Debtwatch No 35: Let’s Do the Time Warp Again

Flattr this!

Eco­nom­ic debate in Aus­tralia today reminds me of one of the great lines in The Rocky Hor­ror Show. As he invites Brad and Janet to meet Rocky, Frank-N-Furter taunts Janet with the lines:

I would like--if I may--to take you on a strange journey...

I would like–if I may–to take you on a strange jour­ney…

I see you shiv­er with antic­i­pa­tion!

But maybe the rain is real­ly to blame

So I’ll remove the cause,…

But not the symp­tom!”

It seems that in Aus­tralia, the reverse can apply: the symp­tom can be removed with­out elim­i­nat­ing the cause. We can avoid a seri­ous reces­sion while doing noth­ing to reduce pri­vate debt. 

Exces­sive pri­vate debt caused the Glob­al Finan­cial Cri­sis. The expan­sion of pri­vate debt caused a false bub­ble pros­per­i­ty for the last one and a half decades. Now that the growth in pri­vate debt has ceased, economies world­wide are going into a severe down­turn dri­ven by delever­ag­ing: con­sumers in par­tic­u­lar are spend­ing far less as they try to reduce their debt lev­els; out­put is plum­met­ing, and unem­ploy­ment is ris­ing.

Aus­tralia was as caught up in this process as any­where else in the OECD. And yet some­how, we aren’t going to suf­fer much in the way of ill con­se­quences? It seems hero­ic to assume so, and yet this was the basis of the recent Bud­get. Dis­cus­sion and crit­i­cism of it by the Oppo­si­tion and many eco­nom­ic com­men­ta­tors like­wise focussed far less on the caus­es and expect­ed sever­i­ty of the down­turn, and far more on the gov­ern­men­t’s pro­jec­tions of how rapid­ly it would return the fed­er­al bud­get to sur­plus.

Trea­sury Sec­re­tary Ken Hen­ry’s speech to Aus­tralian Busi­ness Econ­o­mists (Con­tem­po­rary chal­lenges in Fis­cal Pol­i­cy, Syd­ney, 19 May 2009) pro­vid­ed the most detailed defence of the Bud­get esti­mates that the reces­sion would be over by 2010-11 and be fol­lowed by a boom, do no worse than reduce annu­al GDP by half a per cent in 2009-10, and see net gov­ern­ment debt peak at 14 per cent of GDP in 2013–14 (Bud­get Paper No. 1, p. 3–9). In this Debt­watch I want to take a more crit­i­cal look at this doc­u­ment than our eco­nom­ic jour­nal­ists have done to date, and con­trast the assump­tions behind it, and its mod­el­ling, with my approach.

For Gods sake keep a grip on yourself Janet. Im here - theres nothing to worry about.

For God’s sake keep a grip on your­self Janet. I’m here — there’s noth­ing to wor­ry about.

The Trea­sury’s Approach

I’ll quote the key eco­nom­ic argu­ment in Hen­ry’s speech in its entire­ty first, and inter­pret it lat­er:

So let me tell you what we actu­al­ly did. It’ s a bit com­pli­cat­ed. But not too com­pli­cat­ed, I’ m sure, for this audi­ence.

I’ ve already out­lined some of the con­text for this work. But a quick re-cap: We devel­oped the medi­um-term sce­nario to pro­vide para­me­ters for the medi­um-term pro­jec­tions of the bud­get bal­ance. The lat­ter are required to span the gap between the four-year for­ward esti­mates peri­od and the 40 year pro­jec­tions con­tained in the inter­gen­er­a­tional reports.

In span­ning the gap we also want­ed to rec­on­cile the short and medi­um-term GDP tra­jec­to­ry with the long-term pro­jec­tions con­tained in our IGR [“Inter-Gen­er­a­tional Report”] mod­el­ling. Call us fas­tid­i­ous if you like, but we don’ t like dis­con­ti­nu­ities in our eco­nom­ic pro­jec­tions. We want­ed to be sure that we were describ­ing a medi­um-term sce­nario that is con­sis­tent not only with the short-term fore­casts, but also with the long-term IGR pro­jec­tions.

