“No-one saw this coming?” Balderdash!

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The widely believed proposition that this financial crisis was “a tsunami that no-one saw coming”, and that could not have been predicted, has been given the lie to by an excellent survey of economic models by Dirk Bezemer, a Professor of Economics at the University of Groningen in the Netherlands.

Bezemer did an extensive survey of research by economists or financial market commentators, looking for papers that met four criteria:

“Only analysts were included who:

  1. provide some account on how they arrived at their conclusions.
  2. went beyond predicting a real estate crisis, also making the link to real-sector recessionary implications, including an analytical account of those links.
  3. the actual prediction must have been made by the analyst and available in the public domain, rather than being asserted by others.
  4. the prediction had to have some timing attached to it.”

On that basis, Bezemer found eleven researchers who qualified:

Researcher Role Forecast Date
Dean Baker, US Co-director, Center for Economic and Policy Research 2006
Wynne Godley, US Distinguished Scholar, Levy Economics Institute of Bard College 2007
Fred Harrison, UK Economic Commentator 2005
Michael Hudson, US Professor, University of Missouri 2006
Eric Janszen, US Investor & iTulip commentator 2007
Stephen Keen, Australia Associate Professor, University of Western Sydney 2006
Jakob Brøchner Madsen & Jens Kjaer Sørensen, Denmark Professor and Graduate Student, Copenhagen University 2006
Kurt Richebächer, US Private consultant and investment newsletter writer 2006
Nouriel Roubini, US Professor, New York University 2006
Peter Schiff, US Stock Broker, investment adviser and commentator 2007
Robert Shiller, US Professor, Yale University 2006

Having identified eleven researchers who did “see it coming”, Bezemer then looked for the common elements in the way that these researchers analysed the economy. He argued that if there were common elements—and if these differed from the approach taken by the overwhelming majority of economists, who didn’t have a clue that a crisis was approaching—then the only useful economic models would be ones that included these common elements.

He identified four common elements:

  1. “a concern with financial assets as distinct from real-sector assets,
  2. with the credit flows that finance both forms of wealth,
  3. with the debt growth accompanying growth in financial wealth, and
  4. with the accounting relation between the financial and real economy.”

A non-economist might look at these elements in puzzlement: surely all economic models include these factors?

Actually, no. Most macroeconomic models lack these features. Bezemer gives the topical example of the OECD’s “small global forecasting” model, which makes forecasts for the global economy that are then disaggregated to generate predictions for individual countries—like the ones touted recently as indicating that Australia will avoid a serious recession.

He notes that this OECD model includes monetary and financial variables, however these are not taken from data, but are instead derived from theoretical assumptions about the relationship between “real” variables—such as “the gap between actual output and potential output”—and financial variables. As Bezemer notes, in the OECD’s model:

“There are no credit flows, asset prices or increasing net worth driving a borrowing boom, nor interest payment indicating growing debt burdens, and no balance sheet stock and flow variables that would reflect all this.”

How come? Because standard “neoclassical” economic models assume that the financial system is like lubricating oil in an engine—it enables the “real economy” to work smoothly, but has no driving effect—and that the real economy is a miracle machine that always returns to a state of steady growth, and never generates any pollution—like a car engine that, once you take your foot off the accelerator or brake, always returns to a steady 3,000 revs per minute, and simply pumps pure water into the atmosphere.

The common elements in the models developed by the Gang of Eleven that Bezemer identified are that they see finance as more akin to petrol than oil—without it, your “real economy” engine revs not at 3,000 rpm, but zero—which can contain large doses of impurities as well as hydrocarbons. The engine itself is seen as a rather more typical gas-guzzler that pumps not merely water and carbon dioxide, but sometimes unhealthy amounts of carbon monoxide as well.

That’s encapsulated in the flowchart that Bezemer copied from a paper by Michael Hudson, shown below. Without credit from the Finance sector, producer/employers don’t get the finance needed to run their factories and hire workers; but with credit they accumulate debt that has to be serviced from the cash flows those businesses generate.

