Debtwatch No. 43: Declaring victory at half time

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Note: the first part of this post will mainly be of interest just to Australian readers, but I conclude with a numerical explanation of “Why Debt-Deflation Causes Depressions” that will be of interest to readers everywhere.

Last week I took part in a debate entitled “The Great Residential Housing Debate – the next Bubble or a legitimate Boom?” at the annual conference for Perennial Investment Partners; I put the Bubble case and Chris Joye of Rismark International presented the Boom case (here is my paper and my presentation). As is well-known, Australia is one of the few countries in the OECD not to experience two quarters or more of falling GDP as a result of the GFC, and probably the only country that has not experienced a fall in its property market.

The conference was held twice, firstly in Melbourne on Wednesday February 24th, and then in Sydney on Friday 26th. There were roughly 400 people in the audience on both occasions, all of whom were customers of Perennial–with the majority (roughly 75%) being financial planners. The conference employed an electronic voting mechanism that let participants answer general questions, as well as rate the speakers. In our debate, it was used to work out where people stood on the “Bubble vs Boom” spectrum both before and after the debate. A “1” indicated a complete Bear who expected property to crash and advised getting out now, while a “10” was a complete Bull who advised “Buy, Buy, Buy”.

Prior to our debate in Melbourne, the average score was 4.9. This surprised me, because I expected the audience to be generally pro-property; however a score of below 5.5 indicated that overall the audience was bearish on property (since the average of the ten numbers from 1 to 10 is 5.5; also see ** below).

After our debate, the score was 5.2–a small move in favour of the bullish position, but still slightly in the bearish camp. Chris commented that this was “about even” and “too close to call” as he left the stage, which I thought was a fair enough summary of the outcome.

So I was stunned when Crikey asked me to respond to the report Chris had given them of the Melbourne debate (“Reflections on Cage Match Mk 1“), which included the statements that:

So I think I pretty comprehensively monstered Steve Keen at our debate in Melbourne yesterday. That was certainly the feedback from those who attended (there were 500)

While I felt I was able to intellectually tear Steve apart limb-by-limb, I will say this: he is a lovely guy. Very diplomatic and humble in defeat…; and

Unfortunately, the electronic scoring in yesterday’s debate was a bit convoluted: it measured the shift in the audience sentiment from bearish (Steve) to bullish (Chris) before and after the event. On that basis, I won. But I think a simpler Chris versus Steve voting system would have made the difference much more striking

Huh? The rest of the post was of a similar vein–though there were occasional caveats such as “As I noted in my presentation, Steve has made some valid criticisms of conventional economics, and its neglect of debt capital market imperfections. And he deserves some kudos for anticipating a credit crisis” (gee, thanks!), even this was immediately followed by “But whatever strengths he possesses are overwhelmed by his propensity to make silly statements.”

I had no intention of commenting on the debate prior to seeing this hit a national news site, but of course this couldn’t be ignored–though at the same time it didn’t deserve to be taken seriously. So I took a facetious approach–opening my reply with “I don’t know what Chris consumed after our talk at Perennial’s conference yesterday, but if he has any spare I’d like to try it at a party tomorrow night”, and concluding with the advice to Chris that, “Next time, after a conference, don’t consume anything, just take a cold shower”  (I also pointed out the statistical fact Chris apparently missed, that the middle point in scores from 1 to 10 is not 5, but 5.5).

Chris took this rejoinder very well–despite our fundamental differences over this issue, we get on well personally, and unlike some participants in this debate, he does have a sense of humour.

And so we proceeded to Sydney. There the audience was slightly less bearish than in Melbourne: the average score prior to the debate was 5.3, just slightly below the neutral level. But after the debate, there was a significant shift towards the Bear case. The post debate score was 4.6.

Chris had made the classic mistake of declaring victory at half-time, only to get a cold shower with the full-time result (see below however under **).

