Debtwatch No. 38: The GFC—Pothole or Mountain?

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“The Marxian view is that capitalistic economies are inherently unstable and that excessive accumulation of capital will lead to increasingly severe economic crises. Growth theory, which has proved to be empirically successful, says this is not true.

The capitalistic economy is stable, and absent some change in technology or the rules of the economic game, the economy converges to a constant growth path with the standard of living doubling every 40 years.

In the 1930s, there was an important change in the rules of the economic game. This change lowered the steady-state market hours. The Keynesians had it all wrong.

In the Great Depression, employment was not low because investment was low. Employment and investment were low because labor market institutions and industrial policies changed in a way that lowered normal employment.”

Obviously, I did not write the above. The author was instead Edward C. Prescott, who shared the 2004 Nobel Prize in Economics for the development of real business cycle theory, in his 1999 paper “Some Observations on the Great Depression” (Federal Reserve Bank of Minneapolis Quarterly Review, Winter 1999, vol. 23, no. 1, pp. 25– 31).

This statement is remarkable for a number of reasons I’ll discuss below. But though it is extreme, it does express a belief that is endemic in neoclassical economics, that a market economy is inherently stable and will always return to a stable growth path after a shock.

That common belief lies behind the expectations of economists that, now that the GFC has played itself out, the economy will return to trend growth and the emergency measures that attenuated its impact can be withdrawn.

From this perspective, the GFC was a “pothole in the road” caused by the Subprime crisis, a “change in the rules of the economic game” which is now behind us. With the damage caused by the crisis largely contained, normal economic growth can resume. Over time, the unemployment rate will return to pre-crisis levels as the economic car resumes its steady speed along the highway of history.

The alternative perspective is that the GFC was more akin to an abrupt change in the terrain. The “economic car” had been coasting downhill with the gravity of ever-increasing private debt adding to the speed of the car. With the GFC we reached the bottom of the hill, and the car now has to drive uphill as it attempts to maintain its previous debt-enhanced speed while also reducing debt.

Visually at least, the “change in terrain” analogy stands up better than the pothole. I normally show the debt to GDP ratio as a rising function, but the economy’s speed gets a boost as the increase in debt makes a positive contribution to aggregate demand, and is slowed down when deleveraging reduces demand. So turning the ratio upside down may give a better idea of the depth of the “Valley of Debt” into which we have fallen:

When Australia began its most recent descent into debt in mid-1964, the average annual increase of 4.2% in the ratio added only a trivial amount to aggregate demand—since at the time debt was a mere 25% of GDP. But at the end of the debt bubble in 2008, when debt had become 165% of GDP, that same rate of debt growth added a huge amount to demand—the economic “car” gained speed as the slope of the debt mountain increased.

We hit the bottom of that mountain in March 2008, and now we’re starting to climb out of the valley—though not yet in absolute terms, since thanks to the First Home Vendors Boost, mortgage debt is still growing as business busily delevers (see comments on the data, below). But once deleveraging takes hold, the acceleration caused by racing down Debt Mountain will be replaced by an economic car straining up the Mount Debt Reduction. This change in the terrain will constrain private economic performance until debt has fallen significantly, as it did after the 1890s and the 1930s.

A similar, if more extreme, picture applies in the USA, where private debt is now 300% of GDP. In contrast to Australia, the USA’s debt ratio began to rise as soon as WWII ended: on average, US private debt rose 2.9% faster than GDP every year until 2008, taking the debt ratio from 45% at the end of the War to 300% now. Deleveraging from this level of debt must exert a substantial break on economic performance, by diverting income from expenditure to debt reduction.

I am therefore one of a minority of economic commentators who regard “deflation and deleveraging” as the main dangers facing the global economy in the near future (curiously, this minority might include Australian Prime Minister Kevin Rudd). From my perspective, the Global Financial Crisis marks “a change in the terrain”: for decades, rising debt has turbocharged economic performance; now falling debt will be a drag on economic activity.

The vast majority of economists who perceive the GFC as a pothole on the road that is now behind us do not consider debt and deleveraging in their analysis. Their models have neither credit nor money nor private debt in them, so from their point of view, there is no terrain at all beneath the car—merely a long flat highway of history along which the economic car drives at the speed it is underlying “real” economic performance.

