Empir­i­cal and the­o­ret­i­cal rea­sons why the GFC is not behind us

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Preliminary Remarks

As noted in Debt­watch No. 44, I have stopped writ­ing the monthly Debt­watch Report to focus on my more long term research. I’m still post­ing occa­sional blog posts when I feel the need—like the two recently on Australia’s new resources tax—but gen­er­ally I’ll be work­ing on more tech­ni­cal mat­ters, and post­ing entries based on those here in lieu of the more top­i­cal Debt­watch. This post is a halfway post between the two: it’s a paper that I have just sub­mit­ted to the 2010 Aus­tralian Con­fer­ence of Econ­o­mists, which will be held in Syd­ney in Sep­tem­ber. I have writ­ten it largely as a brief­ing paper for main­stream econ­o­mists who would not have come across the analy­sis that I present here before, let alone the vast vol­ume of lit­er­a­ture in Post Key­ne­sian and Aus­trian eco­nom­ics.

There is one clas­sic SNAFU in going from Word to the blog for­mat, for the for­mat­ting of a table below;  I wasted too much time try­ing to fix it, so I’ll have to live with it for this post!


A major­ity of the 16 indi­vid­u­als iden­ti­fied in Beze­mer (2009) and (Full­brook (2010)) as hav­ing antic­i­pated the Global Finan­cial Cri­sis fol­lowed non-main­stream approaches to eco­nom­ics, with most of them iden­ti­fy­ing as Post-Key­ne­sian (Dean Baker, Wynne God­ley, Michael Hud­son, Steve Keen, Ann Pet­ti­for) or Aus­trian (Kurt Richel­bacher, Peter Schiff). The the­o­ret­i­cal foun­da­tions of these authors there­fore dif­fer sub­stan­tially from those of more main­stream neo­clas­si­cal econ­o­mists. In this paper I will restrict my atten­tion to the Post-Key­ne­sian sub­set, which I will here­inafter refer to as the Beze­mer-Full­brook Group. Beze­mer iden­ti­fied the fac­tors that these authors have in com­mon as:

the dis­tinc­tion between finan­cial wealth and real assets… A con­cern with debt as the coun­ter­part of finan­cial wealth… a fur­ther con­cern, that growth in finan­cial wealth and the atten­dant growth in debt can become a deter­mi­nant (instead of an out­come) of eco­nomic growth …[the] reces­sion­ary impact of the burst­ing of asset bub­bles… [and] Finally, empha­sis on the role of credit cycles in the busi­ness cycle… (Beze­mer (2009))

These authors made fre­quent ref­er­ences to the ratio of pri­vate debt to GDP, and the ratio of asset prices to com­mod­ity prices—both indi­ca­tors of finan­cial fragility that were empha­sized by Min­sky in his finan­cial insta­bil­ity hypoth­e­sis (Min­sky (1982)), which is a com­mon thread in the credit-ori­ented analy­sis of the Beze­mer-Full­brook Group. Since these indi­ca­tors are not com­monly con­sid­ered in main­stream eco­nomic analy­sis, I repro­duce this key data in the next 2 fig­ures, before con­trast­ing them to those fol­lowed by Ben Bernanke (the acknowl­edged main­stream expert on the Great Depres­sion) in his analy­sis of the Great Depres­sion.

Fig­ure 1: Ratio of pri­vate debt to GDP, USA and Aus­tralia

Fig­ure 2: US asset price bub­bles

The Great Depression: Errant Monetary Policy or the Dynamics of Debt?

Bernanke pre­cedes the sum­mary of his expla­na­tion for the Great Depres­sion with the state­ment that its causes must be found in fac­tors that caused a sharp decline in aggre­gate demand:

Because the Depres­sion was char­ac­ter­ized by sharp declines in both out­put and prices, the premise of this essay is that declines in aggre­gate demand were the dom­i­nant fac­tor in the onset of the Depres­sion. This start­ing point leads nat­u­rally to two ques­tions:

First, what caused the world­wide col­lapse in aggre­gate demand in the late 1920s and early 1930s (the “aggre­gate demand puz­zle”)?

Sec­ond, why did the Depres­sion last so long? In par­tic­u­lar, why didn’t the “nor­mal” sta­bi­liz­ing mech­a­nisms of the econ­omy, such as the adjust­ment of wages and prices to changes in demand, limit the real eco­nomic impact of the fall in aggre­gate demand (the “aggre­gate sup­ply puz­zle”)? Bernanke (2000, p. ix)

His expla­na­tion has two com­po­nents: a con­trac­tion in money caused by poor mon­e­tary man­age­ment (and a flawed sys­tem based upon the gold stan­dard), and the impact of non­mon­e­tary finan­cial fac­tors:

there is now over­whelm­ing evi­dence that the main fac­tor depress­ing aggre­gate demand was a world­wide con­trac­tion in world money sup­plies. This mon­e­tary col­lapse was itself the result of a poorly man­aged and tech­ni­cally flawed inter­na­tional mon­e­tary sys­tem…

I also have ascribed an impor­tant role to non­mon­e­tary finan­cial fac­tors, such as bank­ing pan­ics and busi­ness fail­ures, in chok­ing off nor­mal flows of credit and hence exac­er­bat­ing the world eco­nomic col­lapse. Bernanke (2000, p. ix)

With regard to the role of poor mon­e­tary man­age­ment in caus­ing the Great Depres­sion, Bernanke favourably cites Fried­man and Schwartz’s iden­ti­fi­ca­tion of “Four Mon­e­tary Pol­icy Episodes” where respec­tively a tight­en­ing or loos­en­ing of mon­e­tary pol­icy caused a decline or expan­sion dur­ing the Great Depres­sion (Bernanke (2002), cit­ing Fried­man and Schwartz (1963)). These four episodes are sum­ma­rized in Table 1.

Table 1: Fried­man-Schwartz iden­ti­fied peri­ods in US mon­e­tary pol­icy dur­ing the Great Depres­sion (Bernanke (2002))

Pol­icy Type Start End
Tighten Spring 1928 Octo­ber 1929
Tighten Sep­tem­ber 1931 Octo­ber 1931
Loosen April 1932 June 1932
Tighten 1933 March 1933

Bernanke largely dis­missed the debt-defla­tion expla­na­tion given by Fisher, on the grounds that debt-defla­tion was a dis­trib­u­tive mech­a­nism and not a macro­eco­nomic one:

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)

Bernanke then re-inter­preted Fisher from an equi­lib­rium per­spec­tive, whereas Min­sky accepted and built upon Fisher’s explicit non-equi­lib­rium basis:

We may ten­ta­tively assume that, ordi­nar­ily and within wide lim­its, all, or almost all, eco­nomic vari­ables tend, in a gen­eral way, toward a sta­ble equi­lib­rium… But the exact equi­lib­rium thus sought is sel­dom reached and never long main­tained…, in actual fact, any vari­able is almost always above or below the ideal equi­lib­rium…

The­o­ret­i­cally … there must be- over- or under-pro­duc­tion … and over or under every­thing else. It is as absurd to assume that, for any long period of time, the vari­ables in the eco­nomic orga­ni­za­tion, or any part of them, will “stay put,” in per­fect equi­lib­rium, as to assume that the Atlantic Ocean can ever be with­out a wave…

in the great booms and depres­sions … [there are] two dom­i­nant fac­tors, namely over-indebt­ed­ness to start with and defla­tion fol­low­ing soon after Fisher (1933, p. 341)

Min­sky adopted this dis­e­qui­lib­rium per­spec­tive, and argued that a reduc­tion in debt does have macro­eco­nomic effects, because it reverses the process of debt adding to aggre­gate demand that must occur dur­ing a period of expan­sion:

For real aggre­gate demand to be increas­ing … it is nec­es­sary that cur­rent spend­ing plans, summed over all sec­tors, be greater than cur­rent received income and that some mar­ket tech­nique exist by which aggre­gate spend­ing in excess of aggre­gate antic­i­pated income can be financed. It fol­lows that over a period dur­ing which eco­nomic growth takes place, at least some sec­tors finance a part of their spend­ing by emit­ting debt or sell­ing assets. Min­sky (1982, p. 6; empha­sis added)

Minsky’s thus defines aggre­gate demand as the sum of GDP plus the change in debt, and this demand is expended on both com­mod­ity and asset mar­kets, in con­trast to the main­stream macro­eco­nomic focus on com­mod­ity mar­kets alone. Bernanke’s inter­pre­ta­tion and sta­tis­ti­cal mea­sures of tight mon­e­tary pol­icy also implic­itly accepts the money mul­ti­plier expla­na­tion of the rela­tion­ship between base money and broader mea­sures of money such as M1. The Beze­mer-Full­brook Group instead argues that the money sup­ply is endoge­nously deter­mined, and that changes in base money fol­low rather than cause changes in broad money, so that there is no direct causal link between M0 and M1 (Moore (1979); see also Kyd­land and Prescott (1990)). The Bernanke-Fried­man-Schwartz asser­tion is that declines in the rate of growth of the money sup­ply ini­ti­ated by the Fed­eral Reserve caused the Great Depres­sion; the Beze­mer-Full­brook Group asserts instead that con­tract­ing debt caused the Great Depres­sion. These expla­na­tions can be com­pared empir­i­cally, by con­sid­er­ing the cor­re­la­tions between the rate of growth of the money sup­ply and unem­ploy­ment, ver­sus changes in the debt-financed pro­por­tion of aggre­gate demand and unem­ploy­ment.