Why Debt-Deflation Causes Depressions

“Declaring victory at half-time” is a syndrome which afflicts the entire debate over our current economic situation: optimists are of the opinion that the crisis is all over now, while pessimists think it’s only just begun. On this front, as always, I regard history as the best indicator of who may be right. On this front, I can’t commend highly enough the site New from 1930, which from January 1 2009 began publishing summaries of the Wall Street Journal from January 1 1930. The last few entries include these pearls of wisdom from February 1931:

An Old-Timer believes the market rally “will do more to restore prosperity than anything else.” Total security values have increased over $20B since start of year; barring another dive in the market, this assures a recovery since the 10M-15M US owners of stock feel richer. Bulls say the ease with which considerable profit-taking has been absorbed recently is “the surest indication of a strong healthy market.” Market has rallied very substantially; “if it runs true to form, it will have one of those ‘healthy reactions’ that will, according to the bulls, strengthen its ‘technical position.’” “The buying power of the people and the corporations still is large … In other words, the country never was in a better position to stage a comeback after a depression … (Feb. 25th)

One banker cites plenty of evidence that the backlog of consuming power is largest its been in years: corp. inventories are down 20% from a year ago, and even more from 2 years ago; corps. are holding more cash; production of many products is below requirements; products have been wearing out for 18 months of deferred buying; security values up $20B since Jan. 1; easy credit; record-breaking savings deposits. Last year there were few rallies on which to sell; this year there have been few dips on which to buy. Public interest has grown this year, but is still small compared to 1928 and 1929; “a market with a growing public interest is a dangerous market to sell short.” (Feb. 26th)

Yeah, right: in both 1930 and 1931, the belief was widespread–at least in the financial community–that the Depression was over, and recovery was just around the corner. As Australia’s Alan Kohler noted when he first discovered this blog, at least early on during the Great Depression, people didn’t realise that they were in it. They too, were declaring victory at what turned out to be not even half-time.

Ultimately, the debate over whether we’re in a complete recovery or merely a temporary recess from the GFC will only be resolved by time. But well-informed theory can also give a guide as to what we can expect, and here I regard Hyman Minsky’s Financial Instability Hypothesis and Irving Fisher’s Debt Deflation Theory of Great Depressions as the outstanding guides. However they are complex theories, especially when most economists have been mis-educated by neoclassical economics into ignoring money, debt, and disequilibrium dynamics. So the following numerical example might make it easier to understand their arguments:

  • Imagine a country with a nominal GDP of $1,000 billion, which is growing at 10% per annum (real output is growing at 4% p.a. and inflation is 6% p.a.);
  • It also has an aggregate private debt level of $1,250 billion which is growing at 20% p.a., so that private debt increases by $250 billion that year;
  • Ignoring for the moment the contribution from government deficit spending, total spending in that economy for that year–on all markets, both commodities and assets–is therefore $1,250 billion. 80% of this is financed by incomes (GDP) and 20% is financed by increased debt;
  • One year later, the GDP has grown by 10% to $1,100 billion;
  • Now imagine that debt stabilises at $1,500 billion, so that the change in debt that year is zero;
  • Then total spending in the economy is $1,100 billion, consisting of $1.1 trillion of income-financed spending and no debt-financed spending;
  • This is $150 billion less than the previous year;
  • Stabilisation of debt levels thus causes a 12% fall in nominal aggregate demand.

What about if debt doesn’t actually stabilise, but instead grows at the same rate as GDP? Then we get the following situation:

  • In the first year, total demand is $1,250 billion, consisting of $1,000 billion in income and $250 billion in increased debt;
  • In the second year, total demand is also $1,250 billion, consisting of $1,100 billion in income and $150 billion in increased debt;
  • Nominal aggregate demand is therefore constant;
  • But after inflation, real aggregate demand will have contracted by 6%.

This is the real danger posed by debt: once debt becomes a significant fraction of GDP, and its growth rate substantially exceeds that of GDP, the economy will suffer a recession even if the debt to GDP ratio merely stabilises.

A debt-dependent economy has no choice but to record rising levels of debt to GDP every year to avoid a recession. Unfortunately, this makes a debt-servicing crisis inevitable at some point, especially when a large fraction of the increase in debt is financing Ponzi-speculation on asset prices, since this adds to debt without increasing society’s capacity to finance that debt.

That is why falling debt levels caused the Great Depression, as Irving Fisher argued back in 1933, and the phenomenon is obvious in the empirical data. The next few charts illustrate this argument.

