has been in the past, but still a bull rather than a bear move­ment.”  (Fish­er 1929)

Fish­er’s con­fi­dence led him to hang on to his mar­gin-financed stocks (worth over $100 mil­lion in 2000-dol­lar terms). Despite his con­fi­dence, the stock mar­ket con­tin­ued its plunge from its peak of 31.3 in July 1929 to the nadir of 4.77 in May of 1932, while unem­ploy­ment rose from zero to 25 per­cent. Fish­er was wiped out finan­cial­ly, and left to pon­der how he could have got the behav­iour of the mar­ket, and the econ­o­my, so bad­ly wrong.

Three years lat­er, he reached the con­clu­sion that he had been mis­led by two core ele­ments of the neo­clas­si­cal the­o­ry he had helped build: the beliefs that the econ­o­my was always in equi­lib­ri­um, and that the debt com­mit­ments bor­row­ers had entered into to pur­chase finan­cial assets were based on cor­rect fore­casts of future eco­nom­ic prospects.

On equi­lib­ri­um, he rea­soned, even if it were true that the econ­o­my tend­ed towards equi­lib­ri­um, ran­dom events alone would ensure that all eco­nom­ic vari­ables were either above or below their equi­lib­ri­um lev­els. There­fore eco­nom­ic the­o­ry had to be about dis­e­qui­lib­ri­um rather than equi­lib­ri­um:

The­o­ret­i­cal­ly there may be— in fact, at most times there must be—  over- or under-pro­duc­tion, over- or under-con­sump­tion, over- or under spend­ing, over- or under-sav­ing, over- or under-invest­ment, and over or under every­thing else. It is as absurd to assume that, for any long peri­od of time, the vari­ables in the eco­nom­ic orga­ni­za­tion, or any part of them, will “ stay put,”  in per­fect equi­lib­ri­um, as to assume that the Atlantic Ocean can ever be with­out a wave.” (Fish­er 1933)

This real­i­sa­tion in turn put paid to any notion that today’s debt com­mit­ments were based on an accu­rate pre­dic­tion of tomor­row’s eco­nom­ic out­comes. Instead, he iden­ti­fied over-indebt­ed­ness as one of the two key caus­es of Great Depres­sion:

two dom­i­nant fac­tors [are …] over-indebt­ed­ness to start with and defla­tion fol­low­ing soon after… these two eco­nom­ic mal­adies, the debt dis­ease and the price-lev­el dis­ease, are, in the great booms and depres­sions, more impor­tant caus­es than all oth­ers put togeth­er.

Thus over-invest­ment and over-spec­u­la­tion are often impor­tant; but they would have far less seri­ous results were they not con­duct­ed with bor­rowed mon­ey. That is, over-indebt­ed­ness may lend impor­tance to over-invest­ment or to over-spec­u­la­tion.

The same is true as to over-con­fi­dence. I fan­cy that over-con­fi­dence sel­dom does any great harm except when, as, and if, it beguiles its vic­tims into debt.” (Fish­er 1933)

One would hope that eco­nom­ic the­o­ry had learnt from the Great Depres­sion, and in par­tic­u­lar from Fish­er’s insights. Unfor­tu­nate­ly, eco­nom­ics was eager to unlearn these lessons, because the very phe­nom­e­non of a Depres­sion was anath­e­ma to a pro­fes­sion that had always sought to eulo­gise the mar­ket econ­o­my, rather than to under­stand it. Equi­lib­ri­um came back again in the guise of the “Neo­clas­si­cal-Key­ne­sian syn­the­sis” in the 1950s. By the 1990s, all ves­tiges of Keynes had been thrown away–and noth­ing of Fish­er had been even assim­i­lat­ed in the first place (sker­ricks of his thought are per­co­lat­ing through now though: see The Econ­o­mist for a pret­ty good overview of Fish­er).

Today, macro­eco­nom­ic mod­els like TRYM (the TReasurY Macro­eco­nom­ic mod­el that is used to pre­pare the Aus­tralian Fed­er­al Bud­get) pre­sume that the econ­o­my tends towards a “long run equi­lib­ri­um”. The appar­ent dynam­ics such mod­els dis­play are sim­ply the con­ver­gence of the mod­el from an ini­tial start­ing point to the assumed long run equi­lib­ri­um.