The approach is pred­i­cat­ed on a grad­ual recov­ery in aggre­gate demand in the final fore­cast year (2010–11), after which the sup­ply-side dri­vers of the econ­o­my take over.

This is how we went about it. First, recall that we can describe GDP growth using a num­ber of dif­fer­ent decom­po­si­tions. Usu­al­ly, we employ the com­po­nents of aggre­gate demand to tell the sto­ry. But increas­ing­ly we have used the sup­ply-side decom­po­si­tion that iso­lates changes in the fol­low­ing key vari­ables:

(1) the pop­u­la­tion aged 15-plus;

(2) the par­tic­i­pa­tion rate;

(3) the employ­ment rate;

(4) aver­age hours worked; and

(5) labour pro­duc­tiv­i­ty.

All of these things are cycli­cal­ly sen­si­tive, includ­ing the first because of the cycli­cal sen­si­tiv­i­ty of immi­gra­tion.

We can obtain an index of real GDP sim­ply by mul­ti­ply­ing togeth­er these five things.

The weak GDP growth rate fore­cast for 2010-11 can be explained as fol­lows. Despite rel­a­tive­ly strong pro­duc­tiv­i­ty growth of 2½ per cent, and the pop­u­la­tion aged 15-plus grow­ing by 1¾ per cent, GDP growth is only 2¼ per cent. Weak demand sees both a fall in the par­tic­i­pa­tion rate (which sub­tracts about 1 per­cent­age point), and an increase in the unem­ploy­ment rate from 7½ per cent to 8½ per cent (which sub­tracts anoth­er per­cent­age point).

As we move into 2011-12, how­ev­er, growth strength­ens sharply: pro­duc­tiv­i­ty growth is weak­er, but still a healthy 2 per cent; the growth in pop­u­la­tion aged 15-plus is also weak­er, but still a healthy 1½ per cent; the par­tic­i­pa­tion rate is unchanged; and the unem­ploy­ment rate falls by one per­cent­age point. You might be inter­est­ed to know that in com­ing out of the reces­sions of the ear­ly 1980s and 1990s the unem­ploy­ment rate fell by about a per­cent­age point a year for the first two years. Tak­en togeth­er, these fac­tors pro­duce a GDP growth rate of 4½ per cent.

That pat­tern is repeat­ed in the fol­low­ing year, 2012–13. Then in each of the fol­low­ing four years the unem­ploy­ment rate falls by only one-half of a per­cent­age point a year; pro­duc­tiv­i­ty growth slows to only 1½ per cent; and the par­tic­i­pa­tion rate adds half a per­cent­age point a year. These fac­tors pro­duce annu­al growth of 4 per cent.

The pro­duc­tiv­i­ty growth rate of 1½ per cent is less than that used in the two IGRs pub­lished to date. It is the actu­al back­ward-look­ing 30-year aver­age. The pro­files of the unem­ploy­ment and par­tic­i­pa­tion rates over the peri­od 2013–14 to 2016–17 weren’ t plucked out of the air either. They ensure that by the end of that peri­od, poten­tial GDP is back on the long-term tra­jec­to­ry con­tained in our IGR [Inter-Gen­er­a­tional Report] mod­el­ling, hav­ing spent nine years from 2008-09 below that tra­jec­to­ry. By 2016–17 the out­put gap has closed, with an unem­ploy­ment rate of 5 per cent and a par­tic­i­pa­tion rate con­sis­tent with the labour force mod­els used in the IGR pro­jec­tions. (Hen­ry 2009, pp 14–16)

Deconstructing Treasury I: The context

Three con­tex­tu­al points stand out in this state­ment.