Private debt and GDP levels in the USA from 1920 to 1940:

The change in private debt, added to GDP to show aggregate demand as the sum of GDP plus the change in debt:

Now I calculate the proportion of aggregate demand that is debt-financed, by dividing the change in debt by the sum of GDP plus the change in debt: the formula for is:

The correlation of the fraction of demand that is debt financed (lagged one year since the data is end-of-year annual) with unemployment is minus 0.77.  Roughly speaking, this tells us that when the debt-financed fraction of demand rises, unemployment falls, and the correlation of these two series accounts for 77% of the change in unemployment between 1920 and 1940:

Now let’s repeat the same exercise with the data from 1990 till 2010

Private debt and GDP levels in the USA from 1990 to 2010:

The change in private debt, added to GDP to show aggregate demand as the sum of GDP plus the change in debt:

The correlation of the fraction of demand that is debt financed (unlagged since we now have quarterly data on debt) with unemployment (the correlation coefficient is now minus 0.84):

This is why debt-deflation matters, and it’s also why we are barely at the half-time mark in the GFC. Though government spending has countered the fall in debt-financed spending to some degree, that fall has only hit 40% of the level that applied during the Great Depression, even though debt levels are substantially higher (relative to GDP) than they were back then.

The numerical example given above is, by the way, not too far removed from the empirical data for both Australia and the USA prior to the GFC. In the year before the crisis, Australia’s GDP was roughly A$1.1 trillion, and the increase in debt that year was A$260 billion, which was a 17% increase on the previous year; for the USA the comparable figures were roughly US$14 trillion, a US$4.5 trillion increase in debt, and a peak rate of growth of debt of about 10% p.a.

The example also illustrates why the rate of inflation matters, and why a low rate prior to a debt crisis is a serious danger. If inflation is high when the crisis hits (say 20% p.a.) then most of the decline can be taken by a fall in the rate of consumer price inflation itself. But if the commodity inflation rate is low, then the hit will be taken by asset prices and actual output as well as by a fall in the inflation rate.

The process can be countermanded to some degree by the government running a deficit, which counteracts the fall in aggregate demand caused by private deleveraging. But the government deficit would need to be far higher than current levels to return us to prosperity if nothing is also done about the astronomical level of private debt.

With the deficits that are being contemplated today, I expect the outcome to be that the rest of the OECD will “turn Japanese” and enter a long-running, low level Depression. Actions that limit those deficits–or even worse, force countries in crisis like Greece to impose austerity measures to reduce deficits back to zero–will turn this from a drawn-out Depression into a sudden and deep one.

Of course, at the same time that economic policy makers–misled by neoclassical economics–are imposing austerity programs on national governments, they are trying to restart the private debt binge mechanism that gave us the crisis in the first place. I’ll write more on this in a future Debtwatch, but in the meantime I recommend the post on this point on Vox by Peter Boone and Simon Johnson, “The doomsday cycle“.

Why has Australia done so well?

I’ve noted previously that government policy during 2009 boosted household disposable income dramatically, and Gerard Minack of Morgan Stanley recently pointed out just how much: “household disposable income increased by 10.1% over the year to the September quarter, while labour income – the biggest component of household income and traditionally the largest swing factor – increased by just 0.4%.” (Morgan Stanley Australia Strategy and Economics, February 24, 2010: The Odd Expansion). The primary factors driving household disposable incomes higher were the government’s stimulus package (which boosted incomes by about 4%) and the RBA’s rate cuts (which added another 5% to disposable incomes).

As Gerard commented when he first publicised this outcome (Morgan Stanley, Downunder Daily October 9, 2009: Antipodean Lessons), “If that’s recession, bring it on!”: it’s unheard of for household incomes to rise during a recession, and that’s a major reason why Australia avoided a downturn last year.

But it’s not the only reason: the other one, as my numerical example above illustrates, is what happened to debt levels. In our debt-dependent economies today, a recession almost always means a fall in debt levels relative to GDP (while a Depression results from absolutely falling debt). We began that process early in 2008, only to dramatically reverse direction in 2009 so that, once again, debt was growing faster than GDP.

The key cause of this was that other government policy, the First Home Vendors Boost, which enticed Australians back into mortgage debt in droves (both First Home Buyers who actually received the Boost, and the Vendors who sold to them who took levered the extra $15-40K The Boost added to the sale price into another $100-200K for their next house purchase). This policy gave us the fastest turnaround in debt levels in our post-WWII economic history.

