Debtwatch No 41, December 2009: 4 Years of Calling the GFC

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I first realised that the world faced a seri­ous finan­cial cri­sis in the very near future in Decem­ber 2005, as I pre­pared an Expert Wit­ness Report for the NSW Legal Aid Com­mis­sion on the sub­ject of preda­to­ry lend­ing.

My brief was to talk about the impact of such con­tracts on third par­ties, since one ground to over­turn a loan con­tract was that it had dele­te­ri­ous impacts on peo­ple who were not sig­na­to­ries to the con­tract itself. I was approached because the solic­i­tor in the case had heard of my aca­d­e­m­ic work on Hyman Min­sky’s “Finan­cial Insta­bil­i­ty Hypoth­e­sis”.

Min­sky’s hypoth­e­sis argued that a cap­i­tal­ist econ­o­my with sophis­ti­cat­ed finan­cial insti­tu­tions could fall into a Depres­sion as an exces­sive buildup of pri­vate debt occurred over a num­ber of finan­cial­ly-dri­ven busi­ness cycles. I had built a math­e­mat­i­cal mod­el of Min­sky’s hypoth­e­sis in my PhD, which gen­er­at­ed out­comes like the one shown below: a series of booms and busts lead to debt lev­els ratch­et­ing up over time, until at one point the debt-ser­vic­ing costs over­whelmed the econ­o­my, lead­ing to a Depres­sion.

Fig­ure 1

When I began writ­ing my Report, I start­ed with the com­ment that “debt to GDP lev­els have been ris­ing expo­nen­tial­ly”. But since I was an Expert Wit­ness in this case rather than the Bar­ris­ter, I knew that I could­n’t rely on hyperbole–and if the trend of growth was­n’t expo­nen­tial, then I could­n’t call it that. I expect­ed that there would be a ris­ing trend, but that it would­n’t be quite expo­nen­tial, so I would need to amend my ini­tial state­ment.

I down­loaded the data on Aus­tralian pri­vate debt and nom­i­nal GDP lev­els from the RBA Sta­tis­ti­cal Bul­letin, plot­ted one against the oth­er, and my jaw hit the floor: the trend was clear­ly expo­nen­tial. The cor­re­la­tion coef­fi­cient of the data since mid 1964 with a sim­ple expo­nen­tial func­tion was a stag­ger­ing 0.9903. The only thing that stopped the cor­re­la­tion from being absolute­ly per­fect were two super-bub­bles (on top of the over­all expo­nen­tial trend) in 1972–76 and 1985–94.

Fig­ure 2

I expect­ed that the sit­u­a­tion in Amer­i­ca would be as bad or worse, which was con­firmed by a quick con­sul­ta­tion of the Fed­er­al Reserve’s Flow of Funds data. Though not as obvi­ous­ly expo­nen­tial as in Aus­trali­a’s case, the cor­re­la­tion with sim­ple com­pound growth was still 98.8%.

Fig­ure 3

So debt had been grow­ing faster than GDP–4.2% per annum faster in Aus­trali­a’s case for over 40 years, and 2.7% faster for longer in the USA’s. An unsus­tain­able trend in debt had been going on for almost half a cen­tu­ry.

Star­ing at those graphs (at rough­ly 3am in Perth, West­ern Aus­tralia), I realised that these debt bub­bles had to burst (and prob­a­bly very soon), that a glob­al finan­cial cri­sis would erupt when they did, that some­one had to raise the alarm, and that giv­en my knowl­edge, that some­one was me. As soon as my Expert Wit­ness Report was fin­ished, I start­ed mak­ing com­ments in the media about the like­li­hood of a reces­sion.

Less than 2 years lat­er, the Glob­al Finan­cial Cri­sis erupt­ed, and econ­o­mists who did­n’t see it com­ing, and who for decades had argued that gov­ern­ment spend­ing could only cause infla­tion, sud­den­ly called for–and got–the biggest gov­ern­ment stim­u­lus pack­ages in world his­to­ry to pre­vent an eco­nom­ic Armaged­don.

To some degree, the gov­ern­ment stim­u­lus pack­ages worked.