This failure to even consider the role of private credit in a capitalist economy is an endemic weakness in conventional “neoclassical” economics, which ignores the dynamics of credit for a variety of reasons that are both ideological and illogical.

The ideology is apparent in Prescott’s comments on the Great Depression, quoted above. The lack of logic is evident when you compare a key statement in that paper—that “Growth theory, which has proved to be empirically successful, says this is not true”—with the results of some very careful empirical research by the very same author just ten years earlier. There he (and co-author and Nobel Prize recipient Finn Kydland) concluded that the empirical data contradicted neoclassical growth theory:

The purpose of this article is to present the business cycle facts in light of established neoclassical growth theory, which we use as the organizing framework for our presentation of business cycle facts. We emphasize that the statistics reported here are not measures of anything; rather, they are statistics that display interesting patterns, given the established neoclassical growth theory.

In discussions of business cycle models, a natural question is, Do the corresponding statistics for the model economy display these patterns? We find these features interesting because the patterns they seem to display are inconsistent with the theory.” (Finn E. Kydland & Edward C. Prescott, “Business Cycles: Real Facts and a Monetary Myth”, Federal Reserve Bank of Minneapolis Quarterly Review, vol. 14, no. 2, pp 3-18, p. 4).

One key pattern in actual economic data that went against the predictions of neoclassical economic theory was the relationship between broad measures of the money supply and government-created “Base Money”. The standard “money multiplier” view is that:

  1. The government creates “Base Money” via deficit spending, and credits that money to private individuals via social security, goods purchases etc.;
  2. These private individuals then deposit that money in bank accounts;
  3. The banks then retain a proportion of these deposits and lend out the rest, creating credit money (and debt).

If this view were empirically correct, then an analysis of money over time would show that “Base Money” was created first and “Credit Money” was created later, with a time lag.

In fact, what Kydland and Prescott found was that the empirical data was the opposite of this: credit money was created first, and Base Money was created later, with a lag of up to a year:

“There is no evidence that either the monetary base or M1 leads the cycle, although some economists still believe this monetary myth. Both the monetary base and M 1 series are generally procyclical and, if anything, the monetary base lags the cycle slightly.

The difference in the behavior of M1 and M2 suggests that the difference of these aggregates (M2 minus M1) should be considered. … The difference of M2-M1 leads the cycle by even more than M2, with the lead being about three quarters.

The fact that the transaction component of real cash balances (M 1) moves contemporaneously with the cycle while the much larger nontransaction component (M2) leads the cycle suggests that credit arrangements could play a significant role in future business cycle theory. Introducing money and credit into growth theory in a way that accounts for the cyclical behavior of monetary as well as real aggregates is an important open problem in economics.

I couldn’t agree more, but this is not what neoclassical economists did. Instead they continued to develop models in which money and debt played no role.

Despite his excellent empirical work on monetary dynamics in “Real Facts and a Monetary Myth”, Prescott’s “Great Depression” paper made no reference to credit at all as an explanatory factor in the Great Depression. Instead—I’m not joking—he blamed the Depression on a “change in labor market institutions and industrial policies that lowered steady-state, or normal, market hours”.

Except for this bizarre argument that the Great Depression was the result of the voluntary response of workers to unspecified changes in labour market conditions that made labour less desirable, this lengthy quote from Prescott is representative of standard neoclassical thinking about crises like the GFC:

“Essentially, business cycles are responses to persistent changes, or shocks, that shift the constant growth path of the economy up or down. This constant growth path is the path to which the economy would converge if there were no subsequent shocks. If a shock shifts the constant growth path down, the economy responds as follows. Market hours fall, reducing output; a bigger share of output is allocated to consumption and a smaller share to investment; and more time is allocated to leisure. Over time, market hours return to normal, as do investment and consumption shares of output, as the economy converges to its new lower constant growth path. The level of the new path is lower, not the growth rate along the path.

I’ve just described the response of the economy to a single shock. In fact, the economy is continually hit by shocks, and what economists observe in business cycles is the effects of past and current shocks. A bust occurs if a number of negative shocks are bunched in time. A boom occurs if a number of positive shocks are bunched in time. Business cycles are, in the language of Slutzky (1937), the “sum of random causes.”