Note that the period prior to 1965 had as many periods of the debt to GDP ratio falling as rising–which is the sign of a cyclical but non-Ponzi economy. Then from 1965 on, the trend was for debt ratios to rise faster than GDP except during the recessions of 1973-76 and 1990-94. The period of the Howard Government involved the longest sustained period of rising private debt ever–though notably this trend for rising debt began while Keating was still PM.

Then the GFC hit virtually as Rudd came to office, and the rate of growth of private debt plunged–a similar coincidence to the one that had done the Whitlam government in decades earlier (note that the debt bubble whose bursting brought Whitlam undone had also commenced under the preceding Liberal government of Billy McMahon).

Rudd deserves no blame for the bursting of the debt bubble–as I warned since December 2005, this was inevitable and when it happened, a serious global recession would begin (because the phenomenon was global and not merely limited to Australia). But his government does deserve whatever is deserved–credit or blame–for the rapid turnaround in debt. This wouldn’t have happened without the First Home Vendors Boost, since as is illustrated below, the only source of this increase in private debt has been rising mortgage debt.

Had this trick been pulled back in the 1990s, then Rudd would have received credit for it in the long run, since it would have set off a prolonged boom as debt to GDP ratios rose for many years and gave us a strong if illusory recovery from the preceding recession.

But this is 2010: household debt has risen from under 30% to almost 100% of GDP (the RBA has recently changed its statistics on this front–two months ago the figures in D02 yielded a ratio slightly above 100%), and I simply don’t believe there’s capacity for it to continue rising. So I expect that the trend will rapidly reverse itself back into a falling private debt to GDP ratio, and the recovery this rising debt has helped engineer will evaporate.

That will leave government spending as the one prop to keep the Australian economy afloat, and it is a prop that shouldn’t be underestimated, as the next chart illustrates: though the private debt to GDP ratio turned around from falling at 5% p.a. to rising at 2% p.a. courtesy of government policy, the increase in government debt added another 3% to the mix.

The sum of changing private and government debt thus substantially boosted spending in the Australian economy in 2009–enough to stop the GFC in its tracks here. But in 2010, it is highly unlikely that the private sector will continue re-leveraging. That will leave increased government debt-financed spending as the only boost.

If the government’s contribution remains at about the level of 2009–roughly a 3% boost–and the private sector continues the deleveraging it was doing before government policy kicked in–at a rate of close to 6% p.a.–then the net outcome will still be a falling debt to GDP ratio. While that is necessary in the long term to get us out of the Ponzi cycle we have been trapped in for the last 4 decades, it will still mean pain: private sector deleveraging will outweigh government sector pump-priming.

The reason is simple: so much debt has been taken on already by the Australian private sector that its capacity to take on any more is virtually exhausted. Even as households slapped on more mortgage debt under the influence of the FHVB, other personal debt was falling (until just recently) and the business sector has been rapidly deleveraging–and even so, business debt today still exceeds the peak it reached in 1990.

So the Australian gambit out of the GFC–get back into debt as fast as possible–may soon run its course. We should then find ourselves in the same situation as in the rest of the OECD–deleveraging. The fact that we are taking the “hair of the dog” approach to a debt-hangover (get drunk again on debt the next morning) is readily apparent in this comparison of Australian and US private debt levels: Australia actually began to delever before the USA did, but just as they hit deleveraging with a vengeance, our aggregate private debt started to grow once more.

Just like the “hair of the dog” approach to getting over a hangover, it works once or twice, but not forever: the ultimate destination is DA: “Debtors Anonymous”. Australia has merely delayed its entry into the club.


Further reflections on the Perennial debate

Chris in part attributed doing poorly in Sydney to a couple of personal mishaps that morning prior to the debate–and he did say that he expected not to speak as well as in Melbourne before the debate in Sydney took place. That would certainly have been a factor.

One other factor may be that I developed the numerical example used in this DebtWatch Report after the Melbourne conference. That gave the Sydney audience a clearer idea of why debt-deflation matters–and why the servicing cost of debt, which Chris insists is not high, is not the main problem with a debt-driven economy.