The component left out of the above flowchart—but incorporated in all the models praised by Bezemer for seeing the crisis coming—is that the finance system can fund not merely “good” real economy action but “bad” speculation on financial assets and real estate as well. This also leads to debt, but unlike the lending to finance production, it doesn’t add to the economy’s capacity to service that debt.

The growth in thus unproductive debt was the common element identified by Bezemer’s “Gang of Eleven”, which was why we most definitely did see “It” coming.

I’ll finish this analogy-laden article with a sideswipe at an inappropriate one—that this crisis is “like a tsunami”. Though that image captures the suddenness and devastating nature of the crisis, it is wrong not merely once but twice in characterizing how it came about.

Firstly, unlike a tsunami, this crisis was predictable by economists who take what Bezemer characterized as a “Flow-of-fund or accounting” approach. Secondly, a tsunami is actually caused by a huge shift in the planet’s tectonic plates, and the shift itself relieves the tension that caused the tsunami in the first place: in a sense, the tsunami resets the system to a tranquil state.

This financial tsunami was caused by the bursting of asset price bubbles driven by excessive levels of debt, but the bursting of those asset bubbles hasn’t eliminated the debt—far from it. Instead, economic performance for the next decade or more will be driven by the private sector’s attempts to reduce its debt levels, and this will depress economic activity for years. Unlike a tsunami, a debt crisis is a wave of destruction that keeps on rolling unless the debt is deliberately eliminated.

Everything that is being done by policy makers around the world is instead trying to restart private borrowing. A better analogy is therefore not a tsunami but a drug overdose—and our “neoclassical” economic doctors are attempting to bring the patient back to health by administering more of the same drug.

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253 Responses to “No-one saw this coming?” Balderdash!

  1. spadijer89 says:

    “Your an arrogant ponce. That is no way to win political support”

    Each comment obliterates your point – you have stumbled from ignoring the facts altogether and having an no argument whatsoever, to ad hominems. Lovely. I suppose that is the way to win political support (well, I suppose it worked for Paul Keating).

    I think it (an appeal to the FACTS and first hand PRACTICAL evidence) is certainly a way to win political support – who the hell wants to pay income taxes (which third to almost half of earnings go to) as well as taxes on petrol, GST and other taxes which hurt the poor? For the 100th fucking time, my point was redistribution does NOT work because it overlooks the affect Ricardo articulated, and George expand on over a hundred years ago: deriving revenue from capital or labour exacerbates inequality because it gives windfalls to those who own land or other assets. As for the political point (assuming you take typical leftist view that people are stupid, and therefore people do not understand how they are being screwed over), correct me if I am wrong, was this not the argument (i.e. fuck equality and redistribution, through efficiency you have both) that brought Thatcher and Reagan to power and convinced a generation of middle class people to over Conservative?

    And if I may casually ejaculate, I do not think the state, frankly, is there to help people, merely make things worse in order to legitimatise its own expansion, but hey that’s just my view. This is why I said a place like Switzerland, where the populace already has LVT and is well read, may be a better hope.
    “he just ignored or belittled my points.”
    Belittled your points indeed – via the facts (either they were meaningless, or could easily be dealt with). Ignored? Give me evidence of what my ignored (I dissect your premises inch by inch, one by one) – I know, however, you certainly ignored my third request that you provide evidence to your claim high marginal income taxes reduce inequality? Or why owning / inheriting capital is a bad thing?

    “he doesn’t EVEN know what my views on ….redistribution are.”

    Well, you spent a great deal banging on about the inequalities and horror of business people allowing their children, their flesh and blood, from carrying on the family company which they probably had some involvement in since their youth (unless specific otherwise in one’s will). So, no they were not explicit, but you did make it clear you think inheritance taxes *may* be required to reduce “inequality” (ignoring the fact most inherited assets are land related and capital or cash often has to be put into use – spent or used by labourers, providing employment).