The fundamental difference between the Great Depression and business cycles is that market hours did not return to normal during the Great Depression. Rather, market hours fell and stayed low. In the 1930s, labor market institutions and industrial policy actions changed normal market hours. I think these institutions and actions are what caused the Great Depression.”

So the Great Depression was a conscious choice by American workers to enjoy more leisure, in response to unspecified changes in the labour market  ([Later in the same essay, he states: “Exactly what changes in market institutions and industrial policies gave rise to the large decline in normal market hours is not clear….”).

It would be bad enough if Prescott were merely an obscure academic economist, but he is far from obscure: he and Kydland shared the Nobel Prize in Economics for the development of neoclassical growth theory. As ridiculous as his argument is, it does accurately state the conclusions of the neoclassical “real business cycle” model. As is often the case, you find a much clearer—and therefore far more obviously absurd—statement of neoclassical economic theory when you go to the source, rather than relying on a second-hand account from a textbook or run-of-the-mill practitioner.

So the confidence that the vast majority of economists have that the GFC is now behind us, and the “normal” trend rate of growth will resume, is fundamentally based on the belief that credit and debt dynamics do not matter.

I beg to differ. Though the enormous government stimulus has attenuated the immediate impact of debt deleveraging, it has done nothing to reduce the outstanding level of private debt. Instead even sub-par growth has become dependent on continuing government stimuli, and whenever those stimuli are removed, the economy will falter.

Total private debt rose by a mere A$1 billion last month, versus as much as A$30 billion during the height of the debt bubble. But were it not for the First Home Vendors Boost (let’s call it what it is), Australia would now be firmly in the grips of deleveraging.


COMMENTS ON THE DATA—A Mortgage & Government Led Recovery?

Total private debt rose by a mere A$1 billion last month, versus as much as A$30 billion during the height of the debt bubble. But were it not for the First Home Vendors Boost (let’s call it what it is), Australia would now be firmly in the grips of deleveraging.

Nonetheless the debt to GDP ratio fell yet again, because the rate of growth of debt is now substantially below the rate of growth of GDP—even though that is now also anaemic.

The breakdown of debt shows that the business sector is rapidly deleveraging, while mortgage and government debt is escalating—and both those are the result of government policy.

Without the First Home Vendors Boost, it is highly unlikely that mortgage debt would still be rising today. Mortgage debt peaked as a percentage of GDP in March 2008, and fell for the remainder of the year until the First Home Vendors Boost.

The quarterly change in mortgage debt was also trending down from the 2005 peak, and that downward trend has clearly been reversed by the impact of the Boost.

House Prices

The Boost has certainly had the impact the government desired, of arresting the fall in Australian house prices.

It will also almost certainly guarantee that I’ll be walking (and running) to Kosciuszko under the first half of the bet with Rory Robertson.[1] The second half of the bet, that the fall from peak to trough will be of the order of 40%, may still see Rory also walking some years hence—and the withdrawal of the Boost may make this occur sooner rather than later.

The reason is twofold. Firstly, the Boost has obviously brought forward some buying by First Home Buyers that would have occurred anyway, as well as enticing in others who might not have considered it otherwise. The withdrawal of that demand will have a strong impact on the sub-$500,000 price range.

But the withdrawal will also affect houses in the $1 million to $1.5 million range as well, because the Boost did far more than merely boost sub-$500,000 prices.

First Home Buyers who were enticed into the market by the additional $7,000 geared that up with additional debt by at least a factor of 4, to result in something like a  $35,000 price jump for sub-$500K houses. But the sellers of those houses—the real beneficiaries of the Boost—then received an extra $35,000 in cold hard cash. They then used this as a boost to their own deposits on their purchases of houses further up the chain—and if they also geared by a factor of 4 (ie a 80% marginal level of gearing, which is well within current lending practice), then the prices they paid for houses in the $750K-1.5M range would have risen by $140,000.

This works in reverse as well. When the Boost is withdrawn, not only will sellers of sub-$500K houses find that buyers have $35K less to spend than during the boost, the sellers of $750K-1.5M abodes will find their buyers short about $150K compared to during the boost.

2010 could be an interesting year for Australian house prices.