Of course, I dispute the argument that debt servicing costs are not particularly high today. As the next chart shows, even though the RBA’s rate cuts have reduced the cost substantially from its peak, interest payments on mortgages in Australia today consume 7.5% of household disposable income. This is 1.65 times the average from 1976 till now.

Yet this “average” itself is almost as high as the debt servicing costs in 1990, when mortgage rates were an astronomical 17%–2.5 times as high as today’s rates. The primary driver behind this extreme rise in debt servicing costs is the factor Chris loves to ignore, the ratio of mortgage debt to income. This is more than five times larger today than it was in 1990 (130% of household disposable income versus 25% in 1990).

In Sydney, the audience was advised (after our debate) to make a large change to its previous number if they were persuaded one way or the other; this may have made the final swing larger in Sydney than Melbourne.

Finally, Chris later argued later that financial planners are inherently bearish on residential property, since they want to advise people to get into stocks instead. That is an argument that I would prefer to take with a grain of salt. Whether that is true or not as a general proposition, it appears that the people “Mum and Dad investors” might rely upon for advice about where to put their speculative dollars are on average telling them not to put them into residential property, which is the opposite advice to that one sees regularly in the Australian media today (sourced from commentators who clearly have no pecuniary interest in whether house prices rise or fall…).

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137 Responses to Debtwatch No. 43: Declaring victory at half time

  1. ak says:


    I fully agree with you at the personal level. I am doing quite well in Australia and I don’t need any money from the Government.

    However I was not writing about what was good for you or me but what was good or bad for the society. This may not be same.

    We can clearly see the damage done to the American society by the rising unemployment. These people who suffer the most are often the collateral damages of the debt deflation.

    I still have some sympathy to naive Aussie blokes or Asian migrants who fell prey to real estate spruikers. It is not their fault.

  2. mannfm11 says:

    Why don’t we get to the real truth Steve, that debt inflation causes depressions? I think the entire structure of economics is designed to prop the continued growth of debt to the benefit of the banking class that writes most of the laws.

    Shiller was mentioned and if you go to his website at yale economics, he has posted long term data on the S&P 500 or its equivalent. I spent a good amount of time doing analysis on the data and wrote him about it back in 2003. There seems to be some kind of idea that these PE’s matter when in fact stocks are valued as income investments over time,just like housing needs to be able to generate cash flow in order for it to continue to rise over the long term. It was plain to me that the S&P was overvalued a minimum of 300% at the peak in 2000 and likely more, as the long term average yields were even higher than that.

    What few understand is that the inflation not only creates the price of these assets through financing, but the financing itself also creates ripples through the economy. If you look at the debt charts, you will note the nominal trend in debt in the US began in 1995, about the time Rubin came into Treasury in the US. Doug Noland for years has layed the blame of the US bubbles at the feet of the GSE’s. Subprime was just the finish, not the beginning.

    Your early example in this thread of 1% debt at 100% interest or 100% debt at 1% interest generates the same debt service, but you can pay the 1% debt and solve the problem easier. From what I have read elsewhere, I believe in Mish’s site, many Australian cities have home prices that are as much as 900% of median income. Regardless of payment, that is 9 years of income to pay off a mortgage that size at zero interest. The only likely way to manage something like that is to pass it down, not to pay it and that is why inflation and spending to maintain demand is only a stairstep to where we are now and not a solution. Imagine saving 30% of your money for 30 years and then not having any, just a roof over your head?

    The real solution here is to liquidate the speculators, give everyone a haircut and start over. The problem is we have been deprived of your money and left with compound interest notes called dollars, yen, Euro’s and other debt instruments. If they deflate, they cease to exist. It is the evil of banking in its current form that creates these depressions along with the booms and as you have pointed out, it is mathematic. It is the groups behind these entities that feed us this neoclasical economics, which even Keynes was designed to perpetuate the debt bubble, not get rid of it. Speculators, whether they be homebuyers or Wall Street banks should lose their money in a bubble. Otherwise we develop classes of people that serve to make the non-participants liable for their mistakes and relatively poorer through their successes. People should be aware these guys are betting their money and not their own on these endeavors. I firmly believe we are at a point of inevitible deflation and that the current speculations by Goldman and others will result in massive losses and another, we need to save the world cry from Bernanke and Geithner, along with Brown and Darling(?).