    Ps gaday, yawn.

  2. reason says:

    Look Steve,
    to try and defuse this – an answer I might accept would go like:

    I understand that you are concerned about concentrations of wealth, and concerned about diversion of tax distorting my little experiment. I personally don’t have a problem with those things happening, and consider that they would not be major problems anyway. If they did happen and the democratic process decides that for instance inheritance taxes should be in place as well as the LVT, I would still consider that a net plus.

    At one stage you claim that reduction in equality is a plus for your single tax – but then you respond to qualms about potential concentrations of wealth by claiming it is unimportant, or doing something about it is immoral. You can’t have it both ways.

  3. spadijer89 says:

    That’s what I said, albeit using statistics cited above (who gets what – mostly landlords).

    Thus, I said the unearned income is immoral (i.e. land values are created by the community) – you were banging on about the inequality generated from the inheritance of capital and the like,which provides employment and goods and services (a quid pro quo) – it involves sweat, blood and tears. So, I can have it both ways (which to use your words: “I personally don’t have a problem with those things happening, and consider that they would not be major problems anyway. If they did happen and the democratic process decides that for instance inheritance taxes should be in place as well as the LVT, I would still consider that a net plus”).

    Indeed, tough titties.

  4. reason says:

    Earnings based on the capital earned by for benefactors are “blood, sweat and tears”. Really? Can I change places?

  5. spadijer89 says:

    So, to clarify, redistribution (i.e. theft by the use of force) does not reduce inequality because it overlooks the fact that when government expenditure is deployed toward goods and services, it benefits landlords – that is the major source of inequality. Once you start worrying about other people we’ll (probably) return to a society with 1054343 taxes – so, mind your own business – what families do in their privacy of their home is not your business – its only your business when they get 1) windfalls due from the taxes YOU pay, 2) population around YOU and 3) withdraw valuable land from supply for speculative purposes, increasing mortgages which YOU have to pay.

    Moroever, the things you listed as part of “inheritance” such as cash, capital or businesses GIVE people opportunity, employment, involved careful decision making, family history, experience etc, a quid pro quo(not to mention your view ignores the fact most inheritance, for the 100th time is backed on the value of land and other related assets).

  6. spadijer89 says:

    ps Yes, James Packer is crying at how much he has left poor Kerry down.

    The sweat blood and tears mean this: the point is not using capital (which depreciates) is not a luxury – you have to put in toward a calculated use. People have to plan, think and employ what they inherit *IF* it is something like capital, a business or any form of viable enterprise.

  7. Frank says:

    “So, to clarify, redistribution (i.e. theft by the use of force)….”

    The problem with this kind of Libertarian/Austrian outlook is that it assumes that without a government, humans would co-exist without forming a new one through violent competition and the emergence of a new military or intellectual elite.

    The truth is that nothing is “yours” without an agreed concept of property rights. This of course can only exist if an administrative body exists to define those rights, update them, maintain them and enforce them. The operation of this body requires funding, ie taxes.

  8. we_have_kangaroos says:

    MMitchell, some very insightful posting.

  9. Steve Keen says:

    I was at a talk in Parramatta last night and didn’t get a chance to check blog posts until this morning. I hope that the degree of anger on display in some of these posts has dissipated overnight. I expect civility in how blog members debate here. If that is not maintained, then regardless of whether I agree with the views expressed or not, I will block future contributions.

    Remember that your posts are read not solely by an individual you may be having a strong disagreement with, but by roughly 2,000 members of the blog. An angry riposte to one member may feel good at the time, but it will almost certainly detract from your ability to influence the other 1999 members.

  10. PETER_W says:


    In the past 9 months

    The RBA 4% interest rate cuts = $60B stimulus

    The Government = $20 – 30B cash stimulus

    The economy went slightly backward according to the RBA

    The forward export income estimates for the comming year are $50B less national income now most of the April contract prices have been renegotiated.