Money and Unemployment in the Great Depression

Fig­ure 3 shows the rela­tion­ship between M0 and M1 over the period from 1920 to 1940. Though the two mea­sures move in con­cert with each other in the period from 1920 to 1930, it is obvi­ous that there was a break­down in the rela­tion­ship between these two aggre­gates in the period between 1931 and 1934. Infer­ences that are based on the appar­ent rela­tion­ship between M0 and M1 in 1920–1930 will thus be sus­pect in the period 1931–1934.

Fig­ure 3: Rates of change of M0 and M1 1920–1940

This is borne out by a com­par­i­son of the cor­re­la­tion of the rate of growth of the money sup­ply as mea­sured by M1 and unem­ploy­ment in the period 1930–1940, and the cor­re­la­tion using M0. Fig­ure 4 shows that the cor­re­la­tion is mod­er­ate and has the expected sign for M1 (-0.3): an increase in the rate of growth of M1 is cor­re­lated with a fall in unem­ploy­ment, as Bernanke, Fried­man and Schwartz hypoth­e­size (the rate of unem­ploy­ment is inverted on the right hand axis, to enhance visual inspec­tion of the cor­re­la­tion: when the two series move in the same direction—or high rates of money growth cor­re­spond to falling rates of unemployment—the hypoth­e­sized rela­tion holds).

Fig­ure 4: M1 Money sup­ply growth and unem­ploy­ment

The cor­re­la­tion with M0, on the other hand, has the wrong sign (0.42): increases in the rate of growth of M0 are cor­re­lated with increases in the rate of unem­ploy­ment.

Fig­ure 5: M0 Money sup­ply growth and unem­ploy­ment

The pos­si­bil­ity that this appar­ent para­dox reflects the fact that mon­e­tary pol­icy acts with a lag is dis­pelled in Table 2 on page 11, which shows that though the neg­a­tive cor­re­la­tion of changes in M1 does strengthen (peak­ing at –0.5 at a 12 month lag), the pos­i­tive cor­re­la­tion between changes in M0 and unem­ploy­ment remains. One way to make sense of this para­dox is to con­clude that, con­trary to Bernanke’s inter­pre­ta­tion, the Fed­eral Reserve dur­ing the 1930s did try to counter the Great Depres­sion by expand­ing the money sup­ply, but that not until 1938 were its attempts suc­cess­ful. This infor­ma­tion was masked by sta­tis­ti­cal analy­sis that used M1 rather than M0, since only M0 is directly under the con­trol of the Fed­eral Reserve. Sub­tract­ing M1 from M0 con­firms this hypoth­e­sis: non-M0 M1 is more strongly cor­re­lated with unem­ploy­ment than M1 alone (-0.41, peak­ing at –0.52 with an 8 month lag).

Fig­ure 6: Non-M0 M1 Money sup­ply growth and unem­ploy­ment

A sec­ond way to resolve the para­dox fol­lows from the first. Since M1 (and more expan­sive def­i­n­i­tions of the money sup­ply) is deter­mined by the actions of the pri­vate finan­cial sys­tem as well as the Fed­eral Reserve, the pub­lic and pri­vate money cre­ation sys­tems were work­ing in oppos­ing direc­tions in the 1930s. For the first eight years, the pri­vate sector’s reduc­tions in credit over­whelmed the pub­lic sector’s attempts to expand the money sup­ply. By mid-1938, when the USA’s pri­vate debt to GDP ratio had fallen to 140 per­cent of GDP (from its defla­tion-enhanced peak of 238 per­cent in 1932), sub­stan­tial increases in M0 were able to expand the aggre­gate money sup­ply and increase eco­nomic activ­ity by enough to cause unem­ploy­ment to fall.

This inter­pre­ta­tion brings us to the debt-dri­ven analy­sis of the Beze­mer-Full­brook Group, applied in this instance to the Great Depres­sion. From this per­spec­tive, both the boom of the 1920s and the slump of the Great Depres­sion were caused by chang­ing lev­els of debt in an econ­omy that had become fun­da­men­tally spec­u­la­tive in nature. Ris­ing debt used to finance spec­u­la­tion dur­ing the 1920s made that decade “The Roar­ing Twen­ties”, while pri­vate sec­tor delever­ag­ing when the spec­u­la­tive bub­ble burst caused a col­lapse in aggre­gate demand that ush­ered in the Great Depres­sion in the 1930a. Fig­ure 7 illus­trates both the ris­ing debt of the 1920s and the falling debt of the 1930s.

Fig­ure 7: US Pri­vate Debt and Nom­i­nal GDP, 1920–1940

Fig­ure 8 illus­trates how much the increase in debt dur­ing the 1920s added to demand, and then how much its fall in the 1930s sub­tracted from demand.

Fig­ure 8: Aggre­gate demand is the sum of GDP plus the change in debt

Fig­ure 9 cor­re­lates the change in debt with the unem­ploy­ment rate: the cor­re­la­tion has the expected sign, and is sig­nif­i­cantly larger than that for either M1 or M1-M0 (up to –0.85 for a lag of 15 months; see Table 2 on page 11).

Fig­ure 9: Change in pri­vate debt and unem­ploy­ment

Table 2: Lagged cor­re­la­tions between changes in mon­e­tary vari­ables and unem­ploy­ment

This brings us to the cur­rent finan­cial cri­sis, and why—on the analy­sis of those who pre­dicted it—this cri­sis is far from over.

The Great Moderation and the Great Recession

As is well known, a major topic in main­stream macro­eco­nomic debate was explain­ing the sources of “The Great Mod­er­a­tion” (Bernanke (2004); see also Davis and Kahn (2008) and Gali and Gam­betti (2009)). Now the focus­ing is on explaining—and hope­fully escap­ing from—“The Great Reces­sion” that fol­lowed it. From the point of view of the Beze­mer-Full­brook Group, these two events have the same cause, as did the Roar­ing Twen­ties and the Great Depres­sion before them: a debt-dri­ven spec­u­la­tive boom, fol­lowed by a delever­ag­ing-dri­ven down­turn. As an aside, there is no doubt that Ben Bernanke is apply­ing the lessons he took from the Great Depres­sion in his attempts to avoid a sec­ond such cri­sis. Fig­ure 10 shows the annual rate of change of M0, M1, M2 and M3 (which the Fed stopped record­ing in 2006) over the two decades since 1990. Growth in M0 is off the scale from late 2008 until early 2010, as the Fed­eral Reserve more than dou­bled the level of base money (the aver­age annual rate of growth of M0 over this period exceeded 100%). How­ever, as dur­ing the Great Depres­sion, broader mea­sures of the money sup­ply are fail­ing to respond as dra­mat­i­cally. While there has been growth in M1, it has been one sixth that of M0 (and mea­sured M0 now exceeds M1); M2’s growth never exceeded 10 per­cent and is now close to zero; it is likely that growth in the now unrecorded M3 is either ane­mic or neg­a­tive.

Fig­ure 10: Changes in US money stock lev­els since 1990

Changes in debt, on the other hand, were dra­matic. Fig­ure 11 and Fig­ure 12 are the mod­ern equiv­a­lent of Fig­ure 7 and Fig­ure 8 from the 1920s-1940s, and it is evi­dent that the level of debt-financed demand dur­ing “the Great Mod­er­a­tion” far exceeded the level of The Roar­ing Twen­ties.

