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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