I am hap­py to admit that the scale of the gov­ern­ment coun­ter­mea­sures sur­prised me. As Aus­trali­a’s Prime Min­is­ter Kevin Rudd point­ed out, the col­lec­tive stim­u­lus over the 3 years from Sep­tem­ber 2007 till Sep­tem­ber 2010 was expect­ed to be equiv­a­lent to 18 per­cent of glob­al GDP. That was huge–bigger in real terms than the US’s mil­i­tary expen­di­ture dur­ing World War II.

That huge gov­ern­ment stim­u­lus has atten­u­at­ed the sever­i­ty of the cri­sis, and led to pos­i­tive growth fig­ures in many countries–most notably Aus­tralia, which record­ed only one quar­ter of falling GDP ver­sus a norm of 4 con­sec­u­tive quar­ters for most of the OECD. But it still has not addressed the cause of the crisis–the exces­sive lev­el of pri­vate debt, and the tran­si­tion from a peri­od of decades in which ris­ing debt fuelled aggre­gate demand, to one in which the pri­vate sec­tor’s attempts to reduce debt will sub­tract from aggre­gate demand.

For that rea­son, I do not share the belief that the GFC is behind us: while the lev­el of pri­vate debt remains as gar­gan­tu­an as it is today, the glob­al econ­o­my remains finan­cial­ly frag­ile, and a return to “growth as usu­al” is high­ly unlike­ly, since that growth will no longer be pro­pelled by ris­ing lev­els of pri­vate debt.

Pri­vate debt has, as in past down­turns, start­ed to fall com­pared to GDP–though in Aus­trali­a’s case the so-called “First Home Own­ers Boost (which dou­bled the amount of mon­ey the gov­ern­ment gave to first home buy­ers from A$7,000 to A$14,000)  enticed so many new entrants into mort­gage debt that Aus­trali­a’s ratio start­ed to rise again in mid 2009.

Amer­i­ca’s ratio, on the oth­er hand, con­tin­ued to rise through the start of the GFC, but is now clear­ly falling.

Fig­ure 4

Hav­ing dri­ven demand high­er every year since the 1990s reces­sion by ris­ing and ris­ing faster than nom­i­nal GDP, pri­vate debt is now falling and reduc­ing aggre­gate demand. This is delever­ag­ing at work, and it is the force that gov­ern­ments are try­ing to resist by boost­ing their own spend­ing as pri­vate spend­ing stag­nates.

Fig­ure 5

Aus­trali­a’s suc­cess in avoid­ing a reces­sion has been part­ly due to the fact that its poli­cies encour­aged pri­vate debt to grow again, as first home buy­ers took the addi­tion­al A$7,000 of gov­ern­ment mon­ey to the banks and bor­rowed against it (but even there, debt reduc­tion by busi­ness and the reduc­tion in per­son­al debt is coun­ter­act­ing the rise in mort­gage debt).

Fig­ure 6

This is one fool­proof means to avoid a seri­ous recession–go back to bor­row­ing and spend­ing up big. This is, after all, what end­ed the reces­sion of the 1990s–and in the USA’s case, it hap­pened with­out debt actu­al­ly falling. Aus­trali­a’s greater reces­sion then was due to the fact that debt did actu­al­ly fall between 1991 and 1993, so that delever­ag­ing dras­ti­cal­ly reduced aggre­gate demand.

Fig­ure 7

So could the glob­al econ­o­my get out of the glob­al finan­cial cri­sis the same way it got out of the 1990s recession–by bor­row­ing its way up? That’s where the sheer lev­el of debt becomes an issue–and it’s why I stuck my neck out and called the GFC, because I sim­ply did­n’t believe that we could bor­row our way out of trou­ble once more. Debt did con­tin­ue ris­ing rel­a­tive to GDP for sev­er­al years after I called the GFC, but it has now reached lev­els that are sim­ply unprece­dent­ed in human his­to­ry.

For the “bor­row­ing our way out” trick to work once more, we would need to reach lev­els of debt that would make today’s records look like a pic­nic. What are the odds that that could hap­pen again?