Fig­ure 11: US pri­vate debt and GDP 1990–2010

Fig­ure 12: US aggre­gate demand 1990–2010

How­ever, the neg­a­tive con­tri­bu­tion from delever­ag­ing has yet to approach the max­i­mum lev­els set dur­ing the Great Depres­sion. The debt con­tri­bu­tion to demand began at a far higher level this time than last, peak­ing at 22% in 2008 ver­sus at 8.7% in 1928. On this basis, the fall in aggre­gate demand caused by pri­vate sec­tor delever­ag­ing today is more rapid than in the 1930s, has not reached the max­i­mum rate sus­tained dur­ing the Great Depres­sion, and shows no signs of abat­ing. Fig­ure 13 graphs the debt con­tri­bu­tion to aggre­gate demand—defined as the annual change in debt, divided by the sum of GDP plus the annual change in debt. On this mea­sure, delever­ag­ing since the peak level of debt in 2008 has been more severe than delever­ag­ing from the com­pa­ra­ble level in 1928, and the reduc­tion in demand from pri­vate sec­tor delever­ag­ing shows no signs of abat­ing.

Fig­ure 13: Com­par­ing the Great Depres­sion and the Great Reces­sion from both pri­vate and gov­ern­ment bor­row­ing

The rela­tion­ship between change in debt and unem­ploy­ment is also much stronger over the period 1990–2010 (a cor­re­la­tion of –0.95) than it was for the period from 1930 till 1940.

Fig­ure 14: Cor­re­la­tion of change in pri­vate debt and unem­ploy­ment, 1990–2010

Lags now make lit­tle dif­fer­ence to the results (pre­sum­ably because all data is now quar­terly or monthly in fre­quency).

Table 3: Lags add no explana­tory power to the cor­re­la­tions

On the indi­ca­tor of choice by the group that antic­i­pated the GFC, it there­fore appears that the GFC is far from over. This raises one final empir­i­cal issue before I con­sider the the­o­ret­i­cal foun­da­tions of the Beze­mer-Full­brook Group: if pri­vate sec­tor delever­ag­ing this time round is falling from a greater level and at a greater rate than in the 1930s, then why has the econ­omy sta­bi­lized (to some extent) now, ver­sus the almost relent­less decline of the Great Depres­sion? The answer appears to lie in the scale of the gov­ern­ment response to this cri­sis. Fig­ure 13 (on page 14) includes the impact of gov­ern­ment debt on aggre­gate demand. While this added sub­stan­tially to demand dur­ing the depths of the Great Depres­sion (more than 7% of aggre­gate demand between 1931 and 1933 was financed by gov­ern­ment debt), in 1930–2 years after the peak rate of growth of pri­vate debt in 1928—government debt added a mere 1.2% to aggre­gate demand. This time, given the fear of another Great Depres­sion that pol­i­cy­mak­ers had in 2008, the gov­ern­ment response has been far larger and more imme­di­ate. In 2010, gov­ern­ment debt was respon­si­ble for over 12% of aggre­gate demand, and this almost coun­ter­acted the –15% con­tri­bu­tion from pri­vate sec­tor delever­ag­ing. While this suc­cess is heart­en­ing, the fig­ures indi­cate that growth can­not be expected to con­tinue if the gov­ern­ment deficit is reduced. Pri­vate sec­tor delever­ag­ing is still accel­er­at­ing and has some time to go before it could be expected to slow. In the absence of net gov­ern­ment spend­ing, it is highly likely that the down­ward spi­ral in out­put and employ­ment would con­tinue.

Non-mainstream modeling of the GFC

Only two of the econ­o­mists in the Beze­mer-Full­brook Group employ math­e­mat­i­cal macro­eco­nomic mod­els in their research: Wynne God­ley (God­ley (1999), God­ley and Izuri­eta (2002), God­ley and Izuri­eta (2004), God­ley and Lavoie (2007)) and myself (Keen (1995), Keen (2000), Keen (2008), Keen (2009a), Keen (2009b), Keen (2009d)). Both authors’ mod­els dif­fer sub­stan­tially from main­stream “Neo­clas­si­cal” mod­els, in that they explic­itly eschew con­cepts of opti­miz­ing agents, work in aggrega­tive and gen­er­ally mon­e­tary terms, and dis­play non-equi­lib­rium-revert­ing dynam­ics.


Godley’s mod­els employed an account­ing frame­work he described as “stock-flow con­sis­tent” on the basis that account­ing must be cor­rect, and only a lim­ited degree of ratio­nal­ity is needed to accu­rately model eco­nomic behav­ior:

Post Key­ne­sian eco­nom­ics … is some­times accused of lack­ing coher­ence, for­mal­ism, and logic. The method pro­posed here is designed to show that it is pos­si­ble to pur­sue het­ero­dox eco­nom­ics, with alter­na­tive foun­da­tions, which are more solid than those of the main­stream. The stock-flow mon­e­tary account­ing frame­work pro­vides such an alter­na­tive foun­da­tion that is based essen­tially on two prin­ci­ples.

First, the account­ing must be right. All stocks and all flows must have coun­ter­parts some­where in the rest of the econ­omy. The water­tight stock flow account­ing imposes sys­tem con­straints that have qual­i­ta­tive impli­ca­tions. This is not just a mat­ter of log­i­cal coher­ence; it also feeds into the intrin­sic dynam­ics of the model.

Sec­ond, we need only assume, in con­trast to neo­clas­si­cal the­ory, a very lim­ited amount of ratio­nal­ity on the part of eco­nomic agents. Agents act on the basis of their bud­get con­straints. Oth­er­wise, the essen­tial ratio­nal­ity prin­ci­ple is that of adjust­ment. Agents react to what they per­ceive as dis­e­qui­lib­ria, or to the dis­e­qui­lib­ria that they take note of, by mak­ing suc­ces­sive cor­rec­tions. There is no need to assume opti­miza­tion, per­fect infor­ma­tion, ratio­nal expec­ta­tions, or gen­er­al­ized price-clear­ing mech­a­nisms. (Lavoie and God­ley (2000, p. 307))

Fig­ure 15 gives an exam­ple of the God­ley social account­ing matrix.

Fig­ure 15: An exam­ple of the God­ley social account­ing matrix (God­ley (1999, p. 395))

Fig­ure 16 shows a sim­u­la­tion from this model.

Fig­ure 16: Results of a sim­u­la­tion of the model in God­ley (1999, p. 400)

Mod­els are assem­bled from the stock-flow matrix. For exam­ple, house­hold dis­pos­able income in nom­i­nal terms is defined as:

Fig­ure 17: Equa­tion for house­hold dis­pos­able income in God­ley (1999, p. 405)

These terms are taken from the House­holds col­umn of Fig­ure 15, and are the sum of income from prof­its, wages and inter­est pay­ments plus changes in house­hold bank bal­ances. On the basis of pro­jec­tions using this frame­work and US data, God­ley observed in 2002 and again in 2004 that the US seemed inevitably headed for a seri­ous reces­sion:

So the medium term alter­na­tives for the US econ­omy look pretty stark. Either an uncon­venanted and sus­tained rise in net export demand pro­vides a motor for expan­sion in a quite new way; or the fis­cal pol­icy con­tin­ues to gen­er­ate twin (bud­get and bal­ance of pay­ments) deficits, pos­si­bly grow­ing …, or the US econ­omy relapses into stag­na­tion. (God­ley and Izuri­eta (2004, p. 138))


I con­cur with God­ley on the need for accu­rate account­ing, and the capac­ity to model macro­dy­namic behav­ior with only real­is­tic lev­els of rationality—by which I mean that agents ratio­nally react to their own sit­u­a­tion, but nei­ther know nor can pre­dict the char­ac­ter­is­tics or future behav­ior of the entire econ­omy. They there­fore employ “rules of thumb” in their reac­tions to rel­e­vant eco­nomic stim­uli (where these reac­tions tend to be con­sis­tent within each social class, but dif­fer between classes). The most impor­tant rule of thumb is that iden­ti­fied by Keynes in 1936:

The essence of this convention—though it does not, of course, work out quite so simply—lies in assum­ing that the exist­ing state of affairs will con­tinue indef­i­nitely, except in so far as we have spe­cific rea­sons to expect a change. Keynes (1936, p. 152)

The assump­tion of a con­tin­u­ance of cur­rent con­di­tions in the highly non­lin­ear real world (and its sim­u­lacrum in these mod­els) leads to unex­pected out­comes and hence changes in both the model and the state of expec­ta­tions. I add to Godley’s method an insis­tence on mod­el­ing social classes dis­tinctly (I do not employ an aggre­gate house­hold sec­tor, but instead divide agents into at the min­i­mum cap­i­tal­ists, work­ers and bankers), and I work in con­tin­u­ous time rather than the more awk­ward if sim­pler frame­work of dis­crete time (see Keen (2006) and Keen (2008)). I employ two dif­fer­ent frame­works in my mod­els: an exten­sion of Goodwin’s growth cycle model (Good­win (1967)) to include debt (Keen (1995)), and a devel­op­ment of Godley’s stock-flow con­sis­tent frame­work in con­tin­u­ous time (Keen (2008), Keen (2009a)). The for­mer set of mod­els gen­er­ate debt dynam­ics that, under some ini­tial con­di­tions, qual­i­ta­tively approx­i­mate the debt accu­mu­la­tion data seen in Fig­ure 1. The mod­els are expressed as sys­tems of cou­pled ordi­nary dif­fer­en­tial equa­tions (Fig­ure 18).