[1] If the index breaks its current maximum level of 131 in the next release of ABS 6416, I will walk (and run) from Parliament House to Mt Kosciusko as required by the bet in the last weeks of February 2010.

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170 Responses to Debtwatch No. 38: The GFC—Pothole or Mountain?

  1. elliottwave says:

    I guess thats 1 nil to me then BTB.

    Keep following Prechter on gold and you will be the one that gets slaughtered and that i will guarantee.He has been wrong and will always be wrong because he believes fundamentals dont count.

    Keep shorting gold, i love taking your money.

  2. ak says:

    Is there a conspiracy to poison our nation with debt? No, not at all. A conspiracy would require keeping things secret.

    ” LANDLORDS are claiming $11 billion in tax deductions a year as a negative gearing frenzy grips the property market.
    The tax grab from property “losses” – the richest potential deduction for individuals – is about four times the amount claimed 10 years ago.”,28323,26029676-5017313,00.html

    Here we have an arrangement which is known perfectly well to anyone and the majority of people in Australia actually accept it.

    Will it lead to a meltdown? I am not sure. But for sure it makes our economy less competitive. Imagine that in countries where housing is less expensive you can pay an employee $500-$1000 less per month and still the same amount of money is left for other consumer goods. We have a very efficient income and welfare redistribution system.

    Another reason why we are stuck in trade deficits for a long period of time is that our currency is loved by foreign investors driving it higher (by buying bonds and investing directly). Again this is a principle of the economic policy – not an artefact. The Chinese are sometimes called mercantilists what places them in the 18th century but we are a modern highly developed service based economy. We should run deficits.

    This is an antiquated article explaining why running deficits would be good:

    What will happen when the international financial markets finally “take fundamentals into account”?

  3. scepticus says:

    BTB, great reply to EW – concise yet comprehensive.

    Regarding jobs and that CR link, my take is that jobs are the big thing now. Next, it’ll be deficits and the debate over taxation of future generations, which then leads directly into a young vs old confrontation that’s brewing just over the horizon, to be fought on the fronts of welafre, healthcare, savers vs borrowers and immigration. After that, peak oil.

    Exiting times. Our hearts are going to be in our mouths for two decades, which will no doubt provide plenty of gold spikes and opportunities for EW et al to say I told you so.
    However as you noted the gold price simply bobs about on top of these other fundamentals.

    What fun we are going to have.

  4. elliottwave says:


    You call high unemployment and people on the streets “fun”.

    Gold is rising not for fun or speculation but because the world is going to hell and it is ringing an alarm bell, use it to insure yourself, not speculate and have “fun”

    Buy google if you want to have fun and speculate


  5. scepticus says:

    EW I have some gold thank you very much, and am comfortable with the amount of my assets I have allocated to it, which happens to be a reasonable proportion.

    With that done, and so much unknowable (and not discernable in charts because charts don’t do politics) I like to speculate on what’s in store 5, 10, 20, 30 years down the line. I have kids, loved ones and a career to look after and all these mean more to me in the short medium and long term than the price of gold. If gold goes to $10,000 per ounce we shall all probably be dead, with or without gold, so I’ll continue to speculate on alternative, and IMO more likely outcomes.

  6. elliottwave says:

    What other investment is there out there that can trump gold as an investment class?

    I know of no other that can even come close.

    If your “career” is your insurance than you need no other, it will be enough to get you through the greastest depression that your children will ever live through, how do you insure for that?

  7. Tel says:

    Gold has a few things going for it right now. Central banks spent decades pushing down the price of gold as the sold off their hoards. Compare this to other tangible assets such as land where central governments have done their best to pump up the price of land and houses. Any asset is good protection against inflation, and at least in the USA, inflation is coming for sure. No way can the Federal Reserve print trillions after trillions in US dollars backed by nothing without initiating a wave of inflation down the track.

    The Great Depression saw a similar effect with steep deleveraging followed by grinding inflation. Our Keynesian governments have shovelled deficit into the hole caused by deleveraging but they have no way of unshovelling when it filps over to an inflationary stage. Australia is not as bad, China is buying our commodities and foreign investors still love us.