First­ly, there is no dis­cus­sion of what actu­al­ly caused the GFC, here or any­where else in Hen­ry’s speech. The fact that it orig­i­nat­ed in the finan­cial sys­tem is not­ed, but why it orig­i­nat­ed there, and what caused it, is not con­sid­ered.

Sec­ond­ly, “the long run” in the Bud­get papers is deter­mined by assump­tions the Trea­sury made about the econ­o­my’s future in its Inter­gen­er­a­tional Report, which was pub­lished in 2007. Since those assump­tions were made pri­or to the Glob­al Finan­cial Cri­sis, that means that the Trea­sury is assum­ing that the GFC will have no long term effect on the econ­o­my: it will sup­press out­put and employ­ment for a cou­ple of years, but after that every­thing will return to how it was before the GFC came along.

Third­ly, the Trea­sury pro­duced its Bud­get esti­mates for GDP growth by decom­pos­ing growth into 5 fac­tors, mak­ing assump­tions about those fac­tors over time, and adding them up to pro­duce esti­mates for 2010–2017. Four of the five num­bers used–and the Trea­sury’s expec­ta­tions for infla­tion as well–are shown below (the Trea­sury did­n’t pro­vide its esti­mates of aver­age hours worked, so that fac­tor is pre­sum­ably col­lapsed into the employ­ment rate; and their table [Table One on page 15] says “Unem­ploy­ment Rate” where I believe they meant “Employ­ment Rate”).

Note that Hen­ry describes this decom­po­si­tion as a “sup­ply side decom­po­si­tion”. There’s no argu­ment that pop­u­la­tion is a “sup­ply side” issue–not with­stand­ing Peter Costel­lo’s “Baby Bonus”, it’s fair to assume that the house­holds deci­sions about whether to have chil­dren are not deter­mined by eco­nom­ic con­di­tions. Dit­to pro­duc­tiv­i­ty to some degree: high­er eco­nom­ic growth should lead to high­er pro­duc­tiv­i­ty, but there will be pro­duc­tiv­i­ty growth even when the econ­o­my is stag­nant, so at a first pass one can treat pro­duc­tiv­i­ty growth as inde­pen­dent of aggre­gate demand.

But are the par­tic­i­pa­tion rate and the employ­ment rate “sup­ply side” factors–set by house­hold deci­sions alone rather than influ­enced by the demand that cur­rent­ly exists for work­ers? Hen­ry also notes that all these fac­tors “are cycli­cal­ly sen­si­tive”, which implies they are affect­ed by demand con­di­tions. So why call them “sup­ply side” fac­tors?

Because if you fol­low neo­clas­si­cal eco­nom­ic the­o­ry, the rate of growth “in the long run” is deter­mined by the labour sup­ply deci­sions of house­holds and the rate of pro­duc­tiv­i­ty growth. While “in the short run”, neo­clas­si­cal econ­o­mists will con­cede that there can be insuf­fi­cient aggre­gate demand to employ all work­ers who wish to work, in the long run they assume that every­one who wants a job can get one, so that “in the long run” the unem­ploy­ment rate is deter­mined by house­holds, based on their pref­er­ences for income and leisure.

Cred­it issues–even ones as severe as the GFC–don’t fac­tor into the Trea­sury’s mod­el­ling because, fol­low­ing neo­clas­si­cal eco­nom­ics, they assume that mon­ey and cred­it don’t have any long term impact. Mon­e­tary fac­tors like cred­it and debt are not includ­ed in Trea­sury’s macro­eco­nom­ic mod­el (TRYM) in any way. Ulti­mate­ly, their mod­el assumes that the econ­o­my will set­tle down to a long run equi­lib­ri­um rate of growth deter­mined sole­ly by house­hold labour sup­ply deci­sions and the rate of tech­no­log­i­cal progress.