Fig­ure 18: Equa­tions for the model in Keen (2009d, p. 353)

In this sys­tem, the state vari­ables are respec­tively GDP, the wage rate, pri­vate debt, the level of spec­u­la­tive invest­ment as a frac­tion of GDP, labour pro­duc­tiv­ity, and pop­u­la­tion (g, ?r and ? are vari­ables rep­re­sent­ing the rate of growth, profit rate and the employ­ment rate that them­selves depend on the val­ues of the state vari­ables). With­out spec­u­la­tive borrowing—defined as bor­row­ing that finances spec­u­la­tion on asset prices but does not finance the con­struc­tion of new assets—the model gen­er­ates a cycli­cal sys­tem which gen­er­ally does not break down; with spec­u­la­tive bor­row­ing, the model almost inevitably approaches a cri­sis caused by the accu­mu­la­tion of debt to lev­els that exceed the economy’s debt ser­vic­ing capac­ity.

Fig­ure 19: Results of a sim­u­la­tion with the model in Keen (2009d)

Fig­ure 20: Results of a sim­u­la­tion with the model in Keen (2009d) con­tin­ued

My own ver­sion of Stock-Flow con­sis­tent mod­el­ing uses a tab­u­lar approach to build­ing sys­tems of cou­pled dif­fer­en­tial equa­tions. The sys­tem states are bank accounts attrib­uted to spe­cific social classes, and the rows in each table reflects flows between accounts. The mod­els are derived sim­ply by sym­bol­i­cally adding up the columns of the rel­e­vant matrix. An exam­ple sys­tem is shown in Table 4.

Table 4: A sam­ple table of finan­cial flows (Keen (2009c))

Bank Accounts

Assets (Reserves & Loans)

Lia­bil­i­ties (Deposits)

Actions Reserves (BR) Loans (FL) Firms (FD) Work­ers (WD) Banks (BI)
A Com­pound Inter­est


B Pay Inter­est




C Deposit Inter­est



D Wages



E Worker Inter­est



F+G Con­sump­tion




H Loan Repay­ment




I Money relend­ing




J Money cre­ation



K Res­cue Banks


Res­cue Firms


The dynam­ics of the model are sim­ply given by adding up the sym­bolic entries in each col­umn (Table 5):

Table 5: Dynam­ics of the model shown in Table 4 

Rate of change of… Equals…
Bank Reserves BR H-I+K
Firm Loans FL –H+I+J
Firm Deposits FD –B+C-D+F+G-H+I+J+K
Worker Deposits WD D+E+F
Bank Income BI +B-C-E-G

Each of the sym­bols A to K is replaced by a suit­able oper­a­tor based on the 5 sys­tem states in the model (Table 6):

Table 6: Sym­bolic sub­sti­tu­tions for the model in Table 5 

Action Descrip­tion Terms
A Com­pound Inter­est Out­stand­ing debt FL is increased at the rate of inter­est on loans rL.


B Pay Inter­est Accrued inter­est on out­stand­ing debt is paid. This involves a trans­fer from the firm sector’s deposits FD to the bank sector’s income account BI, and the record­ing of this trans­fer on the debt ledger FL.


C Deposit Inter­est Inter­est is paid (at the lower rate rD) on the bal­ance in the firm sector’s deposit account


D Wages This is a trans­fer from the firm sector’s deposit accounts to work­ers’ deposit accounts WD, using two insights from Marx: firstly that the sur­plus in pro­duc­tion is dis­trib­uted between work­ers and cap­i­tal­ists (in shares that sum to 1 in this model–so work­ers get 1-s and cap­i­tal­ists get s); sec­ondly that there is a turnover period (?S as a frac­tion of a year) between M and M+ (see Cap­i­tal II Chap­ter 12).


E Worker Inter­est The deposit inter­est rate times the bal­ance in work­ers’ accounts.


F+G Con­sump­tion This employs the con­cept of a time lag–the length of time it takes work­ers to spend their wages is 2 weeks (say) or 1/26th of a year so that ?W equals 1/26. Wealth­ier bankers spend their account bal­ances much more slowly.


H Loan Repay­ment The rate of loan repay­ment is pro­por­tional to the out­stand­ing level of loans divided by the time lag ?L in loan repay­ment (for a stan­dard hous­ing loan this would be shown as ?L =25)


I Money relend­ing The rate of new money cre­ation is the bal­ance in the bank­ing sector’s unlent reserves, divided by a turnover lag rep­re­sent­ing how rapidly exist­ing money is recy­cled.


J Money cre­ation The rate of new money cre­ation is the bal­ance in the firm sector’s deposit account, divided by a time lag that rep­re­sents the length of time it takes for the money sup­ply to dou­ble.


K Res­cue Banks This is a ‘Deus Ex Machina’ injec­tion of 100 cur­rency units one year after the cri­sis begins, for a period of one year, into either the bank­ing sec­tors reserves BR or the firm sector’s deposit accounts FD.


Res­cue Firms

The model’s equa­tions are as shown in

Fig­ure 21: Equa­tions for the model sim­u­lated in Keen (2009a) and Keen (2009c)

A sim­u­la­tion of a credit crunch and two dif­fer­ent pol­icy responses is shown in Fig­ure 22.

Fig­ure 22: Sim­u­la­tion of a credit crunch using the model in Keen (2009c)


The core propo­si­tions shared by the Beze­mer-Full­brook group were that the super­fi­cially good eco­nomic per­for­mance dur­ing “The Great Mod­er­a­tion” was dri­ven by a debt-financed spec­u­la­tive bub­ble, which would nec­es­sar­ily burst because the debt added to the economy’s ser­vic­ing costs with­out increas­ing its capac­ity to finance those costs. At some stage, the growth of unpro­duc­tive debt had to fal­ter, and when it did a seri­ous finan­cial cri­sis would ensue as aggre­gate demand col­lapsed. The pol­icy res­cues since that pre­dic­tion came true have not addressed the fun­da­men­tal cause of the cri­sis, which was the exces­sive level of pri­vate debt. The delever­ag­ing that the Group pre­dicted has thus been slowed to some degree by gov­ern­ment action, but the need for that delever­ag­ing has not been removed. As Fig­ure 13 in par­tic­u­lar empha­sizes, the scale of that poten­tial delever­ag­ing appears cer­tain to exceed that expe­ri­enced in the Great Depres­sion.

Bat­tellino, R. 2007, ‘Some Obser­va­tions On Finan­cial Trends’, Reserve Bank of Aus­tralia Bul­letin, vol. 2007, no. Octo­ber, pp 14–21.

Bernanke, B. S. 1995, ‘The Macro­eco­nom­ics of the Great Depres­sion: A Com­par­a­tive Approach’, Jour­nal of Money, Credit, and Bank­ing, vol. 27, no. 1, pp 1–28.

Bernanke, B. S. 2000, Essays on the Great Depres­sion, Prince­ton Uni­ver­sity Press, Prince­ton.

Bernanke, B. S. 2002, ‘Remarks by Gov­er­nor Ben S. Bernanke’, paper pre­sented to Con­fer­ence to Honor Mil­ton Fried­man, Uni­ver­sity of Chicago, Chicago, Illi­nois, Novem­ber 8, 2002.

Bernanke, B. S. 2004, ‘The Great Mod­er­a­tion: Remarks by Gov­er­nor Ben S. Bernanke At the meet­ings of the East­ern Eco­nomic Asso­ci­a­tion, Wash­ing­ton, DC Feb­ru­ary 20, 2004’, paper pre­sented to East­ern Eco­nomic Asso­ci­a­tion, Wash­ing­ton, DC.