    William Black, who is at UMKC along with Michael Hudson(thanks for the introduction of Hudson on this site), contends every lending bubble is fronted by what he calls control fraud. Control fraud is where the heads of the lending institutions adopt easy lending guidelines that result in large profits, mainly by failing to reserve for losses. As long as something like home prices can be continually inflated, the losses out of the bad loans don’t show up. I think they call this Ponzi financing, as the need to pass the bag to keep the game going in paramount. I witnessed a collapse in home prices locally when the game ran out in the mid 1980s. In any case, it isn’t necessary for prices to go down to start this process, merely quit going up.

    It is highly likely those that are promoting the housing game could be complicit in this control fraud. Most of the economic advisors in the Obama administration had been involved in such a scam, one being Franklin Raines, who ran FNMA and took out total salaries in excess of $100 million. Clearly the system worldwide is loaded with it and much of the financial education game is to keep the process going. The speculative bubble worldwide is larger than it ever has been, just the pressure that can be generated by inflation in general is less.

    One last thing. I noted something you wrote in this post. That if inflation in the form of price inflation is high, the effect is cushioned. In essence, the inflation was the result of excess demand brought about by excessive lending and would merely disappear, with not that much effect on AD. The effect would show up, quite possibly in the bottom line profits of companies. The current situation is more about the CPI inflation of debt inflation has lost its effect and the real effect has moved to asset inflation. This asset inflation, in stocks and real estate is brought about by falling interest rates and inflated incomes acting in concert to create a trend, ripe for Ponzi finance. Shiller had CPI’s for every year since 1871 in that data he posted and I found that CPI inflation under the gold standard between 1895 and 1920 was just as high as it was in the 1965 to 1990 era. Some of it was the result of the World War and the Federal Reserve, but the trend started in the mid 1890’s, maybe as a result of a recovery from a deflationary period. In any case, it was enough to generate a trend in asset prices that ended in the big bubble of 1929.

  3. BrightSpark1 says:


    That wiki thrift paradox article describes a classical dynamic system feedback effect but never uses the term “feedback”. However it does suggest a connection with the “vicious circle” concept which is a popular term used to describe a positive run away feedback loop. The fact that such a system can be characterised using dynamic feedback methodology seems to escape every one of these wiki editors as it does escape the small understanding of neoclassical economists.

    I also noticed that the wiki article claims that J M Keynes quoted Adam Smith way out of context, but that is another story.


  4. noah cross says:

    How long has the lucky country got?

    “Fiscal transfers increased personal disposable incomes by 4 per cent, according to Professor Steve Keen of the University of Western Sydney.
    Australian home prices are currently some 70 per cent above their long-term trend level. A recent survey by Demographia International finds that all of Australia’s major housing markets were valued at more than five times average incomes, and defines them as “severely unaffordable.”
    Aussie house prices have not fallen since the early 1950s. A certain complacency is therefore understandable. Yet not long ago many Americans also believed that domestic home prices could never fall. So far Australia has avoided its day of reckoning. But how long will the lucky country’s luck last?”

  5. Marco2 says:

    I apologize for posting this message so long after Prof. Keen’s original article (Debtwatch No. 43). My excuse for doing so is that I have tried my best to give a fair hearing to both Prof. Keen and Mr. Joye, in their debate.

    As I often read Prof. Keen’s pieces, I thought it would be an interesting exercise to read one of his critics with equal care.

    A few of words of caution are required here. I’ve had some difficulty with elements in Mr. Joye’s prose. Frankly: I am not interested in a personal confrontation between Mr. Joye and Prof. Keen. Irony and sarcasm, however cleverly applied, are not acceptable arguments.

    To a large extent, Prof. Keen seems entirely capable to separate the professional and academic dispute from any personal differences. Mr. Joye, regrettably, seems much less able. And this, I am afraid, did not win Mr. Joye my sympathy. Thus, it’s possible that my final opinion had been affected by this.

    Similarly, Mr. Joye has not been as active as Prof. Keen in the exposition of his views, and this must be taken into account, as well. In particular, I had only access to the presentation Mr. Joye linked to in his own blog, and the blog posts.

    On the interest of complete disclosure: I make no secret that I am sympathetic to Prof. Keen’s theories.