Deconstructing Treasury II: Alternative Long Run Assumptions

Now let’s con­sid­er the Trea­sury’s approach in detail, start­ing with the the fram­ing of the Bud­get’s assump­tions so that they were con­sis­tent with the out­comes of the IGR. Hen­ry’s defence that “Call us fas­tid­i­ous if you like, but we don’ t like dis­con­ti­nu­ities in our eco­nom­ic pro­jec­tions” does­n’t mean that the approach it took here was the only one avail­able. It could also have revised the IGR pro­jec­tions in the light of the GFC, and then made the Bud­get assump­tions con­sis­tent with these low­ered assump­tions about the future.

And there are sev­er­al­ways it could have done that. It could have:

  • stuck with the IGR’s assump­tions about long run rates of growth, but treat­ed the GFC as a “one-off” event that took a per­ma­nent chunk out of eco­nom­ic per­for­mance for a few years; or
  • treat­ed the GFC as some­thing that per­ma­nent­ly altered the econ­o­my’s long term growth rate so that the econ­o­my was on a per­ma­nent­ly dif­fer­ent path; or
  • some com­bi­na­tion of the two.

Because it did none of the above, the Trea­sury was forced to assume that the medi­um term impact of the GFC would be to accel­er­ate Aus­trali­a’s eco­nom­ic growth: since their long run sce­nario assumed that the GFC altered nei­ther the lev­el of out­put in 2040 nor the rate of growth then, and yet in the short run (the next two years) it would reduce growth, then in the medi­um term growth had to accel­er­ate to catch up with the IGR fore­casts.

There­fore the Bud­get’s pro­jec­tions come down to hope. IF the GFC has no impact on the econ­o­my in the long run, AND the econ­o­my nec­es­sar­i­ly set­tles down to an equi­lib­ri­um rate of growth inde­pen­dent of finan­cial fac­tors, THEN the Bud­get’s fore­casts will be cor­rect.

If on the oth­er hand the GFC does have a long term impact–either by tak­ing push­ing the econ­o­my down but not affect­ing the long run rate of growth, or by tak­ing a chunk out of the econ­o­my now and alter­ing the rate of growth–and the econ­o­my’s equi­lib­ri­um isn’t inde­pen­dent of finan­cial fac­tors, then the Bud­get’s fore­casts will be wild­ly wrong.

Deconstructing Treasury III: Alternative Short Run Assumptions

Equal­ly the short run assumptions–that the GFC will cause out­put to fall by 0.5 per­cent this finan­cial year and grow by just 2.25 per­cent next year–can be chal­lenged. The Trea­sury’s Bud­get Papers abound with state­ments like “The 2009-10 Bud­get has been framed against the back­drop of the deep­est glob­al reces­sion since the Great Depres­sion” (State­ment 1, p. 1–1). And yet this reces­sion is expect­ed to be shal­low­er than those of 90–92 and 82–84, when GDP fell by 1.25 per­cent and 2.5 per­cent respec­tive­ly?

What if “the deep­est glob­al reces­sion since the Great Depres­sion” has an out­come like its pre­de­ces­sor, when out­put fell by as much as 10 per­cent a year?

This might sound extreme, but it’s in the ball­park of what’s hap­pen­ing in the rest of the OECD, where US out­put is falling at 6 per­cent and Japan­ese at over 10 per­cent. Cer­tain­ly it would have been more real­is­tic to assume that “the deep­est glob­al reces­sion since the Great Depres­sion” would have a greater impact than any post-WWII reces­sion, espe­cial­ly since the fig­ures com­ing out of the rest of the OECD imply that, in the words of Rocky Hor­ror’s Nar­ra­tor, this reces­sion will be “no pic­nic”.

What if Trea­sury had assumed that some­thing half that bad–something like the cur­rent down­turn in the USA of a 5 per­cent fall in real GDP in a year–as the imme­di­ate impact of the GFC, rather than a mere 0.5 per­cent?

Though Trea­sury had to use a sin­gle fore­cast to frame the Bud­get, it could also have con­sid­ered a range of sce­nar­ios, rather than the sin­gle incred­i­bly upbeat sce­nario it pre­sent­ed and now defends.