Beze­mer, D. J. 2009, ’”No One Saw This Com­ing”: Under­stand­ing Finan­cial Cri­sis Through Account­ing Mod­els’, Fac­ulty of Eco­nom­ics Uni­ver­sity of Gronin­gen, Gronin­gen, The Nether­lands.

Davis, S. J. and Kahn, J. A. 2008, ‘Inter­pret­ing the Great Mod­er­a­tion: Changes in the Volatil­ity of Eco­nomic Activ­ity at the Macro and Micro Lev­els’, Jour­nal of Eco­nomic Per­spec­tives, vol. 22, no. 4, pp 155–180.

Fisher, C. and Kent, C. 1999, ‘Two Depres­sions, One Bank­ing Col­lapse’, in Reserve Bank of Aus­tralia Research Dis­cus­sion Papers, vol. 1999, Reserve Bank of Aus­tralia, Syd­ney, NSW, Aus­tralia.

Fisher, I. 1933, ‘The Debt-Defla­tion The­ory of Great Depres­sions’, Econo­met­rica, vol. 1, no. 4, pp 337–357.

Fried­man, M. and Schwartz, A. J. 1963, A mon­e­tary his­tory of the United States 1867–1960, Prince­ton Uni­ver­sity Press, Prince­ton.

Full­brook, E. 2010, ‘Keen, Roubini and Baker win Revere Award for Eco­nom­ics’, in Real World Eco­nom­ics Review Blog, vol. 2010, ed E. Full­brook, Real World Eco­nom­ics Review, New York.

Gali, J. and Gam­betti, L. 2009, ‘On the Sources of the Great Mod­er­a­tion’, Amer­i­can Eco­nomic Jour­nal: Macro­eco­nom­ics, vol. 1, no. 1, pp 26–57.

God­ley, W. 1999, ‘Money and Credit in a Key­ne­sian Model of Income Deter­mi­na­tion’, Cam­bridge Jour­nal of Eco­nom­ics, vol. 23, no. 4, pp 393–411.

God­ley, W. and Izuri­eta, A. 2002, ‘The Case for a Severe Reces­sion’, Chal­lenge, vol. 45, no. 2, pp 27–51.

God­ley, W. and Izuri­eta, A. 2004, ‘The US Econ­omy: Weak­nesses of the ‘Strong’ Recov­ery’, Banca Nazionale del Lavoro Quar­terly Review, vol. 57, no. 229, pp 131–139.

God­ley, W. and Lavoie, M. 2007, Mon­e­tary Eco­nom­ics: An Inte­grated Approach to Credit, Money, Income, Pro­duc­tion and Wealth, Pal­grave Macmil­lan, New York.

Good­win, R. 1967, ‘A growth cycle’, in Social­ism, Cap­i­tal­ism and Eco­nomic Growth, ed C. H. Fein­stein, Cam­bridge Uni­ver­sity Press, Cam­bridge.

Keen, S. 1995, ‘Finance and Eco­nomic Break­down: Mod­el­ing Minsky’s ‘Finan­cial Insta­bil­ity Hypoth­e­sis.”, Jour­nal of Post Key­ne­sian Eco­nom­ics, vol. 17, no. 4, pp 607–635.

Keen, S. 2000, ‘The Non­lin­ear Eco­nom­ics of Debt Defla­tion’, in Com­merce, com­plex­ity, and evo­lu­tion: Top­ics in eco­nom­ics, finance, mar­ket­ing, and man­age­ment: Pro­ceed­ings of the Twelfth Inter­na­tional Sym­po­sium in Eco­nomic The­ory and Econo­met­rics, ed W. A. Bar­nett, Cam­bridge Uni­ver­sity Press, New York.

Keen, S. 2006, ‘The Need and Some Meth­ods for Dynamic Mod­el­ling in Post Key­ne­sian Eco­nom­ics’, in Com­plex­ity, Endoge­nous Money and Macro­eco­nomic The­ory: Essays in Hon­our of Basil J. Moore, ed M. Set­ter­field, Chel­tenham, U.K. and Northamp­ton, Mass: Elgar.

Keen, S. 2008, ‘Keynes’s ‘revolv­ing fund of finance’ and trans­ac­tions in the cir­cuit’, in Keynes and Macro­eco­nom­ics after 70 Years, eds R. Wray and M. Forstater, Edward Elgar, Chel­tenham.

Keen, S. 2009a, ‘Bail­ing out the Titanic with a Thim­ble’, Eco­nomic Analy­sis & Pol­icy, vol. 39, no. 1, pp 3–24.

Keen, S. 2009b, ‘The dynam­ics of the mon­e­tary cir­cuit’, in The Polit­i­cal Econ­omy of Mon­e­tary Cir­cuits: Tra­di­tion and Change, eds S. Rossi and J.-F. Pon­sot, Pal­grave Macmil­lan, Lon­don.

Keen, S. 2009c, ‘The Global Finan­cial Cri­sis, Credit Crunches and Delever­ag­ing’, Jour­nal Of Aus­tralian Polit­i­cal Econ­omy, vol. 64, pp 18–32.

Keen, S. 2009d, ‘House­hold Debt-the final stage in an arti­fi­cially extended Ponzi Bub­ble’, Aus­tralian Eco­nomic Review, vol. 42, pp 347–357.

Keynes, J. M. 1936, The gen­eral the­ory of employ­ment, inter­est and money, Macmil­lan, Lon­don.

Kir­man, A. 1989, ‘The Intrin­sic Lim­its of Mod­ern Eco­nomic The­ory: The Emperor Has No Clothes’, Eco­nomic Jour­nal, vol. 99, no. 395, pp 126–139.

Kyd­land, F. E. and Prescott, E. C. 1990, ‘Busi­ness Cycles: Real Facts and a Mon­e­tary Myth’, Fed­eral Reserve Bank of Min­neapo­lis Quar­terly Review, vol. 14, no. 2, pp 3–18.

Lavoie, M. and God­ley, W. 2000, ”Kaleck­ian Mod­els of Growth in a Stock-Flow Mon­e­tary Frame­work: A Neo-Kaldo­rian Model,”, Levy Eco­nom­ics Insti­tute, The, Eco­nom­ics Work­ing Paper Archive.

Min­sky, H. P. 1982, Can “it” hap­pen again? : essays on insta­bil­ity and finance, M.E. Sharpe, Armonk, N.Y.

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About Steve Keen

I am Professor of Economics and Head of Economics, History and Politics at Kingston University London, and a long time critic of conventional economic thought. As well as attacking mainstream thought in Debunking Economics, I am also developing an alternative dynamic approach to economic modelling. The key issue I am tackling here is the prospect for a debt-deflation on the back of the enormous private debts accumulated globally, and our very low rate of inflation.
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  • sir­ius


    Mas­sive fraud…I see many well writ­ten arti­cles but the fol­low­ing arti­cle cov­ers much ground and psy­chol­ogy


    I don’t want to get “off-topic” but I wanted to stress that there are many like-minded peo­ple that realise that the GFC could not have sur­faced with­out fraud on a mas­sive scale.

    *But* I would state cat­e­gor­i­cally that our mon­e­tray sys­tem is based upon per­pet­ual growth on a finite planet as well as some other things that sim­ply are invalid. (That is if one cares about all peo­ple on the planet and the state of the planet itself). From this point of view this sys­tem needs a com­plete re-write even with­out the pres­ence of fraud. 

    I think Mr Keen’s efforts will allow peo­ple to appre­ci­ate this more clearly by ignor­ing the fraud aspects.

    Per­son­ally I find the sys­tem so all-pre­va­sive that it pre­vents me from liv­ing the (sus­tain­able for the plantet) life I would wish to lead.

    Even 10 years ago I could see the direc­tion things were tak­ing — my wage stay­ing the same while house prices aoared. I could clearly see that there was a “con” in progress but sim­ply did not appre­ci­ate the (very sim­ple) mech­a­nism.

    I knew when I sold my house that the price I had received was far much more than it should have been. Did I accept the money (credit)? Yes I did, sim­ply because I was coerced by the sys­tem to do do since the house that I would buy had gone up in price also.

    Put sim­ply I had no (rea­son­able) choice. This is the prob­lem with a global fraud­u­lent sys­tem — there is no choice to evade the fraud. I say this after try­ing out 2 other coun­tries. The same game played every­where.