    Australian mortgages have become the new stealth tax. Government spends the money on “stimulus” and runs up a deficit. This in turn generates inflation so Government allows the banks to up interest rates “because we have to control inflation”. Banks take the difference out of the mortgage holders, then the government takes the tax out of the banks. Ta da! Wealth distribution. Take from the middle class, push some of it down to the poor, some of it up to the wealthy.

    Getting back to gold, aside from the inflation protection it offers, the potential for upside comes down to how we move forward reconfiguring international trade. It seems obvious that US dollars cannot remain the core of international trade forever. The Federal Reserve printing press is beating that message into the whole world and the coming wave of US inflation will beat the message even harder.

    China is experimenting with various options right now. They are making deals with Russia for bi-lateral exchanges… not sure how successful that might be. They have purchased some IMF SDR paper (presumably purchased with US dollars), but it remains to be seen what this IMF paper can do.

    My feeling is that we will end up with some commodity basket as the reference for international trading, and both gold and silver will be in that basket. No doubt a lot of closed door negotiations are under way, no doubt the doors will stay closed until the very last minute to ensure none of the small-time punters get the advantages that the insiders get.

  8. Bullturnedbear says:

    Hi Elliotwave,

    I don’t know where you get the 1 nil from. But go for it all you like. Call it 100 to nil. I have said repeatedly, I don’t care if gold goes up or down and it will go up and down all the time. If gold fell $40 or $50 in a few weeks will you say that you were wrong? Of course not!

    I can’t go past your comment “What other investment is there out there that can trump gold as an investment class?”. That is simply a crazy comment.

    Almost all commodities greatly outgrew gold in the last 10 years and all blew gold off the planet in the last 30 years. Uranium rose some massive figure (I forget, can’t bother looking it up) say 1,400% in the last 10 years, before crashing 60 or more % last year. From 1980 to today gold has risen in $US by $45. That’s a .34% per annum return. Go gold. That’s a terrible return.

    Even AIG and Citi have risen 300% or 600% in the last 5 months. You are obsessed with gold and you can’t see it.

    Gold might rise or fall. From an elliot wave POV there is a strong bullish case and a strong bearish case (the outlook is uncertain). I said that on this site 4 or 6 months ago.

    Take a look at sugar instead. Sugar just blew off to a multi decade high top of $24.85 (front month). It has now fallen impulsively to $20.50 (intra-day low today) in a few days. Looking at the graph I would have much more confidence shorting sugar that could fall under $10 than going long gold that is a few dollars from its all time high. Not to mention that I have made 10 times more shorting sugar in the last week than I would have going long in gold. Gold rose 5% or 6%. Sugar just fell over 20% in less than 5 days.

    Also have a look at Natural gas. It is forming an ending diagonal (terminating pattern) into its low of the last 10 years and a very long term low point, if you exclude the 2001 bottom. Nat gas makes much more sense if you want to go long as it is bottoming. Why buy at the top. Sell high (against the herd) and buy when no one else wants it (against the herd). I have no position in nat gas yet. The pattern is not complete. I think some time in the next 6 months nat gas will bottom and turn out to be the best investment of the next 2 or 3 years.

    What ever I have discussed here is just my opinion. Not investment advice.

  9. elliottwave says:

    Not if but when hyperinflation (a currency event not an economic event), occurs their is nothing that will compare to gold.You perhaps do not understand how bad the world will look like within a years time?

    The amount of pain financially and emotionally that the world will commence to feel by May of 2010, will be something that one does not wish upon their worst enemy.

    I feel sorry for families with young children they will be scarred for years.

    I do not want gold to rise but it is out of my hands and is the only way to insure ones self.

    This will be the worst experience that we as a human race will ever face and it all starts in May 2010.

  10. Bullturnedbear says:

    Hi Elliotwave,

    Please explain to me how there can be a currency induced hyper-inflation everywhere? Currencies are relative. If one currency were to crash, it is in relation to others.

    How can speculators crash all the world’s currencies simultaneously. Or are you just suggesting a hyper-inflation in the US. ($US value of gold would rise, but $A value may stagnate or fall) or a hyper-inflation in Australia where the $US value of gold may rise or fall, but the $A value of gold would skyrocket?

    I think I have asked this question of you 4 times now. You don’t have to answer me. Please ask the question of yourself.

  11. elliottwave says:

    Ask the the people of Iceland that question i am sure they will be able to answer that question for you.They seem to be more experienced in the art of financial chit hitting the fan.