Fig­ure 8

The debt servicing burden

The sim­plest mea­sure of the impact of debt lev­els on the econ­o­my is to look at the ratio of inter­est pay­ments to GDP. There are obvi­ous­ly two fac­tors here: the lev­el of inter­est rates, and the ratio of debt to GDP. A very high rate of interest–such as applied dur­ing the 1970s–can mean that even a low lev­el of debt (rel­a­tive to income) is hard to ser­vice; con­verse­ly, a low rate of interest–such as we have now–can be hard to ser­vice if debt lev­els are very high.

The next two charts illus­trate this for Aus­tralia and the USA by record­ing inter­est rates on the ver­ti­cal axis and the debt to GDP ratio on the hor­i­zon­tal. The smooth curves on the charts show com­bi­na­tions of the debt to GDP ratio and the rate of inter­est that require the same pro­por­tion of GDP to be devot­ed to debt ser­vic­ing. The jagged lines show the actu­al progress of the debt ser­vic­ing bur­den over time in both countries–starting from 1959 in Aus­trali­a’s case and 1971 in the USA’s (the ear­li­est date for my data on US aver­age inter­est rates). The dia­grams tell an inter­est­ing sto­ry about the evo­lu­tion of the Ponzi finan­cial sys­tem we now inhab­it.

Back in 1960, debt ser­vic­ing in Aus­tralia required a mere 2% of GDP. This rose rapid­ly to a peak of 16.7% of GDP in 1990–the begin­ning of Aus­trali­a’s most severe post-War recession–as both inter­est rates and the debt to GDP ratio rose.

Then the ser­vic­ing costs plum­met­ed dra­mat­i­cal­ly in the after­math to the 1990s reces­sion, as the Reserve Bank dras­ti­cal­ly cut rates–in the belat­ed real­i­sa­tion that they had set them far too high in the late 80s in an attempt to con­trol the asset bub­ble of that decade–and as the debt to GDP ratio fell (as did the actu­al debt lev­el) dur­ing the reces­sion.

Then Aus­tralia bounced along an 8% debt bur­den con­tour between 1993 and 2000, as inter­est rates fell while debt levels–driven by ris­ing mort­gage debt–rose.

Next the bur­den began to rise from 2003, as mort­gage and busi­ness debt both expand­ed and the RBA began increas­ing rates to attempt to con­trol the boom­ing econ­o­my.

Rates then reached their peak in mid-2008 when the RBA final­ly realised that, rather than infla­tion being the main dan­ger fac­ing the econ­o­my, we were actu­al­ly in a finan­cial cri­sis. At this point, the debt ser­vic­ing bur­den on the econ­o­my was the same as it was in 1990–even though rates were half what they were then–because the pri­vate debt to GDP ratio had dou­bled in the mean­time.

The RBA went rapid­ly into reverse–cutting rates at 1% a month after hav­ing pre­vi­ous­ly increased them in 1/4% steps. The debt  ratio start­ed to fall, and the debt ser­vic­ing bur­den fell back to 10.25% of GDP–from where it is now ris­ing once more as First Home Buy­ers pile on more debt, and the RBA is back once again fight­ing the myth­i­cal drag­on of con­sumer price infla­tion (though recent com­ments imply it is also final­ly tar­get­ting house price infla­tion too).

Fig­ure 9

The Amer­i­can sto­ry is sim­i­lar, but involves much larg­er lev­els of debt and a con­se­quent­ly high­er debt ser­vic­ing bur­den. This began at over 5% of GDP in 1971, and rose to a mas­sive 23.4% of GDP in 1981–a dif­fer­ent date to Aus­trali­a’s, but also the time of the USA’s worst post-War reces­sion (this is not a coin­ci­dence). Aver­age inter­est rates peaked at 19.75% under Vol­ck­er in mid 1981.

The bur­den then fell rapid­ly as rates were cut sig­nif­i­cant­ly, only to rise once more as the 1980s stock mar­ket bub­ble took off, and the Vol­ck­er Fed tried to restrain the bub­ble once more with ris­ing rates.

Then the 1987 crash hit, fol­lowed by the 1990s reces­sion, and under Greenspan rates were pared back as the debt to GDP ratio actu­al­ly fell for a time.

Then the Dot­Com bub­ble began, and debt began to rise once more–and the Sub­prime bub­ble com­menced in the back­ground. The Fed respond­ed to the Dot­Com bust of 2000 with a rapid cut in its rate that drove aver­age rates down from around 9% to just 4.4%, while at the same time ris­ing mort­gage and finan­cial sec­tor debt pushed the aggre­gate debt ratio past the Great Depres­sion record of 235% of GDP.