For exam­ple, the fig­ure below shows the TRYM mod­el’s pre­dic­tions for unem­ploy­ment from March 1995 till March 2010 (Fig­ure 10: Dynam­ic Adjust­ment towards Steady State — Unem­ploy­ment; Mod­el­ling Sec­tion, Macro­eco­nom­ic Analy­sis Branch, Com­mon­wealth Trea­sury, The Macro­eco­nom­ics Of The Trym Mod­el Of The Aus­tralian Econ­o­my,  Com­mon­wealth of Aus­tralia 1996). The mod­el “pre­dict­ed” that unem­ploy­ment would fall from around 9 per­cent in 1995 to just below 7 per­cent in 2010, sim­ply on the basis that unem­ploy­ment was assumed to con­verge to an a long run equi­lib­ri­um rate of 7 per­cent over time (the actu­al lev­el fell well below this, and the  assumed equi­lib­ri­um unem­ploy­ment rate–the “NAIRU”–was there­fore lat­er reduced to 5.25 per­cent).

Vir­tu­al­ly every­one knows Key­nes’s quip that “in the long run we are all dead”. Yet very few realise that Key­nes’s tar­get was pre­cise­ly this approach to eco­nom­ic modelling–of assum­ing that the econ­o­my would sim­ply tend to return to equi­lib­ri­um after any dis­tur­bance:

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, 1923)

Hob­bled by this naive belief in equi­lib­ri­um, the eco­nom­ics pro­fes­sion was as unpre­pared for today’s cri­sis as it had been for the Great Depres­sion. Now that the cri­sis is well and tru­ly with us, all con­ven­tion­al “neo­clas­si­cal” econ­o­mists can offer is the hope that the cri­sis can be over­come by a good, strong dose of con­fi­dence.

From Fish­er’s point of view, such a belief is futile. In an econ­o­my with an exces­sive lev­el of debt and low infla­tion, he argued that con­fi­dence was irrelevant–and in fact dan­ger­ous­ly mis­lead­ing, as he knew from painful per­son­al expe­ri­ence. Giv­en over-indebt­ed­ness and low lev­els of infla­tion, a “chain reac­tion” would occur in which: 

(1) Debt liq­ui­da­tion leads to dis­tress sell­ing and to

(2) Con­trac­tion of deposit cur­ren­cy, as bank loans are paid off, and to a slow­ing down of veloc­i­ty of cir­cu­la­tion. This con­trac­tion of deposits and of their veloc­i­ty, pre­cip­i­tat­ed by dis­tress sell­ing, caus­es

(3) A fall in the lev­el of prices, in oth­er words, a swelling of the dol­lar. Assum­ing, as above stat­ed, that this fall of prices is not inter­fered with by refla­tion or oth­er­wise, there must be

(4) A still greater fall in the net worths of busi­ness, pre­cip­i­tat­ing bank­rupt­cies and

(5) A like fall in prof­its, which in a “ cap­i­tal­is­tic,”  that is, a pri­vate-prof­it soci­ety, leads the con­cerns which are run­ning at a loss to make

(6) A reduc­tion in out­put, in trade and in employ­ment of labor. These loss­es, bank­rupt­cies, and unem­ploy­ment, lead to

(7) Pes­simism and loss of con­fi­dence, which in turn lead to

(8) Hoard­inq and slow­ing down still more the veloc­i­ty of circulation.The above eight changes cause

(9) Com­pli­cat­ed dis­tur­bances in the rates of inter­est, in par­tic­u­lar, a fall in the nom­i­nal, or mon­ey, rates and a rise in the real, or com­mod­i­ty, rates of inter­est.” (Fish­er 1933; The Debt Defla­tion The­o­ry of Great Depres­sions)

One key phe­nom­e­non that Fish­er empha­sised was that defla­tion could make the debt bur­den worse even as bor­row­ers reduced their nom­i­nal debt levels–something I have termed “Fish­er’s Para­dox”. In Fish­er’s words:

Each dol­lar of debt still unpaid becomes a big­ger dol­lar, and if the over-indebt­ed­ness with which we start­ed was great enough, the liq­ui­da­tion of debts can­not keep up with the fall of prices which it caus­es.

In that case, the liq­ui­da­tion defeats itself. While it dimin­ish­es the num­ber of dol­lars owed, it may not do so as fast as it increas­es the val­ue of each dol­lar owed.