  • Re #10 Gamma,

    Yes that’s correct–I’m using pre­dom­i­nantly the data from D02, sup­ple­mented in some graphs by data from D04, fol­low­ing advice from the RBA:

    Email from RBA on this topic:
    Dear Steve

    Busi­ness debt should cap­ture busi­ness credit (from Bul­letin table D.2)and non-inter­me­di­ated debt such as short and long-term secu­ri­ties issued both in Aus­tralia and off­shore (from Bul­letin Table D.4, columns C, Hand O). To be more accu­rate, you should also con­sider a mea­sure of cross-bor­der lend­ing to busi­nesses in Aus­tralia. How­ever, items such as asset-backed secu­ri­ties and Eurobonds from Bul­letin table D.4 should not be con­sid­ered as they are not a part of busi­ness lia­bil­i­ties in Aus­tralia. An alter­na­tive source of data for busi­ness debt is the ABS Finan­cial Accounts (#5302).Yours sin­cerely Lynne

    I haven’t had the time to explore the ABS sources in detail.

  • mar­venger1


    Looks like another great post which unfor­tu­nately i don’t have time to read in detail yet. Sorry to get off topic — feel free to ignore 🙂 — I was actu­ally inter­ested how aware you were of the work of Pasinetti, think he might be clas­si­fied as post-key­ne­sian. I’ve only just started to read him and it seems he focuses more on mod­el­ling the pro­duc­tion econ­omy in a dynamic way where the struc­ture of the econ­omy is allowed to change in response to tech­ni­cal changes and demand is given pri­or­ity in deter­min­ing what is pro­duced — not much of a mon­e­tary focus. This demand fol­lows a heirachi­cal devel­op­ment as national incomes rise. So I guess he’s more rel­e­vant to delevop­ment eco­nom­ics but not wholly so. 

    Cen­tral to his analy­sis is a philo­soph­i­cal focus on the con­sis­tent wage rate in a coun­try reflect­ing the aver­age pro­duc­tiv­ity in the coun­try. His analy­sis seems the most con­vinc­ing to me so far of ‘plan­ning’ that can the­o­ret­i­cally cre­ate sta­bil­ity and full employ­ment — always a mov­ing tar­get and just by luck that you ever reach full employ­ment.

    Well I was just inter­ested if you had given Pasinetti’s ver­ti­cally inte­grated mod­els with ‘nat­ural’ wage rates much thought and what you thought of them. 


  • Hi Mark,

    I know Pasinetti’s work fairly well, and regard the ver­ti­cally inte­grated approach as an unfor­tu­nately lin­ear approach to a non­lin­ear prob­lem. I also think avoid­ing money was a mistake–it’s actu­ally needed to make sense of the inter­sec­toral flows. But that said, he’s a giant of the non-neo­clas­si­cal world.

  • Brett in Man­hat­tan

    Caught you on the John Batch­e­lor show. You men­tioned you’d be in NYC in early July. Will you be doing any speak­ing gigs that the gen­eral pub­lic can attend?

  • Hi Brett,

    A col­league is organ­is­ing some­thing for an after­noon on the 6th-8th. I’ll add your name to the list of con­tacts and see what even­tu­ates.

    Cheers, Steve

  • can­cer­ward

    Bat­tellino also com­mented on the level of house­hold and for­eign debt today:


  • mar­venger1

    Thanks Steve

    I thought that might be the case. I guess I’m inter­ested in the nat­ural wage part as an effec­tive and per­haps fair way to cre­ate effec­tive demand with­out rely­ing on debt bub­bles that seem to be last resort when pro­duc­tiv­ity increases and shift­ing pro­duc­tion to cheap labour coun­tries dimin­ishes effec­tive demand. What are your thoughts on includ­ing this into a non-lin­ear model that incor­po­rates money?

  • cja

    @cancerward #32
    I noticed these points in rela­tion to house­hold debt:
    “As you know, house­hold debt has risen sig­nif­i­cantly faster than house­hold income since the early 1990s”

    Con­sid­er­ing that other per­sonal debt remained rel­a­tively flat, it would appear to be the only aspect of house­hold debt of con­cern, which he then con­firms:
    “Most of the rise was due to hous­ing debt, includ­ing debt used to fund invest­ment prop­er­ties. Other house­hold debt, which includes credit card debt, car loans, mar­gin loans and so on, has not changed much rel­a­tive to income over the period.”

    But then later, in rela­tion to inflated asset val­ues, says:
    ”…even if we exclude hous­ing and focus only on house­holds’ finan­cial assets…”
    So it’s all OK as long as we ignore the asset class related to the most sig­nif­i­cant increase in house­hold debt!

  • djc

    ak #17

    From your Bernanke quote: “Absent implau­si­bly large dif­fer­ences in mar­ginal spend­ing propen­si­ties among the groups…”

    This is some­thing that seems rea­son­able until you give it more than 10 sec­onds thought. One group is a lender who has money but no par­tic­u­lar desire to spend right now. The other is a bor­rower who has a very strong desire to spend imme­di­ately, strong enough to go into debt to do it. It seems to me that far from being “implau­si­ble” the dif­fer­ences in propen­sity to spend are inevitable and very large.

  • Philip

    Some arti­cles of inter­est:

    Aus­tralian hous­ing mar­ket ‘a time bomb’

    Mr Grantham, who is in Aus­tralia to meet with GMO clients in Syd­ney and Mel­bourne this week, said any bub­ble could be an excep­tion to the rule.

    Bub­bles have quite a few things in com­mon but hous­ing bub­bles have a spec­tac­u­lar thing in com­mon, and that is every one of them is con­sid­ered unique and dif­fer­ent,” he said.”

    Reserve Bank waters down fears of real estate hous­ing bub­ble in Aus­tralia (usual RBA pro­pa­ganda)

    It’s The Econ­o­mists, Stu­pid

    ECONned: How Unen­light­ened Self Inter­est Under­mined Democ­racy and Cor­rupted Cap­i­tal­ism

    In eConned, author Yves Smith reveals:

    –why the mea­sures taken by the Obama Admin­is­tra­tion are mere pal­lia­tives and are unlikely to pave the way for a solid recov­ery

    –how econ­o­mists have come to play a pro­foundly anti-demo­c­ra­tic role in pol­icy

    –how finan­cial mod­els and con­cepts that were dis­cred­ited more than thirty years ago are still widely used by banks, reg­u­la­tors, and investors

    –how man­age­ment and employ­ees of major finan­cial firms looted them, enrich­ing them­selves and leav­ing the mess to tax­pay­ers

    –how finan­cial reg­u­la­tion enabled preda­tory behav­ior by Wall Street towards investors

    –how eco­nom­ics has no the­ory of finan­cial sys­tems, yet econ­o­mists fear­lessly pre­scribe how to man­age them”

  • ak


    The coun­ter­party to the bor­row­ers in the mort­gage loans are not the lenders who do not want to con­sume so they want to invest and lend. 

    These lenders are needed to replen­ish the bank reserves. The coun­ter­party to the bor­row­ers are mostly the banks (the bank­ing sys­tem as a whole).

    Even if we look at the frac­tional reserve bank­ing money cre­ation model (which is flawed as the cau­sa­tion goes the other way around, money mul­ti­plier is not con­stant and mod­ern banks are not reserve con­strained due to the role of cen­tral banks as the lender of last resort) it is evi­dent that the bulk of money is cre­ated (“mul­ti­plied”) by banks when loans are extended and then destroyed when loans are repaid.

    Extend­ing the credit by the bank­ing sys­tem involves mul­ti­ply­ing the ini­tial deposit. Money is cre­ated. Repay­ing the debt does not return all the money to the lenders. Money is destroyed. There is not much of redis­tri­b­u­tion of income between agents. There is a process of redis­tri­b­u­tion of mon­e­tary flows (what include the income) and oblig­a­tions in time. Yes I know this sounds weird but if we under­stand how money is cre­ated the oppo­site process of money destruc­tion is also obvi­ous.

    This is what really dri­ves the busi­ness cycle.