    Does that mean Australia now needs $130B of aggregate stimulus in the comming year just to have the economy stand still again?


  11. Steve Keen says:

    That’s not a bad summary Peter_W. As I have noted repeatedly, aggregate demand is the sum of GDP plus the change in debt. The latter has gone from +250bn a year in 2007-08 to near zero now, so to simply stand still an additional $250 billion in demand is needed. With even the best outcome implying GDP growth of less than $100 billion (if output were independent of debt changes, which it’s not), something of the order of $150 billion has to be injected into the economy to keep it from going backwards.

    Or another debt-financed bubble has to be generated to keep the debt-fuelled prosperity rolling–hence the First Home Vendors Grant… However I think this is unlikely to work–deleveraging seems inevitable and is occurring now, with falls in business and personal debt outweighing the increase in mortgage debt.

  12. PETER_W says:

    $130 – $150B stimulus

    The RBA can take the cash rate to zero but the banks can’t pass on the full 3% because they are only 60% deposit funded but 40% commercial funded. Also they need a margin. As a ballpark figure I guess the best the banks can pass on is 1 – 1.5%. At best = 25B stimulus

    So were now relying on $95 – 125B of stimulus from the Government just to stand still!


    The AUD could fall ALOT which would boost export income


  13. PETER_W says:

    Is the best solution to the $150B stimulus/demand gap to run a 15% GDP ~ $150B trade surplus.

    Would a massive fall in the AUD work?

    That would seem a better solution than ratcheting up aggregate debt.


  14. spadijer89 says:

    “The problem with this kind of Libertarian/Austrian outlook is that it assumes that without a government, humans would co-exist without forming a new one through violent competition and the emergence of a new military or intellectual elite…”

    Firstly, in Westernised, European societies (like Switzerland), I think this could indeed be possible. So, domination does not go from being covert (i.e. the nation state), to overt (Somalia). But this can be discussed in the future.

    Secondly, Frank, in case you missed it, we all agreed here there is a need for “taxes” – a single tax of 100%, in particular – except I noted that other taxes (e.g. income taxes) are often counterproductive, plant seeds which legitimatise the need for a even bigger state (to address the “mistakes” the state itself generated in the first place), or really simply a result of jealously.

    A single tax on land, I think in and of itself, is enough to fund a) the military, b) a police force, c) a legal system and d) infrastructure (roads, scientific research funds to university etc), endowments all of which are deposited through higher land values.

    I don’t think there is any “anger” or “angry riposte” but merely a passionate plea (with a few caps locks here and there) requesting a clear, lucid (rather than merely assertions), which ought to have been sustained / maintained throughout the blog comment, or response and supplement by empirical evidence. After this failed, exacerbation / frustration set in.

    Now indeed, returning back to notions of an argument, here is an interesting paper which shows beyond reasonable doubt how neoclassical theory was a direct attempt to divert attention away from Henry George’s ideas:


  15. ueberbaer says:

    a massive fall in AUD = a massive increase in imported inflation. It’s not only flatscreen tellies we’re importing, but food, clothing, fuel, fertiliser etc. etc. Basic essentials.

    Which means people will have less disposable income which means more unemployed = crashing home prices = less tax receipts = more stimuli?

    Not looking rosy. Glad we’re having 4 parties today looking at buying our home.

  16. PETER_W says:

    An AUD currency correction does not have to be fast. It could be done over 5 years to allow inventory, purchase patterns, jobs, wages to adjust.

    It occured during the 1890’s 1930’s 1950’s 1970’s 1980’s

    Yes it’s inflationary BUT that’s the remedy for a debt deflation.

    It’s not a new concept.


  17. bfg says:

    PETER_W, but won’t everybody do the same thing? Currency value is only relative.