    Likewise, I want to make it clear that I am no economist and my knowledge of the housing market is exactly the same as that of any other interested observer.

    Still, in keeping with the spirit of disclosure, I must also add that I do have a PhD education (although I did not finish studies) and during my studies I did complete courses in intellectual foundations of the social sciences. In other words, even though I am by no means an expert, I am no absolute novice, either.

    In any case, with all the limitations and personal biases I’ve already mentioned, I will try my best to be impartial.

    In the first section I will compare two seemingly contradictory statements by Mr. Joye and draw some general conclusions about the Joye vs. Keen debate. I would also take the liberty to make a suggestion to Prof. Keen.

    In the second section I will try to analyze more deeply what seems to be Mr. Joye’s most recent opinion on Prof. Keen’s work.

    In the closing section I will formulate my own conclusions on the debate.

    Section 1. Preliminaries.

    It is possible that Mr. Joye’s vision of Prof. Keen’s work has been evolving, as Mr. Joye gains more exposure to Prof. Keen’s theories. This would be natural.

    Additionally, Prof. Keen’s work continues and is still being perfected.

    Nevertheless, this evolution may have caused some unnecessary and predictable misunderstandings from Mr. Joye. As an example, on 25/02/2010, Mr. Joye stated:

    “My chief criticism, which I relayed to him privately in addition to vocalising during the debate, is that he massively overstates the explanatory power of his models” [1]

    This paragraph, in my understanding, signifies that Mr. Joye admits that (1) there is a model, and (2) this model has some explanatory power, however overstated Mr. Joye might consider it.

    The previous statement, I suppose, is a step forward from the assessment Mr. Joye made just one day before:

    “What I do not say in the slides, but will communicate in the presentation, is this: Keen mounts his housing market critique based on crude comparisons of mortgage debt to GDP, amongst a few other things. This is a pretty meaningless benchmark. If you want to understand the viability of debt levels, you can use two key measures: debt-to-assets ratios and debt-to-income” [2]

    In this earlier statement we do not see a model, only “crude comparisons of mortgage debt to GDP, among a few other things”. As an example of an element that, in my opinion, is central in Prof. Keen’s models is the insight that changes in debt affect aggregate demand.

    I may have misinterpreted Prof. Keen, but I believe he sees the “crude comparison of mortgage debt to GDP”, that Mr. Joye speaks of, as a diagnostic tool. That’s not the whole of his theory, or even the bulk of it

    That Mr. Joye seemed to think otherwise suggests he might have been criticizing what he did not fully understand.

    Regardless, Mr. Joye proposes two other diagnostic tools: “If you want to understand the viability of debt levels, you can use two key measures: debt-to-assets ratios and debt-to-income”.

    Mr. Joye’s two suggestions are intuitively appealing, if one considers that the speculators that might go burst are only home buyers. Under that understanding, I would have to side with Mr. Joye.

    The insight I got from reading Prof. Keen’s article, though, is this: not only home buyers are vulnerable to a bubble bursting. This makes Mr. Joye’s suggestions largely irrelevant.

    Furthermore, Mr. Joye does not argue his case. He merely states that Prof. Keen’s “debt to GDP” ratio “is a pretty meaningless benchmark”, while his own suggestions are better. But Mr. Joye does not explain why his ratios better or why Keen’s benchmark is meaningless? The answers to these two questions, I suspect, would have been highly enlightening.

    In the third section of Mr. Joye’s presentation, he goes to a great length to show that Australia is “middle of the road” case among a number of OECD countries, in terms of house prices and house price to income growths: “no evidence of unusually high growth in housing costs”. From this Mr. Joye seems to conclude that, as Australia house prices did not growth as fast as, say, the UK and Ireland (countries that did suffer house prices deflation) there is little risk of a local house prices deflation.

    However, this conclusion does not follow from Mr. Joye’s reasoning, for in the sample chosen one sees that even though the US had slower house prices growth than Australia, it also suffered from a house prices deflation. This means that an extremely fast house prices growth, relative to incomes, is not a necessary condition for a housing bubble to burst. If such were the case, the US would not have been affected.

    Mr. Joye also seems to place great faith on the capacity of home buyers to service their mortgage debts, on the argument that interest rates have been higher in the past, without causing generalized bankruptcies. In his opinion, “Keen ignores cost of debt”.

