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. First Loan Buyer says:
  6. 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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