  18. mahaish says:

    hi peter w,

    your assumptions about falling domestic demand will depend on wether we get any further credit growth or not. so the financing requirment for the government may be considerably less than you anticipate. or am i wrong about this. please feel free to correct me.

    and according to chris richardson, the women of this nation havnt stopped being shop aholics just yet.

    since we are coming off a lower debt to gdp base than the US, perhaps we can leverage things up a bit more before we suffer the consequences.

  19. PETER_W says:

    I don’t know the answer.

    The AUD is presently 80+ and if it stays around that level or goes higher then our net trade income is likely to be worse not better.

    The present macro plan seems is the government will borrow to to stimulate the economy and fill the demand gap while GDP stands still.

    This may work for a while but in all previous examples in Australias history we ultimately solved the same basic problem by depreciating the AUD, earning more than we spent and paying down debt.

    Maybe it’s different this time!


  20. spadijer89 says:

    “unemployed = crashing home prices = less tax receipts = more stimuli?”

    (Not a criticism), but I’m curious about why you put unemployment before “crashing house prices” because I would like to see a graph which contrasts, in a reliable time series, monthly changes in residential or commercial property, changes in the growth debt, changes in unemployment, changes in growth in credit – my bet is that property prices leads the cycle.

    A similar result was found here:

    For me the next few years will be interesting because recall that the Great Depression started in the US and Europe following a huge building boom (25% of US GDP was construction based, 8% ALONE was residential construction)- the construction industry was ruined during the Depression (due to overbuilding)- Australia bore the brunt of this through the falling terms of trade and demand for goods.
    Accordingly, I believe most of our problems will be the result of endogenous structural weakness (i.e. huge mortgage debts which will threatened the solvency of our banking system)- although a drop in trade might be the fuel to the fire of a spiralling debt deflation (which has spill over effects in a credit markets, which determines output).

    Today, construction contributed less to US GDP (so we have to see whether the downturn will be as deep and how big, if any, should initial shock be to trickle over to other parts of the economy). So, we may after all require a capital theory to understand the dynamics and what triggers a debt deflation…

    What do other people think?

  21. PETER_W says:

    If Steve’s right and we need $150B p.a. of stimulus/demand just to have GDP stand still then Australias aggregate public & private debt/GDP ratio will be ~ 220% GDP in three years.

    At an AUD 80+ Australia will be running a Balance of Payments deficit near 9% of GDP

    If this transpires my best guess is our external creditors would be looking to downgrade our credit rating which would ultimately raise domestic interest rates despite a zero RBA cash rate.

    The ultra simple conclusion is that as an individual, a family, a company, a nation, you can’t forever spend more than you earn.


  22. ned says:

    Hi PeterW,

    I have heard the idea of the planned currency de-valuation before, and as far as I can see it is one of Bernake’s main strategys. I just fail to see how it is accomplished in an orderly fassion as you described. If people get wind that this is the plan then it ends up causing a crash, we have seen this with the Fed intervention to control long term treasury rates in the US.

  23. clive says:

    What I find amazing is the little effect some of these figures coming out have on the markets at present.
    The latest from the UK is terrible…
    “Figures from the Office for National Statistics showed that GDP shrank at a rate of 0.8% between April and June, far faster than the 0.3% economists had been expecting.

    This fifth successive quarter of contraction means that the economy has shrunk 5.7% since the recession began in the second quarter of 2008.”

    The Market punters just shrugged this off, some even didn’t believe the figures were correct. Looking at the UK figures where are the green shoots.

    In the US, analysts seem to have the approach that if a company shows a profit of minus 50% and even it got that result from a taxpayer injection of cash then “core earnings beat analysts’ expectations” and up goes the market. These clowns would be intellectually challenged with the average household budget let alone the world economy. No wonder the worlds in such a mess.

  24. bfg says:

    Yes, something is certainly not right…


  25. PETER_W says:

    Assuming S&P earnings normalise in the $40 – 60 range over 3 – 5 years (they are depressed by write downs) and US GDP growth is ~ zero (like Japan) for a long time the S&P p/e @ 20 seems overpriced whereas a p/e 8-9 would make more sence.

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