On its record with pick­ing the GFC to date, the Trea­sury is in no posi­tion to rest on its fore­cast­ing lau­rels. The com­par­i­son of its expec­ta­tions in 2008 for the most recent finan­cial year with real­i­ty makes for inter­est­ing read­ing:

Deconstructing Treasury IV: Doing the Time Warp Again

The real prob­lem with the Bud­get is that it is based on the same approach to eco­nom­ic fore­cast­ing that Keynes lam­pooned in his often cit­ed but rarely appre­ci­at­ed state­ment on the long run. It was not a quip about mor­tal­i­ty, but a jus­ti­fied crit­i­cism of the man­ner in which the econ­o­mists of his day assumed that the econ­o­my would always 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, A Tract on Mon­e­tary Reform, 1923)

Though one might hope that eco­nom­ics had learnt from the past and improved since Key­nes’s day, the real­i­ty is that it has instead recon­struct­ed the same man­ner of thought that exist­ed before Keynes and the Great Depres­sion. The vast major­i­ty of mod­els used by econ­o­mists to pre­dict the future course of the econ­o­my today are sub­ject to Key­nes’s crit­i­cism of 1923. The  Trea­sury’s TRYM mod­el has these same characteristics–though now expressed in math­e­mat­i­cal mod­els rather than impen­e­tra­ble prose:

There are those who say life is an illusion - And reality as we know it, is merely a figment of our imaginations.

There are those who say life is an illu­sion — And real­i­ty as we know it, is mere­ly a fig­ment of our imag­i­na­tions.

  1. A short term that into which “shocks” can be fed like a change in the growth rate, which then affects all relat­ed vari­ables;
  2. A long run which is in equi­lib­ri­um with assump­tions made about pro­duc­tiv­i­ty, labour sup­ply, and pop­u­la­tion growth that gen­er­ate growth pro­jec­tions which match recent expe­ri­ence, altered only by antic­i­pat­ed changes in demo­graph­ics; and
  3. Assump­tions about how quick­ly the equi­lib­ri­um will reassert itself that gen­er­ate a cycli­cal con­ver­gence from any short term dis­tur­bance.

So if an enor­mous finan­cial shock–whose caus­es are not understood–has only a minor impact on the Aus­tralian econ­o­my, after which we will return to an equi­lib­ri­um path that reflects recent his­to­ry, then the Bud­get will be accu­rate. And if not?…

It’s just a jump to the Left…

There is a minor­i­ty of econ­o­mists who com­plete­ly reject this approach to eco­nom­ics. But when the econ­o­my itself appeared to be boom­ing, that minor­i­ty was ignored by the major­i­ty of “neo­clas­si­cal” econ­o­mists, and regard­ed as “left wing crit­ics of cap­i­tal­ism” by the pub­lic.

Now that the GFC is afoot, it is final­ly pos­si­ble to get across the fact that the crit­i­cism was direct­ed not so much at cap­i­tal­ism itself, as at wool­ly and delu­sion­al think­ing about cap­i­tal­ism mas­querad­ing as eco­nom­ic log­ic.

Much of this minor­i­ty’s time was tak­en up with point­ing out why neo­clas­si­cal eco­nom­ics was delu­sion­al (see my Debunk­ing Eco­nom­ics for a col­la­tion of those cri­tiques). Only part of it was devot­ed to devel­op­ing alter­na­tive the­o­ries of how the econ­o­my oper­at­ed, with the out­stand­ing con­tri­bu­tion there being Hyman Min­sky’s Finan­cial Insta­bil­i­ty Hypoth­e­sis. The core aspects of this approach to the econ­o­my are that:

And then a step to the right...