    Mr. Joye’s exposition, however, appears to rest on the idea that house prices represent only 4 to 5 times incomes. As his income estimates are not explained, it’s hard to ascertain how accurate they might be. Nevertheless, they do sound dubious for several reasons. For one, most housing advisors are talking about house prices representing 6 to 8 times average incomes, as has been widely publicized in the media.

    Furthermore, Mr. Joye states that “only 0.66% of Australian home loans in 90 days arrears (Sep ’09)” and favorably compares this with a figure of over 5% home loans in arrears in the US for the same date. What Mr. Joye does not seem to have noticed is that by 2007, all countries in the group graphed had at most 1% home loans in 90 days arrears: it only took one year for the rate to rise to 2% in the US in 2008, when the sub-prime crisis had been clearly recognized.

    In any case, in my opinion, this is a point deserving further exploration by Prof. Keen: are “mortgage debt to GDP” ratio and “debt-to-assets” and “debt-to-income” ratios revealing entirely different pictures? If so, why?

    Section 2. The Keen Model and Mr. Joye.

    In the more recent quote, then, Mr. Joye apparently accepts that there is a model, although he has doubts about its explanatory power. I suppose one may interpret that Mr. Joye’s view on Prof. Keen’s theory matured somewhat.

    Here I will suggest that Mr. Joye’s opinion about what constitutes an explanation is an important contributor to his lack of appreciation for Prof. Keen’s theory explanatory power.

    Based on my admittedly limited knowledge of Prof. Keen’s work, it’s my belief he rejects the notion of methodological individualism.

    Methodological individualism traces the ultimate explanation of macro behaviors to individual micro behaviors. Therefore, for a methodological individualist, a true explanation only makes sense when stated in terms of individual motivations.

    That view became predominant in mainstream economic circles.

    I would venture the opinion that this is what Mr. Joye (who, I believe, by formation is a neoclassical economist) understands as explanation and that may be why he has doubts on Prof. Keen’s model explanatory power.

    I myself doubt that this difference in opinion could be entirely settled on theoretical grounds, within economics. It’s certainly possible to argue about these subjects on philosophical grounds. But I believe it wise to leave these matters aside, for the time being.

    This does not mean that Prof. Keen’s theories cannot be tested, but, on the absence of a meta-theoretical discussion, the test should be attempted on empirical grounds.

    And it is on these grounds that Mr. Joye’s critique seems more devastating. Here I will suggest that the power of Mr. Joye’s critique is more apparent than real.

    In Mr. Joye’s own words:

    “Put bluntly, Steve has got all his other calls horribly wrong. With the utmost confidence he proclaimed (1) we would have a depression, (2) precipitous house price falls, (3) double-digit unemployment, and so on. Of course, nothing like any of these events came to pass. And (4) Steve complains about the impact of counter-cyclical government policy. Yet this is precisely what he was advocating during the darkest days of the crisis.”

    That is, Mr. Joye reproaches three empirical predictions and an alleged change in Prof. Keen’s mind:

    (1) The recession was not severe enough to qualify as a depression.
    (2) House prices did not fall precipitously.
    (3) Unemployment did not reach double-digits.
    (4) Prof. Keen complains about counter-cyclical policy, when he advocated it before.

    As can be observed, (1), (2) and (3) are clearly interrelated and can be summed up thus: the recession has not hit Australia as severely as it hit other national economies, like the US, UK and Ireland, where, on top of a large fall in production and employment, deflation severely affected real estate assets.

    As can be seen in Prof. Keen’s article, all these observations have clear explanations. I will not repeat them here and instead recommend Prof. Keen’s article itself.

    Section 3. Conclusions.

    On the basis of my previous observations, I find that Mr. Joye’s exposition is lacking in both depth and clarity. He does not address Prof. Keen’s models, perhaps due to lack of familiarity with them. Furthermore, Mr. Joye’s reasoning in defense of his own position seems faulty.

    It’s possible that Mr. Joye’s view might evolve, but a complete acceptance of Prof. Keen’s models looks unlikely, given a probably fundamental different approach around what a successful economic explanation involves.

    [1] Reflections on Cage Match Mk 1. 25/02/2010.

    [2] Deconstructing Steve Keen. 24/02/2010.

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