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

  1. Pingback: Australian bank pushes for full reserve banking! « Karmaisking's Blog

  2. Andre says:

    Steve, you said in reply to my post: “The power and research-capability imbal­ance between most bor­row­ers and banks is so great that the lat­ter deserve to feel 99% of the pain for this catastrophe.”

    Per­haps this is fair enough, though I still think indi­vid­u­als in soci­ety should be pre­pared to accept the con­se­quences for their actions far more than they do these days. I have not the wis­dom of Solomon on this one. I will, of course only be con­tent if the two par­ties involved share the full pain, in what­ever por­tions, and I as an inno­cent bystander (tax­payer) suf­fer exactly and pre­ci­cely 0% of the pain.

    Any­way, thank you for your com­ments and thank you for your blog, which I find inter­est­ing and refresh­ing com­pared to the mostly dri­vel I read in the main­stream media.

  3. jono1 says:

    Hi Steve, and all read­ers. Just a lit­tle obser­va­tion from the coal­face regard­ing prop­erty. It seems that the major­ity of vis­i­ble action on prop­erty is ren­o­va­tion, but this “value adding” (spending)is not accounted for in the prop­erty price infla­tion fig­ures. Also, with all these units going up (on major cur­rent trans­port arter­ies so govt DOESN’T incur the infra spend!)and Aussie houses being the world’s largest, could the units start rent­ing room by room, and the houses start sup­port­ing the new­ly­wed kids? Could this short­age turn into a glut by the exten­sion of some sim­ple trends?

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  5. littledavesab says:

    Great arti­cle Steve. Also liked the Frisby Bears and Bulls radio show you did with Dominic Frisby

    I do hope he gets you back again to expand on what you talked about — would like to hear the two of you dis­cussing Aus­tralia (from a is it a safe haven cur­rency point of view) and your views on Hyman Misky

  6. parrotile says:

    The prob­lem with clas­si­cal / neo­clas­si­cal eco­nom­ics is that these demon­stra­bly very weak the­o­ries are (for the major­ity of Uni. Eco­nom­ics courses) taught as incon­tro­vert­ible “facts”. This dog­matic blink­ered approach also extends to the much-favoured (and mer­ci­lessly hyped) MBA courses, which seem to have a lot less to do with pro­vid­ing use­ful Busi­ness Skills (espe­cially for the Small Busi­ness Oper­a­tor), and rather a lot more to do with the mas­sag­ing of the egos of self-important “Pro­fes­sors of Eco­nomic The­ory” — at least in the UK where the (aca­d­e­mic) World and his Wife have all jumped on the extremely lucra­tive “MBA-Bandwagon”. Many major retail­ers mow expect this rather use­less Degree in even Junior Man­age­ment, and I sup­pose it’ll be just a mat­ter of time until we see the MBA as an “Essen­tial Cri­te­rion” of employ­ment on the check-outs of the likes of Tesco!

    The fact that neo-classical dog­ma­tism has, and still con­tin­ues to fail the work­ing pop­u­la­tion seems to have been com­pletely missed (maybe delib­er­ately ignored?) by the “Movers and Shak­ers”. Just why can the “aver­age Man in the Street” eas­ily under­stand the obvi­ous cause and effect analy­ses, whilst the “Super Eco­nomic Elite” con­sis­tently fail to do so must be a mat­ter of con­sid­er­able con­cern, or, “maybe there’s some kind of Con­spir­acy” — prob­a­bly not, more likely “I know best so my word must be accepted as Gospel truth!”

    Future’s look­ing far from rosy, espe­cially for the hordes of Hous­ing Spec­u­la­tors jump­ing on the “free money in return for min­i­mal effort” band­wagon. For most of the Aussie pop­u­la­tion I sus­pect 2010 will be a year they will remem­ber for all the wrong reasons!

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