  12. Bullturnedbear says:

    Please explain how Iceland is relevant? I am one of the dummies that posts on this site.

    Iceland has had a currency event, agreed. But that has not triggered global hyper-inflation.

  13. elliottwave says:


    I have put out what i know will happen, but i still have no idea what the hell you think is happening or what will happen?

    I gave you the bottom in gold and you mocked me, then when it bottomed in July and is on a tear now you still mock me.

    Who on this website has made a ballsy call like the one i made on gold and the other call of 1224 by November 5, who has actually said anything constructive of this website that HAS ACTUALLY HAPPENED, NOT WILL HAPPEN IN 5 YEARS?

    You actually have the hide to mock me.

    You think by trading natural gas futures or stocks will get you out of trouble?You are truly delusional and have no idea whatsoever is about to transpire in the world.


  14. Bullturnedbear says:

    Thanks for that Elliotwave.

    You are the guru!

  15. elliottwave says:

    Very intelligent response, keep shorting equities and trading nat gas futures that will keep you safe.

    Your view on financial markets does not exist? Bit difficult?

  16. AUSUSD20090907 says:

    Although Australia is regarded as a debtor nation so indebted it should be suffering from its own currency crisis, the AUD has gained impressive ground in the past 6 months.

    AUD/USD has gone up to 0.85 from the February low of 0.65. That means the Australians are buying more from the US with the same amount of AUD. I wonder this currency crisis will someday permeate thru to other debtor nations like Australia.

    Dr Keen believes that the impact by private debts contractions could hamper the authorities remedies. I think Dr Keen’s model has not taken into account the proportion of risk-free private debts. E.g., some of the housing loans borrowed by overseas students are guaranteed by their wealthy parents who would bring in millions in cash once their son or daughter gained a foothold in Australia.

    What role is this inflow of private cash funds playing in the larger economy?

  17. Pingback: Pothole or Mountain? The common belief behind the expectations of economists that, now that the GFC has played itself out is that the economy will return to trend growth and the emergency measures that attenuated its impact can be withdrawn. Think again &

  18. Pingback: A housing bubble illustration | Bear Market Investments

  19. blueinca says:

    I actually agree with the basic theory of: debtjunkies
    September 1st, 2009 at 3:34 pm

    “Here is another article that confirms the increasing debt burden of excessively priced housing.…………………………………

    I have long maintained that while interest rates are relatively low, that housing prices would rise, especially if so-called experts starting talking about the financial crisis being over. These grabs to ‘ordinary man or woman on the street’ who are in the market for an owner-occupied property has triggered an unprecedented splurge on property in recent weeks.

    I take a great interest in the inner to mid northern suburbs of Melbourne, and if you think prices were outrageous last year, then prepare for what is to come. There was a window for the first couple of months of this year- where prices had actually started to genuinely come back, there was lots of talk in the media about concerns of the greater economy- Steve’s points were even starting to stick! Unfortunately interest rates held firm low then, and so we now have this extraordinary situation where people are paying even more than 2007/2008- and therefore taking on even more debt.

    My research on property in Melbourne North’s at it’s most updated- ie: yesterday!: an unrenovated cream BV on a small block two doors down from fibro commission flats sold for $609,000- undoubtedly it would’ve made no more than $420k last year at the property market’s peak. Another unrenovated ‘beauty’ red brick in North Coburg- not Coburg, not Thornbury, not NOrthcote- but North Coburg, almost at the cemetery sold for $561k, undoubtedly would’ve struggled to reach $400k at the peak last year.

    One contemplates what sort of loan approval analysis are banks going through- the charade they play over approvals including what valuation they place on the property are farcical. The amount of debt if current activity continues into summer, is going to be monstrous. If government policy continues in the same vein as I have alluded to from debtjunkies post above, there’s going to be a lot of hands grabbing for the government handout pot, especially when interest rates go up, or can Wayne Swan wangle his mates at the RBA to leave them alone til next year- if he does Armageddon may arrive sooner than the ordinary man expects, even worse the ordinary man probably isn’t even aware of it’s coming- he too busy servicing his debt under the illusion he’s paying off the principle.

  20. Pingback: Angry Bear » A housing bubble illustration

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