And then a step to the right…

  • The econ­o­my is inher­ent­ly cycli­cal and will nev­er be in equi­lib­ri­um, either now or in the future;
  • Cred­it and mon­ey are crit­i­cal and impact on real eco­nom­ic activ­i­ty in “the long run” as well as in the short, and must be includ­ed in any macro­eco­nom­ic mod­el; and
  • Asset mar­kets mat­ter because debt-financed spec­u­la­tion on them can both dri­ve eco­nom­ic activ­i­ty and lead to finan­cial crises.

These insights lead non-neo­clas­si­cal econ­o­mists to focus on issues that neo­clas­si­cal econ­o­mists ignore–such as the lev­el and rate of growth of pri­vate debt–and require a dif­fer­ent, tru­ly dynam­ic approach to mod­el­ling the econ­o­my, as opposed to the equi­lib­ri­um-obsessed approach that dom­i­nates neo­clas­si­cal eco­nom­ics.

I’ve recent­ly pub­lished two aca­d­e­m­ic papers based on this cred­it-dri­ven, non-equi­lib­ri­um approach to eco­nom­ics (one is already avail­able in Eco­nom­ic Analy­sis and Pol­i­cy, the oth­er will be pub­lished in the Aus­tralian Eco­nom­ic Review in Sep­tem­ber). They’ll be com­bined into one approach in the book I’m writ­ing on the finan­cial cri­sis for Edward Elgar Pub­lish­ers (Finance and Eco­nom­ic Break­down, esti­mat­ed date of pub­li­ca­tion Decem­ber 2011). Here I’ll show how both of them pre­dict a rather dif­fer­ent out­come from the GFC to the “return to busi­ness as usu­al” hopes of the Trea­sury.

These mod­els are still very basic and incomplete–in par­tic­u­lar, I have not attempt­ed to fit them to the Aus­tralian data. But they indi­cate the essen­tial dif­fer­ences between the mod­el­ling approach the Trea­sury takes and true dynam­ic mod­el­ling.

What is a Credit Crunch?

The phrase “cred­it crunch” has entered the ver­nac­u­lar, but what in fact is it? The eas­i­est way to describe it is as a sud­den reduc­tion in peo­ple’s will­ing­ness to take on debt, and banks’ will­ing­ness to extend cred­it. This phe­nom­e­non can be cap­tured by the mod­el I out­lined in the Rov­ing Cav­a­liers of Cred­it by chang­ing three key para­me­ters:

Its something we ourselves have been working on.  But it seems our friend here has found a way of perfecting it.  A device which is capable of breaking down solid matter and then projecting it through space, and - who knows - perhaps even time itself!

It’s some­thing we our­selves have been work­ing on. But it seems our friend here has found a way of per­fect­ing it.

  1. The aver­age time hori­zon over which bor­row­ers aim to repay their loans drops;
  2. The rate of recir­cu­la­tion of exist­ing bank reserves falls; and
  3. The rate of cre­ation of new cred­it mon­ey drops.

The changes to finan­cial para­me­ters are shown in the table below. The impact of these three vari­ables on eco­nom­ic activ­i­ty in this mod­el of a cred­it-dri­ven econ­o­my are dra­mat­ic.

The mod­el itself is quite sim­ple, but it dif­fers from TRYM and its neo­clas­si­cal cousins in one vital way: it is fun­da­men­tal­ly dynam­ic. As not­ed above, TRYM’s “dynam­ics” sim­ply result from the mod­el’s key vari­ables con­verg­ing to some assumed “long run” val­ues that are arbi­trar­i­ly imposed on the mod­el. For exam­ple, the graph below from TRYM’s doc­u­men­ta­tion shows what TRYM assumes will hap­pen to unem­ploy­ment “in the long run”: it will con­verge to a steady state lev­el that in 1995 they assumed was 7%.

The fact that unem­ploy­ment behaved very dif­fer­ent­ly between 1996–when this doc­u­ment was written–forced the Trea­sury to change the 7% fig­ure to 5.25%. But it it still imposed on the model–it is not some­thing that results from the inter­ac­tion of unem­ploy­ment with oth­er vari­ables in the mod­el.