    This is a very good paper pub­lished by BIS on func­tion­ing of the frac­tional reserve bank­ing sys­tem :

    The bank lend­ing chan­nel revis­ited”

    More gen­er­ally, quan­ti­ta­tive con­straints on bank lend­ing should be de-empha­sized. Even if one accepts the notion that deposits fall in response to tight pol­icy, banks nowa­days are able to eas­ily access whole­sale money mar­kets to meet their fund­ing liq­uid­ity needs.4 Impor­tantly, since banks are able to cre­ate deposits that are the means by which the non-bank pri­vate
    sec­tor achieves final set­tle­ment of trans­ac­tions, the sys­tem as a whole can never be short of funds to finance addi­tional loans. When a loan is granted, banks in the first instance cre­ate a new lia­bil­ity that is issued to the bor­rower. This can be in the form of deposits or a cheque drawn on the bank, which when redeemed, becomes deposits at another bank. A well­func­tion­ing inter­bank mar­ket over­comes the asyn­chro­nous nature of loan and deposit cre­ation across banks. Thus loans drive deposits rather than the other way around.5 This is the key fea­ture that dif­fer­en­ti­ates bank lend­ing from non-bank credit. Cap­i­tal mar­ket inter­me­di­a­tion, like barter and com­mod­ity money or cash-based sys­tems, requires that the cred­i­tor have on hand the means of pay­ment to deliver to the debtor before the credit is extended. In mod­ern finan­cial sys­tems, credit trans­ac­tion between non-bank agents essen­tially
    involves the trans­fer of deposits. Bank lend­ing, on the other hand, involves the cre­ation of bank deposits that are them­selves the means of pay­ment. A bank can issue credit up to a cer­tain mul­ti­ple of its own cap­i­tal, which is dic­tated either by reg­u­la­tion or mar­ket dis­ci­pline. Within this con­straint, the growth of bank lend­ing is deter­mined by the demand for and will­ing­ness of banks to extend loans. More gen­er­ally, all that is required for new loans is that banks are able to obtain extra fund­ing in the mar­ket. There is no quan­ti­ta­tive con­straint as such. Con­fu­sion some­times arises when the flow of credit is tied to the stock of sav­ings (wealth) when the appro­pri­ate focus should in fact be on the flow.”

  • TruthIs­ThereIs­NoTruth


    That’s essen­tially true if you for­give one or two innacu­ra­cies, or points which are under­em­pha­sised. The impor­tant dif­fer­ence between this descrip­tion and what I have seen before is that it includes the caveat “More gen­er­ally, all that is required for new loans is that banks are able to obtain extra fund­ing in the mar­ket”.

    Within this con­straint, the growth of bank lend­ing is deter­mined by the demand for and will­ing­ness of banks to extend loans” — this point needs to be expanded as this is in real­ity where all the action hap­pens. The bal­anc­ing forces in this whole mech­a­nism are that the mar­ginal cost of extra fund­ing in the mar­ket is gen­er­ally increas­ing, given eco­nomic con­di­tions kept con­stant. And, in a prop­erly func­tion­ing sys­tem like Aus­tralia, the will­ingess to extend loans is lim­ited by con­sid­er­a­tion of risk, in the whole mech­a­nism this should be the focal point. Credit cre­ation is con­strained by ris­ing mar­ginal cost of fund­ing and ris­ing mar­ginal risk in extend­ing extra loans. If you include that into the model than I can say that this is get­ting very close to what hap­pens in real­ity. The GFC is an inter­est­ing case study — the mar­ginal cost of funds was not increas­ing much and too much risk was tol­er­ated by cer­tain banks. Sub­se­quent reac­tion to that is a sharply ris­ing mar­ginal cost of funds and increased risk aver­sion and dis­ap­pear­ance of the most risk tol­er­ant enti­ties.

  • bald­bad­ger
  • ak


    Of course you are per­fectly right — this is how it works. I would only like to add that indi­vid­ual banks can­not assess long-term sys­temic risk increased by the growth of an assets bub­ble financed by credit money cre­ated by the whole bank­ing sys­tem. Even if that risk was prop­erly iden­ti­fied it is not in the inter­est of an indi­vid­ual bank to limit lend­ing just because the whole sys­tem may even­tu­ally col­lapse in 10 years time or so. 

    “a sit­u­a­tion in which mul­ti­ple indi­vid­u­als, act­ing inde­pen­dently, and solely and ratio­nally con­sult­ing their own self-inter­est, will ulti­mately deplete a shared lim­ited resource even when it is clear that it is not in anyone’s long-term inter­est for this to hap­pen.”

    Such a deci­sion can only be made by a cen­tral super­vi­sory body. In fact the pro­posal men­tioned in the arti­cle linked by Bald­bad­ger may par­tially address the issue and it goes along the lines of the orig­i­nal idea put for­ward by Steve to limit the max­i­mum size of mort­gage loans. 

    The reforms, to be sketched out in the Chancellor’s first Man­sion House speech in the City of Lon­don, rep­re­sent a rev­o­lu­tion for the City, since in the past banks have always had free­dom to decide to whom they can lend.
    The Bank and its Gov­er­nor, Mervyn King, would be able to pre­vent banks from lend­ing too much, or to over-extended cus­tomers, if they judge that this would desta­bilise the econ­omy. ”

  • djc


    I inter­preted the quote to mean that Bernanke was talk­ing about con­sumers. I would have been happy to con­cede your point except I have read today

    “Credit card debt over­took mort­gage debt as the main form of house­hold debt in June, 36.6 per cent com­pared to 33.9 per cent,” Mel­bourne Insti­tute research fel­low Dr Edda Claus said in a state­ment on Thurs­day.

  • djc


    I had to strug­gle to under­stand the y axis labelling in Fig­ures 10,11,12. I think you mean year 2000 = 0, 1990 = –10 etc; but “since 1990” doesn’t work for me.

  • Peter T


    This is a nice piece. I won­dered if the model might be expanded to include non-mon­e­tised (more pre­cisely, unpriced) areas of eco­nomic activ­ity? The avail­able sta­tis­tics and sim­ple arith­metic tell me that roughly 60% of eco­nomic activ­ity is unpriced — not traded in any mar­ket (house­holds, not-for-profit sec­tor, inter­nal to firms, gov­ern­ment tax and trans­fer…). This would seem to me to con­sti­tute a reser­voir which would affect the trends in the area you look at in sev­eral ways. One is that, in the 30s, a lot more peo­ple lived in rural areas or small towns, and hence had access to off-mar­ket resources, while large firms were often ver­ti­cally inte­grated. Both would mod­er­ate the impact of finan­cial crashes on real activ­ity, while exac­er­bat­ing the effect on the mar­ket sec­tor (each with­drawal from the mar­ket would be a larger frac­tion of the whole, hence have more impact). This option is now less avail­able, which would heighten the real impact, but cush­ion the finan­cial fall.

    Some such mech­a­nism would go some way to explain the dif­fer­ing out­comes in eg Spain and Italy (with larger off-mar­ket sec­tors) to the US or Aus­tralia.

    Any thoughts?

  • Yes you’re right djc–I’ll edit the axis.

  • ak

    Credit card debt over­took mort­gage debt as the main form of house­hold debt in June”

    It may come from this arti­cle:

    Credit cards ‘now main form of debt’”

    But this is just the num­ber of house­holds with debt not the amount they owe. The head­line of the story is writ­ten in such a way that it is dif­fi­cult to under­stand what it is about.

    A quick Google search shows more…
    “Its lat­est research found that in the June quar­ter, 36.6 per cent of house­holds had credit card debt, while 33.9 per cent had mort­gage debt.”

    The fol­low­ing data set may be a few years old but it shows the “Median amount owing on type of debt among house­holds with type of debt $‘000” “INDEBTED HOUSEHOLDS: COMPONENTS OF DEBT — 2005–06”


    Owner-occu­pied prop­erty 130.8
    Credit card 2.3

  • Steve, I don’t under­stand any­thing about those equa­tions because any of that math I learned I for­got or didn’t learn it. But, plain and clear is the idea of aggre­gate demand, where demand is greater than GDP. I don’t know how that is, but I would sus­pect the cap­i­tal flows and the trade deficits, along with accu­mu­lated inter­est and accu­mu­lat­ing cash bal­ances, held by non-debtors or net savers if you pre­fer, absorb the excess. This is prob­a­bly the source of high cor­po­rate prof­its we saw in the US dur­ing the mid­dle years of the past decade. 

    In any sense, the prob­lem is clearly, how do you clear the mar­ket with­out more debt, when the econ­omy has been addicted to it? It is fairly clear that deficit spend­ing isn’t going to work long term, as every coun­try that tries it is going to end up in the mess Greece finds itself. I have brought this up before and I believe you agreed with my con­clu­sion, that the mess was beyond repair this time and the solu­tions Min­sky was so on to had run their course. The con­trary is to go into total col­lapse, which of course is sui­cide. If I am read­ing these graphs cor­rectly, your point is this is going to take time. 

    What I see is a prob­lem of amaz­ing para­doxes. In itself, Fish­ers the­ory is cor­rect, but the solu­tion I see from it seeks to main­tain the prob­lem in some sense. The other para­dox is that assets and lia­bil­i­ties are one and the same and that to reduce lia­bil­i­ties means to reduce assets. Sav­ings is debt, thus the idea a coun­try has a high sav­ings rate means it also has a high debt rate. I believe the coun­try of Japan proves this out, as they saved so much they went broke. 