Then, the very effort of indi­vid­u­als to lessen their bur­den of debts increas­es it, because of the mass effect of the stam­pede to liq­ui­date in swelling each dol­lar owed. Then we have the great para­dox which, I sub­mit, is the chief secret of most, if not all, great depres­sions:

The more the debtors pay, the more they owe. The more the eco­nom­ic boat tips, the more it tends to tip. It is not tend­ing to right itself, but is cap­siz­ing.”

This is a “dis­e­qui­lib­ri­um” phe­nom­e­non par excel­lence, because not only does it occur out of equi­lib­ri­um, it actu­al­ly dri­ves the sys­tem fur­ther from equi­li­bi­um. And it is indeed what hap­pened dur­ing the Great Depres­sion: Amer­i­ca’s debt to GDP ratio rose even as nom­i­nal debt lev­els were reduced. The debt ratio rose from 175 at the end of 1929 to 235 per­cent in 1932, even as nom­i­nal pri­vate debt fell from US$163 bil­lion to US$134 bil­lion.

Even though the pub­lic’s ini­tial attempt to reduce its debt bur­den was foiled, the reduc­tion in debt nonethe­less did have an impact: it drove the econ­o­my into Depres­sion. In the cred­it-dri­ven real world in which we live, aggre­gate demand is the sum of GDP plus the change in debt. The pub­lic’s attempt to reduce debt meant that the reduc­tions in debt sub­stan­tial­ly reduced demand, and this delever­ag­ing was the unstop­pable force that made the Great Depres­sion “great”.

As the next chart shows, dur­ing the Roar­ing Twen­ties, the annu­al increase in debt was respon­si­ble for up to ten per­cent of aggre­gate demand. But when the Great Crash brought this peri­od of lever­aged spec­u­la­tion to an end, the delever­ag­ing that Fish­er described meant that the change in debt start­ed to reduce from demand–and at its peak, the reduc­tion in debt in 1932 reduced aggre­gate demand by 25 per­cent.

As is obvi­ous, unem­ploy­ment sky­rock­et­ed as aggre­gate demand col­lapsed. When debt reach­es the sky high lev­els it did before the Great Depres­sion, delever­ag­ing becomes the dom­i­nant force deter­min­ing the lev­el of unemployment–but obvi­ous­ly there is a lag. Unem­ploy­ment is the clas­sic “lag­ging indi­ca­tor”, because firms take time to respond to a drop in demand, first­ly by ceas­ing to hire new work­ers and then by sack­ing exist­ing ones.

When work­ing with annu­al data at the time of the Great Depres­sion, this lag appears to be about one and a half years. Apply­ing that lag to the peri­od from mid-1929 till mid-1938 (when Gov­ern­ment spend­ing and arma­ments pro­duc­tion for the loom­ing war in Europe start­ed to boost demand and caused unem­ploy­ment to fall), the cor­re­la­tion between debt’s con­tri­bu­tion to demand and unem­ploy­ment was ‑0.85. The change in debt’s con­tri­bu­tion to demand thus explains 85 per­cent of the unem­ploy­ment expe­ri­ence of the Great Depres­sion.

This is not good news for us today, for three rea­sons. First­ly, debt lev­els today are far high­er than they were pri­or to the Great Depression–the force of delever­ag­ing is thus like­ly to be greater now than it was in the 1930s. Sec­ond­ly, giv­en this high­er lev­el of debt, the cor­re­la­tion between the debt-financed pro­por­tion of aggre­gate demand and unem­ploy­ment is even stronger now than it was dur­ing the Great Depres­sion. Third­ly, giv­en the greater depen­dence on debt today than ever before, and the social changes that have gone with the Ponz­i­fi­ca­tion of Cap­i­tal­ism, the lag between a fall in the debt-financed com­po­nent of demand and a rise in unem­ploy­ment has dropped to just two months.

The change in debt is there­fore the best–and most ominous–predictor of future unem­ploy­ment lev­els. Though well down from the peak lev­el of being respon­si­ble for 25% of aggre­gate demand, pri­vate debt is still gen­er­at­ing 10 per­cent of demand in the USA. Yet even with still pos­i­tive debt-financed demand, unem­ploy­ment has risen to 8.7 per­cent. If delever­ag­ing results in debt reduc­ing aggre­gate demand by 25 per­cent as it did in the Great Depres­sion, then unem­ploy­ment is going to go much, much high­er.