This is why the Trea­sury can assert that the GFC will have no long term impact on the unem­ploy­ment rate: because its mod­el sim­ply assumes so.

Things are rather dif­fer­ent in the real world, and a tru­ly dynam­ic mod­el goes at least part of the way to cap­tur­ing that. Below are four sim­u­la­tions of the impact of a per­ma­nent cred­it crunch–a per­ma­nent shift in finan­cial parameters–in the Rov­ing Cav­a­liers mod­el. Not only does the size of the shock have a dra­mat­ic impact on unem­ploy­ment in the short term–causing every­thing from a short reces­sion with a mild shock to a long Depres­sion with a large one–but the equi­lib­ri­um rate of unem­ploy­ment changes per­ma­nent­ly as well.

The mod­el gen­er­ates an accel­er­a­tion of growth after a cred­it-crunch-induced reces­sion, rather like the one that Trea­sury is assum­ing will happen–but again, in con­trast to the Trea­sury’s mod­el, this accel­er­a­tion is not mere­ly an assump­tion, but a prod­uct of the mod­el’s many feed­backs.

Deleveraging and Economic Breakdown

The Rov­ing Cav­a­liers mod­el above sim­u­lates a cri­sis of liq­uid­i­ty, some­thing which can eas­i­ly be over­come if firms’ will­ing­ness to take on debt, and banks’ will­ing­ness to lend, can be restored. If this were the nature of the cri­sis we are expe­ri­enc­ing, then it could be reversed sim­ply by increas­ing confidence–which is the one thing that can be said in favour of an offi­cial fore­cast that the reces­sion will only last a year and result in unem­ploy­ment no worse than 8.5 per cent.

But its the pelvic thrust That really drives you insane...

But it’s the pelvic thrust That real­ly dri­ves you insane…

But what if the cri­sis is one of sol­ven­cy instead? What if the real cause of the cri­sis is not mere­ly a sud­den drop in con­fi­dence result­ing in low­er rates of cre­ation and cir­cu­la­tion of cred­it, but too much debt alto­geth­er?

That pos­si­bil­i­ty is cap­tured in my Min­sky mod­el, in which a series of booms and busts leads to one final bust where the accu­mu­lat­ed debt is so great that the econ­o­my can no longer ser­vice it. Out­put and employ­ment col­lapse, and the only way out is to delib­er­ate­ly reduce the debt.

This mod­el’s dynam­ics are gen­er­at­ed by four inter­act­ing fac­tors:

  1. Wage demands by work­ers based on the rate of employ­ment
  2. Invest­ment deci­sions by firms based on the rate of prof­it
  3. Spec­u­la­tive bor­row­ing by firms based on the rate of eco­nom­ic growth; and
  4. Lend­ing by banks

Its equa­tions can be sum­marised as say­ing that:

  1. Work­ers share of out­put will rise if wage demands exceed the growth in pro­duc­tiv­i­ty
  2. The employ­ment rate will rise if eco­nom­ic growth exceeds the sum of pro­duc­tiv­i­ty and pop­u­la­tion growth
  3. Banks lend to finance invest­ment and spec­u­la­tion and charge inter­est on the out­stand­ing debt; and
  4. Spec­u­la­tion ris­es as the rate of eco­nom­ic growth increas­es.

Those four fac­tu­al state­ments result in a mod­el that gen­er­ates a series of trade cycles, each appar­ent­ly like the pre­vi­ous one, but with the lev­el of debt alter­ing over time.

A cru­cial fac­tor is the dis­tri­b­u­tion of debt between pro­duc­tive and unpro­duc­tive purposes–between gen­uine invest­ment and mere spec­u­la­tion. The for­mer builds addi­tion­al pro­duc­tive capac­i­ty that can be used to meet finan­cial com­mit­ments in the future, even if today exces­sive increas­es in the debt bur­den leads to a reces­sion. But bor­row­ing that mere­ly finances spec­u­la­tion on the stock exchange or the hous­ing mar­ket about the prices of shares and hous­es adds to debt now with­out increas­ing our capac­i­ty to ser­vice it in the future.