    The first thing that must be rec­og­nized is bank­ing is a scam that always leaves some­one besides the banker hold­ing the bag. I recently read some­thing a guy from the 1800’s named Lysander Spooner wrote about the devel­op­ment of bank­ing and how it was con­trary to the US Con­sti­tu­tion. What was con­trary was bank char­ters were granted to start. Sec­ondly, states weren’t to inter­fere in con­tracts between peo­ple and they allowed bankers to incor­po­rate. Incor­po­ra­tion allowed bankers to shield most of their assets and limit their lia­bil­ity. Spooner rec­og­nized that bank­ruptcy was the end result of all bank­ing, even­tu­ally and the depos­i­tors didn’t get paid. Being that money can only be insured by money, deposit insur­ance can only be paid for out of the money it insures. The money, all their is, can be used to buy the assets of the bank­ing sys­tem, which in itself extin­guishes the money. I think we agree that the share­hold­ers of the major banks involved in the worst of this should have been wiped out. Even bail­ing out bor­row­ers only stresses the idea that if you get in debt, it is pos­si­ble to get some­thing for free, while if you are respon­si­ble you get lit­tle or noth­ing

    It appears to me the cen­tral banks of the world should be closed, debts liq­ui­dated and the money sup­ply be enhanced by cash spent into the sys­tem. At the same time, a swift col­lapse would do the trick as well, with the gov­ern­ment restor­ing a debt free money sup­ply.

    What is going on now is kind of like giv­ing a over amped speed freak a shot of meth to keep him up. As I see it, the depos­i­tors of the bank­ing sys­tem own the assets of the bank­ing sys­tem once the cap­i­tal of the banks is wiped out. A for­mula for bail­ing this mess out should be attacked from the stand­point of these banks being insol­vent with the gov­ern­ment pro­vid­ing money, maybe by buy­ing back some of their own debt with legal ten­der and liq­ui­date this mess. The assets are still there in some form and we would merely see a wipe out of non-self liq­ui­dat­ing debt in the process. 

    I know this reads as a ram­bling post, but I hap­pen to believe we are past crit­i­cal on this mess and what is being done isn’t going to work because it is only geared to make the prob­lem worse. We need a solu­tion that isn’t in the text books, isn’t in a for­mula, because there isn’t a math­e­mat­i­cal solu­tion. The idea of main­tain­ing a GDP which is noth­ing but count­ing units tha bor­der on fic­tion in the first place and main­tain­ing prices, when it is appar­ent that to main­tain prices means we need more debt and in the process forstalls a solu­tion just isn’t going to work. It is the pop­u­lar solu­tion, but for years the pop­u­lar solu­tion has been one to find a way to keep spend­ing, to keep pil­ing on debt and imag­i­nary wealth. 

    What we have is a mass bank­ruptcy and I believe the present efforts are to main­tain soci­ety in a form of debt peon­age that is quite pos­si­bly going to lead us to the dark ages and away from a soci­ety of free men. Bank­rupt­cies deal with solv­ing impos­si­ble math­e­mat­i­cal solu­tions and com­ing to a solu­tion in a place where there isn’t one. In the mean­time, bankers are using a mas­sive amount of deriv­a­tive prod­ucts to appear to earn money and main­tain sol­vency where there is none, shift­ing the mon­e­tary bal­ances from oth­ers to them­selves while they oper­ate with­out real cap­i­tal. Hang­overs always fol­low binges, true whether we are talk­ing drink­ing binges or credit binges.

  • I believe bank lend­ing is con­strained in 3 ways. One, the cap­i­tal posi­tion of the bank, sec­ond, the avail­abil­ity of cred­it­wor­thy bor­row­ers who pos­sess the capac­ity to gen­er­ate enough cash flow from their oper­a­tions to repay the loan and third, the capac­ity of the bank to cover its lia­bil­i­ties. The third is what cre­ates a credit crunch. Once a bank runs out of liq­uid assets, it has to match its lend­ing with its capac­ity to attract deposits. Deposits are the result of lend­ing and in real­ity, deposits are not in them­selves loaned, but instead are bal­ances due between banks. If one bank has, lets say, $1 bil­lion in excess deposits, there is another bank that owes $1 bil­lion in deposits. 

    I took money and bank­ing in col­lege. To under­stand bank­ing, one needs to throw out the non­sense taught in money and bank­ing and under­stand bal­ance sheet account­ing instead. If there was only one bank and we had a cash­less soci­ety, all the money would rest in that bank. One must under­stand that all deposits are already owed cus­tomers. The reserve require­ments were for the rea­son that cus­tomers desired cash. The mul­ti­plier effect is for con­sump­tion only, as the real game is whether a bank is a legit­i­mate surety or not, as its posi­tion is to sup­port the liq­uid­ity needs of its cus­tomers and to guar­an­tee the funds on deposit are good. 

    What hap­pens as time goes on is the deposits in a bank are nec­es­sary for the pay­ment of the assets on the banks bal­ance sheet and with­out the deposits the loans rep­re­sent­ing the assets can’t be paid. As time goes on in a long term expan­sion, more and more of the deposits are owned by peo­ple who don’t owe the bank any money or far less money than is in the accounts and the net debtors begin to default. All the money is what is in the bank accounts or in cir­cu­lat­ing cur­rency, thus the capac­ity of a debtor to pay revolves around whether he can get his hands on the deposits. 

    Min­sky men­tioned in his book “Sta­bi­liz­ing an Unsta­ble Econ­omy” that by 1973, the banks had already cashed in their good col­lat­eral and had evolved finan­cial games to cre­ate liq­uid­ity from other sources. He said that one thing behind the recov­ery after the war was that banks and cus­tomers had plenty of trea­sury debt,which served the pur­pose of steady liq­uid­ity from the Fed. Out of trea­suries in the bank­ing sys­tem, Bernanke bought mort­gages, which really didn’t have a mar­ket over a year ago. Much of the TARP was repaid out of this money, but what it really did was allow banks funds to pay each other. That side of bank­ing has a far less impact on lend­ing and more impact in keep­ing the sys­tem itself liq­uid. This is not money as we would have it in our pock­ets or accounts, though it can be used to deliver cash to a cus­tomer. The first $1 tril­lion roughly was already cashed out and no longer was in the bank­ing sys­tem, but in places like the walls of Sad­dam Hussain’s palace. 

    I believe in mod­ern bank­ing, what lend­ing revolves around or what lim­its it is the cap­i­tal posi­tion of the bank and not the deposits or what peo­ple believe are reserves. The Fed didn’t print money, as the money rep­re­sented by the aseets bought was already in the accounts. They instead printed liq­uid­ity. What they didn’t cre­ate was cap­i­tal.

  • aagold

    Sorry if my ques­tion is not directly related to your post, but I’ve been won­der­ing about some­thing related to the con­cept of “Demand = GDP + change_in_debt” for a while, so I finally decided to reg­is­ter on your web­site and post this ques­tion.

    Why is “change_in_e­quity” ignored in the above equa­tion? I real­ize that change_in_e­quity applies only to the cor­po­rate and finan­cial sec­tors, not con­sumers or gov­ern­ment. So the effect on aggre­gate demand is prob­a­bly not as large as change_in_debt. Still, it seems like a sig­nif­i­cant omis­sion to me. When a cor­po­ra­tion issues new com­mon stock to finance invest­ment spend­ing, isn’t the effect on aggre­gate demand the same as if it issued new debt? 


  • Hi aagold,

    A change in equity doesn’t nec­es­sar­ily get spent; a change in debt where it involves either issu­ing new debt or retir­ing old debt does involve a change in spend­ing. It’s the direct link to expen­di­ture that I am focus­ing on.

    Of course there are changes in debt that don’t involve expenditure–such as going bank­rupt and hav­ing it writ­ten off. So the debt to expen­di­ture link isn’t per­fect. But it is far more direct than the change in the val­u­a­tion of assets–and in fact it also tends to be the real force dri­ving changes in asset val­u­a­tion in any case.

  • Hi aagold,

    I answered your ques­tion rather too quickly this morning–rushing for the plane in effect.

    The increase in equity issued by a cor­po­ra­tion doesn’t increase the money stock; its finance has to come from other peo­ple trans­fer­ring money to it. The issuance of new debt (or its retire­ment by a trans­fer from a debtor to a bank) does increase the money stock.