Fig­ure 10

The Fed, first­ly under Greenspan and then Bernanke, tried to restrain the bub­ble with ris­ing inter­est rates once more–until the Sub­prime Cat­a­stro­phe hit and it once again went into reverse, dri­ving its own rate down to zero and the aver­age rate to about 3.5%. That is where the USA now wal­lows, with a debt bur­den of almost 300% and a debt ser­vic­ing bur­den of 10% of GDP.

Both coun­tries now have low­er aver­age inter­est rates than they had back in the 1960s, but a debt ser­vic­ing bur­den that is many times high­er (five times high­er in Aus­trali­a’s case and dou­ble in Amer­i­ca’s) because both Cen­tral Banks obsessed about the rate of con­sumer price infla­tion, while ignor­ing ram­pant growth in pri­vate debt.

And it’s actu­al­ly worse than that when one con­sid­ers the longer term.

Deflation and Depressions

There are actu­al­ly two ways to reduce your debt burden–by pay­ing it down your­self, or by let­ting infla­tion do it for you. So to gauge the real impact of debt on an econ­o­my, you have to con­sid­er the after-infla­tion rate of interest–and when infla­tion is high, this can actu­al­ly be neg­a­tive.

Con­verse­ly, when defla­tion strikes, the real rate can be higher–much higher–than the nom­i­nal rate. This is why Fish­er called his the­o­ry “the Debt-Defla­tion The­o­ry of Great Depression”–because debt on its own was nowhere near as dan­ger­ous as defla­tion. Con­sid­er­ing the real debt ser­vic­ing bur­den empha­sis­es how much dan­ger we are in now. The two big Depres­sions of the last one and a half centuries–the 1890s and the 1930s–had sub­stan­tial deflation–with prices falling at up to 15 per­cent per annum in the 1890s, and over 10 per­cent per annum for two years dur­ing the Great Depres­sion. That meant that even a low nom­i­nal rate of inter­est was a huge real rate.

Fig­ure 11

Fig­ure 12

Con­verse­ly, peri­ods of high infla­tion in the post-WWII peri­od have meant that even high nom­i­nal rates meant low–and in some cas­es negative–real inter­est rates (it was cheap­er to bor­row mon­ey now and pay it back lat­er than it was to avoid debt).

The effect of infla­tion dras­ti­cal­ly trans­forms the inter­est pay­ment bur­den map–and it empha­sis­es the dan­gers in the low infla­tion envi­ron­ment we are now in.

For Aus­tralia, the worst real bur­den of debt ser­vic­ing occurred in the 1890s, when our debt to GDP ratio was high­er than in the 1930s, and defla­tion drove the real rate of inter­est to over 20 per­cent. At that point, 19% of Aus­trali­a’s GDP was need­ed to ser­vice debt–and the econ­o­my fell into a deep Depres­sion (worse than the Great Depres­sion) as a result.

Fig­ure 13

Fig­ure 14

I don’t have data on 1890s debt lev­els in the USA, but I doubt that it could com­pare the the Great Depres­sion in that coun­try, as the real debt repay­ment map below empha­sis­es. The com­bi­na­tion of–until then–an unprece­dent­ed lev­el of pri­vate debt and steep defla­tion meant that the real debt bur­den on the econ­o­my con­sumed 50% of GDP (using Moody’a Baa rate as a proxy for the aver­age inter­est rate).

Fig­ure 15

Fig­ure 16

All of the above points out how dan­ger­ous a sit­u­a­tion we are in with infla­tion rates as low as they have been dri­ven by glob­al­i­sa­tion and by Cen­tral Banks that have obsessed about the rate of con­sumer price infla­tion and ignored both asset price infla­tion and the debt lev­els that have dri­ven it.

In Aus­trali­a’s case, all it would take is a 6% change in the real inter­est rate to put us back in the same sit­u­a­tion we were in dur­ing the 1890s–because debt today is about 65% high­er than back then.