The “No Spec­u­la­tion” sim­u­la­tion shown in the fol­low­ing graphs has only pro­duc­tive bor­row­ing; the “Ponzi Finance” sim­u­la­tion has bor­row­ing to spec­u­late on asset prices as well as pro­duc­tive bor­row­ing.

It is pos­si­ble to gen­er­ate a cri­sis in the “No Spec­u­la­tion” case by choos­ing a set of ini­tial con­di­tions that result in more extreme cycles–it is a “chaot­ic” mod­el that has “sen­si­tive depen­dence on ini­tial con­di­tions” in the tech­ni­cal vernacular–but gen­er­al­ly speak­ing it is a sta­ble sys­tem that won’t lead to a debt cri­sis (in fact in the sim­u­la­tion here, debt to GDP ratios are neg­a­tive, which means that firms accu­mu­late pos­i­tive bank bal­ances).

The Ponzi Finance sys­tem how­ev­er is inher­ent­ly unsta­ble: the growth of unpro­duc­tive debt dur­ing a boom–when peo­ple bor­row mon­ey to spec­u­late on ris­ing asset prices–adds so much to debt that the amount accu­mu­lat­ed in the pre­vi­ous boom is nev­er com­plete­ly repaid before the next boom takes off. The debt to GDP ratio there­fore ratch­ets up over time, until ulti­mate­ly, so much debt is tak­en on that the econ­o­my expe­ri­ences not mere­ly a reces­sion but a Depres­sion.

These mod­els are far from “the ant’s pants” in terms of what tru­ly dynam­ic eco­nom­ic mod­el­ling could be. But they are far in advance of mod­els like Trea­sury’s TRYM that pre­dict the future sim­ply by assum­ing that it will be pleas­ant.


Comments on the Data

The lat­est cred­it fig­ures indi­cate that, were it not for the First Home Ven­dors Boost (let’s call it what is real­ly is), pri­vate debt in Aus­tralia would now be falling. The increase in debt for the month of April was a mere A$776 mil­lion, with a A$6.5 bil­lion increase in mort­gage debt almost off­set by a A$4.8 bil­lion fall in busi­ness debt and a A$1 bil­lion fall in per­son­al debt. The change in pri­vate debt is there­fore on the cusp of reduc­ing aggre­gate demand, where­as for the past 17 years, it has been adding to it.

Table One

Table Two

Even though I expect that the gov­ern­men­t’s “Key­ne­sian pump prim­ing” will not pre­vent a Depres­sion, it is still instruc­tive to com­pare the Gov­ern­ment debt lev­els, which are the focus of Can­ber­ra’s cur­rent hys­ter­i­cal debate over the Bud­get, with pri­vate debt lev­els.

It is an indict­ment of eco­nom­ic and polit­i­cal think­ing that our last forty years of eco­nom­ic debate have been dom­i­nat­ed by a song and dance about the Gov­ern­men­t’s debt lev­els when out of con­trol pri­vate debt lev­els have been vir­tu­al­ly ignored.

The run up in pri­vate debt since the reces­sion of 1990 has been so great that changes in gov­ern­ment spend­ing are sim­ply too small to neu­tralise the impact of de-lever­ag­ing by the pri­vate sec­tor. The next graph shows the con­tri­bu­tion that change in debt makes to aggre­gate demand–defined as the sum of GDP plus the change in debt. Delever­ag­ing has only just begun in Aus­tralia, and yet already the reduc­tion in the rate of growth of pri­vate debt has sliced about 8 per­cent off aggre­gate demand. The gov­ern­men­t’s attempts to counter this, though huge by his­tor­i­cal stan­dards, are triv­ial com­pared to the scale of pri­vate sec­tor de-lever­ag­ing.

Bookmark the permalink.