The same analy­sis applies to Aus­tralia. Since the cri­sis has yet to hit Aus­tralia as strong­ly as it has the USA or Europe, the belief that “we are different”–which I call “Kan­ga­roo Eco­nom­ics” in hon­our of our nation­al fauna–is still preva­lent here. So too is the belief that, if we do suf­fer a reces­sion, it will be due to exter­nal forces rather than to our own eco­nom­ic cir­cum­stances.

The data begs to dif­fer. Though our aggre­gate debt lev­el did­n’t reach Yan­kee heights–our peak debt to GDP lev­el was about 165%, ver­sus 290% in the USA before defla­tion started–our rate of growth of debt was much high­er, so that at its peak the growth in debt was respon­si­ble for 22% of aggre­gate demand. Now that debt is start­ing to fall, unem­ploy­ment is start­ing to rise. There is every rea­son to expect delever­ag­ing in Aus­tralia to dri­ve unem­ploy­ment well into dou­ble dig­its.

So con­fi­dence is not “all it is about”: con­fi­dence played its role over the last thir­ty years as it “beguiled its vic­tims into debt”, in Fish­er’s evoca­tive phrase. We don’t need more of it now, so much as less of it back then–but of course, we can’t amend his­to­ry.

The vic­tims of past over­con­fi­dence include Cen­tral Bankers, whose res­cues of the finan­cial sys­tem sim­ply encour­aged it to search out a new group of poten­tial bor­row­ers to replace those who had already been debt-sat­u­rat­ed. They were vic­tims of debt, as much as were the bor­row­ers, because the naive the­o­ry of eco­nom­ics they fol­lowed ignored the role of debt com­plete­ly. They there­fore could­n’t see the process that was lead­ing to cri­sis, even as their inter­ven­tions egged that process on to heights that it could nev­er have reached with­out them.

Had Greenspan and his equiv­a­lents around the world not inter­vened in 1987, it is quite pos­si­ble that we would have expe­ri­enced a mild Depres­sion back then–mild because debt was only equiv­a­lent to 1929 lev­els then, because a larg­er Gov­ern­ment sec­tor than in the 1920s would have coun­ter­bal­anced the pri­vate sec­tor down­turn, and because high­er infla­tion in the late 80s would have helped reduced the real bur­den of debt.

Now we are sit­ting on the precipice of a moun­tain of debt twice as high as in the Great Depres­sion, with low infla­tion turn­ing into defla­tion as Fish­er warned, and with Cen­tral Bankers who do not have a clue why the econ­o­my has sud­den­ly gone from “the Great Mod­er­a­tion” to “the Great­est Cri­sis Since the Great Depres­sion”.

Over-con­fi­dence in the face of ris­ing debt did beguile us dur­ing the long boom. Con­fi­dence in the face of delever­ag­ing will not save us dur­ing the com­ing Depres­sion.


Comments on the Australian Data

Debt lev­els in Aus­tralia are very close to falling in nom­i­nal terms, and in fact only mort­gage debt is still ris­ing: both busi­ness and per­son­al debt (oth­er than mort­gages) have fall­en in the last few months. It is con­ceiv­able that, were it not for the “First Home Buy­ers Boost”, mort­gage debt as well would be falling now too (the scheme is more apt­ly described as the “First Home Ven­dors Boost”, since prices at the low end of the mar­ket have been dri­ven up by far more than the $7,000 increase in the grant).

As a result, the debt to GDP ratio has fall­en for the last four months–though this is to some extent masked by Aus­trali­a’s prac­tice of sum­ming the pre­vi­ous four quar­ters of GDP data to derive annu­al GDP, ver­sus the Amer­i­can prac­tice of sim­ply mul­ti­ply­ing the cur­rent quar­ter’s GDP fig­ure by 4. Using the Aus­tralian approach, our debt to GDP ratio is now 160%; using the Amer­i­can, it is 162%, since GDP fell by 0.5% in the pre­vi­ous quar­ter.

Whichev­er way you cut it, delever­ag­ing is now well and tru­ly under­way, and unem­ploy­ment will there­fore rise dra­mat­i­cal­ly in the next few months. Most neo­clas­si­cal econ­o­mists are pre­dict­ing 7.5% unem­ploy­ment by mid-2010; I expect it will have entered dou­ble fig­ures by ear­ly in 2010.

Table One

Table Two

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