In Amer­i­ca’s case, a much larg­er jump of 11.5% is required to bring it back to the 1930s situation–but that’s before we take into account the impact of defla­tion on the debt ratio itself, since defla­tion actu­al­ly increas­es the real debt bur­den as well as increas­ing real inter­est rates. That effect was dras­tic dur­ing the Great Depres­sion: the US’s debt ratio rose from 175% to 235% even as debt fell from $162 bil­lion to $125 bil­lion.

Fig­ure 17

If a sim­i­lar effect applied this time and defla­tion drove pri­vate debt lev­els to 400% of GDP, it would only take a 6% rate of defla­tion to put Amer­i­ca in the same posi­tion it was in in 1932.

I hope this review estab­lish­es why the debt to GDP ratio is such an impor­tant indi­ca­tor of finan­cial fragili­ty, and why as a con­se­quence the GFC is far from over.

Only one ques­tion remains: why do Cen­tral Banks ignore the debt to GDP ratio?

There is nothing more dangerous than a bad theory

The sim­ple rea­son is: because they are neo­clas­si­cal econ­o­mists. You don’t get to be a Cen­tral Banker with­out a degree in eco­nom­ics, and the school of thought that dom­i­nates eco­nom­ics today is known as neo­clas­si­cal eco­nom­ics. Though a lot of what it says appears to be super­fi­cial­ly intel­li­gent, almost all of it is intel­lec­tu­al dri­v­el, as I out­lined in my book Debunk­ing Eco­nom­ics (which sum­marised a cen­tu­ry of pro­found cri­tiques of this the­o­ry which its prac­ti­tion­ers have stu­dious­ly ignored).

Since cri­tiques by econ­o­mists and math­e­mati­cians of this the­o­ry have lit­er­al­ly filled books, I won’t try to go into all of them here. Just three key neo­clas­si­cal myths suf­fice to explain why they do not under­stand the dynam­ics of our cred­it dri­ven soci­ety. They believe that:

(1) The nom­i­nal mon­ey sup­ply does­n’t affect real eco­nom­ic out­put;

(2) The pri­vate sec­tor is ratio­nal while the gov­ern­ment sec­tor is not; and

(3) That they can mod­el the econ­o­my as if it is in equi­lib­ri­um.

The first myth means that they ignore mon­ey and debt in their math­e­mat­i­cal mod­els: most neo­clas­si­cal mod­els are in “real” terms and com­plete­ly omit both mon­ey and debt. So since debt does­n’t even turn up in their mod­els, they are unaware of its influ­ence (even though their sta­tis­ti­cal units do a very good job of record­ing the actu­al lev­el of debt).

The sec­ond myth means that they are quite will­ing to obsess about gov­ern­ment debt, but they implic­it­ly believe that pri­vate debt has been incurred for sen­si­ble rea­sons so that it can’t cause any prob­lems.

The third myth means that they ignore evi­dence that indi­cates that the econ­o­my is very far removed from equi­lib­ri­um, and they mis­un­der­stand the effect of cru­cial vari­ables in the dis­e­qui­lib­ri­um envi­ron­ment in which we actu­al­ly live.

I can give two instances of how this has affect­ed attempts to get Cen­tral Bankers to realise that the debt to GDP ratio mat­ters: Ben Bernanke’s dis­cus­sion of Irv­ing Fish­er’s “Debt Defla­tion The­o­ry of Great Depres­sions”, and a dis­cus­sion I had with a Assis­tant Gov­er­nor of Aus­trali­a’s Reserve Bank on the top­ic.

Bernanke an expert on the Great Depression?

Ben Bernanke got his cur­rent posi­tion large­ly on the basis of his rep­u­ta­tion as an expert on the Great Depres­sion. In his Essays on the Great Depres­sion, he explained why most econ­o­mists ignored Irv­ing Fish­er’s the­o­ry of how the Depres­sion occurred–which empha­sised the impor­tance of debt and defla­tion:

The idea of debt-defla­tion goes back to Irv­ing Fish­er (1933). Fish­er envi­sioned a dynam­ic process in which falling asset and com­mod­i­ty prices cre­at­ed pres­sure on nom­i­nal debtors, forc­ing them into dis­tress sales of assets, which in turn led to fur­ther price declines and finan­cial dif­fi­cul­ties. His diag­no­sis led him to urge Pres­i­dent Roo­sevelt to sub­or­di­nate exchange-rate con­sid­er­a­tions to the need for refla­tion, advice that (ulti­mate­ly) FDR fol­lowed. Fish­er’s idea was less influ­en­tial in aca­d­e­m­ic cir­cles, though, because of the coun­ter­ar­gu­ment that debt-defla­tion rep­re­sent­ed no more than a redis­tri­b­u­tion from one group (debtors) to anoth­er (cred­i­tors). Absent implau­si­bly large dif­fer­ences in mar­gin­al spend­ing propen­si­ties among the groups, it was sug­gest­ed, pure redis­tri­b­u­tions should have no sig­nif­i­cant macro­eco­nom­ic effects.” (Bernanke, 1995 p. 17).[1]

Though Bernanke notes that Fish­er “envi­sioned a dynam­ic process”, his state­ment of why neo­clas­si­cal econ­o­mists ignored his the­o­ry is inher­ent­ly couched in equi­lib­ri­um terms–it sees debt-defla­tion as mere­ly redis­trib­ut­ing income from one group in soci­ety (debtors) to anoth­er (cred­i­tors).  How can aggre­gate demand fall so much, if all that is hap­pen­ing is a trans­fer of income and wealth from one group of con­sumers to anoth­er?

How­ev­er when one thinks in tru­ly dynam­ic terms, income is not all there is to aggre­gate demand. In a dynam­ic set­ting, aggre­gate demand is not mere­ly equal to income, but to income plus the change in debt.

Dur­ing a debt-dri­ven finan­cial bubble–which is the obvi­ous pre­cur­sor to a debt-deflation–rising lev­els of debt pro­pel aggre­gate demand well above what it would oth­er­wise be, lead­ing to a boom in both the real econ­o­my and asset mar­kets. But this process also adds to the debt bur­den on the econ­o­my, espe­cial­ly when the debt is used to finance spec­u­la­tion on asset prices rather than to expand production–since this increas­es the debt bur­den with­out adding to pro­duc­tive capac­i­ty.

When debt lev­els rise too high, the process that Fish­er described kicks in and eco­nom­ic actors go from will­ing­ly expand­ing their debt lev­els to active­ly try­ing to reduce them. The change in debt then becomes neg­a­tive, sub­tract­ing from aggre­gate demand–and the boom turns into a bust.

Debt has lit­tle impact on demand when the debt to GDP ratio is low–such as in Aus­tralia in the 1960s, or the USA from the start of WWII till the ear­ly 60s. But when­ev­er the debt to GDP ratio becomes sub­stan­tial, changes in debt come to dom­i­nate eco­nom­ic per­for­mance, as can be seen in the next two charts.

Fig­ure 18

Fig­ure 19

It is this effect that elud­ed Bernanke and his neo­clas­si­cal brethren, because of their insis­tence on try­ing to mod­el the world as if it is always in equi­lib­ri­um. The debt-dri­ven demand process is obvi­ous when you think dynam­i­cal­ly, but if you try to put it into an equi­lib­ri­um straightjacket–as neo­clas­si­cal econ­o­mists did–then you can’t under­stand it at all.

A “schoolboy error”?

In 2008 I spoke at a sem­i­nar in Ade­laide that was also addressed by Guy Debelle, an Assis­tant Gov­er­nor (Finan­cial Mar­kets) of the RBA. After my talk he com­ment­ed that he could­n’t under­stand why I com­pared debt to GDP, since that was com­par­ing a stock to a flow.

I was rather non­plussed by the question–to me, the rea­sons why it mat­ters are obvious–but I attempt­ed an answer and thought lit­tle more about the inci­dent.

Some time lat­er, Debelle’s ex-col­league and good friend Rory Robert­son of Mac­quar­ie Bank repeat­ed Debelle’s obser­va­tions in his inter­est rate newslet­ter, parts of which were then repub­lished on a num­ber of busi­ness blogs, includ­ing Busi­ness Spec­ta­tor. Amongst oth­er things, Rory remarked that:

Dr Steve Keen amongst oth­ers con­tin­ues to make the school­boy error of com­par­ing debt to income (a stock to a flow — apples to oranges) and miss­es the main game. (Rory Robert­son)

The propo­si­tion that com­par­ing debt to GDP is mak­ing a stock/flow error may appear wise at first glance, but it is in fact non­sense. It instead shows that the per­son mak­ing the com­ment does not under­stand dynamics–which is a fail­ing shared by almost all neo­clas­si­cal econ­o­mists.

In dynam­ic terms, the ratio of debt to GDP tells you how many years it would take to reduce debt to zero if all income was devot­ed to debt repay­ment. That is an extreme­ly valid indi­ca­tor of the degree of finan­cial stress a soci­ety (or an indi­vid­ual) is under.

I find that mem­bers of the gen­er­al pub­lic under­stand this eas­i­ly. Only econ­o­mists seem to have any trou­ble com­pre­hend­ing it–not because it is dif­fi­cult but because their own train­ing pays almost no atten­tion to dynam­ic analy­sis, and there­fore they don’t learn–as sys­tems engi­neers do–that stock/flow com­par­isons can be extreme­ly impor­tant indi­ca­tors of the state of a sys­tem.

Marching ignorantly forward

With such igno­rance about the dynam­ics of debt, aca­d­e­m­ic econ­o­mists and Cen­tral Banks around the world are hop­ing that the cri­sis is behind them, even though the cause of it–excessive lev­els of pri­vate debt–has not been addressed. They are rec­om­mend­ing wind­ing back the gov­ern­ment stim­u­lus pack­ages in the belief that the econ­o­my can now return to nor­mal after the dis­tur­bance of the GFC.

In fact “nor­mal” for the last half cen­tu­ry has been an unsus­tain­able growth in debt, which has final­ly reached an apogee from which it will fall. As it falls–by an unwill­ing­ness to lend by bankers and to bor­row by busi­ness­es and house­holds, by delib­er­ate debt reduc­tions, by default and bankruptcy–aggregate demand will be reduced well below aggre­gate sup­ply. The econ­o­my will there­fore falter–and only reg­u­lar gov­ern­ment stim­uli will revive it.

This how­ev­er will be a Zom­bie Cap­i­tal­ism: the pri­vate sec­tor’s reduc­tions in debt will counter the pub­lic sec­tor’s attempts to stim­u­late the econ­o­my via debt-financed spend­ing. Growth, if it occurs, will not be suf­fi­cient­ly high to pre­vent grow­ing unem­ploy­ment, and growth is like­ly to evap­o­rate as soon as stim­u­lus pack­ages are removed.

The only sen­si­ble course is to reduce the debt lev­els. As Michael Hud­son argues, a sim­ple dynam­ic is now being played out: debts that can­not be repaid, won’t be repaid. The only thing we have to do is work out how that should occur.

Since the lend­ing was irre­spon­si­bly extend­ed by the finan­cial sec­tor to sup­port Ponzi Schemes in shares and real estate, it is the lenders rather than the bor­row­ers who should feel the pain–which is the exact oppo­site of the bailout men­tal­i­ty that dom­i­nates gov­ern­ments around the world.

Unfor­tu­nate­ly, it will take a sus­tained peri­od of fail­ures by con­ven­tion­al pol­i­cy before uncon­ven­tion­al poli­cies, like delib­er­ate debt reduc­tion, will gain polit­i­cal trac­tion. Imple­ment­ing them will require both a dra­mat­ic change of mind­set and prob­a­bly also a wide­spread chang­ing of the polit­i­cal guard.

It will also require the break­ing of the hege­mo­ny of neo­clas­si­cal eco­nom­ics over eco­nom­ic think­ing, but I doubt that the aca­d­e­m­ic pro­fes­sion, or econ­o­mists in Cen­tral Banks and Trea­suries, are up to the task of chang­ing their spots. Change in eco­nom­ics will have to come from the rebels, and from out­siders tak­ing over a dis­ci­pline that econ­o­mists them­selves have failed.

The sec­ond decade of the 21st cen­tu­ry promis­es to be a dra­mat­ic one, polit­i­cal­ly and eco­nom­i­cal­ly.

[1] Bernanke went on to devel­op his own inter­pre­ta­tion of Fish­er which I won’t both­er with here because I don’t think it’s worth the effort.
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