I met with Yves Smith of Naked Capitalism on the weekend, at a superb Japanese restaurant that only New York locals could find (and I’ll keep its location quiet for their benefit–too much publicity could spoil a spectacular thing). Yves was kind enough to post details of my latest academic paper at her site in a post she entitled “Steve Keen’s scary Minsky model“.

Yves found the model scary, not because it revealed anything about the economy that she didn’t already know, but because it so easily reproduced the Ponzi features of the economy she knows so well.

I have yet to attempt to fit the model to data–and given its nonlinearity, that won’t be easy–but its qualitative behavior is very close to what we’ve experienced. As in the real world, a series of booms and busts give the superficial appearance of an economy entering a “Great Moderation”–just before it collapses.

The motive force driving the crash is the ratio of debt to GDP–a key feature of the real world that the mainstream economists who dominate the world’s academic university departments, Central Banks and Treasuries ignore. In the model, as in the real world, this ratio rises in a boom as businesses take on debt to finance investment and speculation, and then falls in a slump when things don’t work out in line with the euphoric expectations that developed during the boom. Cash flows during the slump don’t allow borrowers to reduce the debt to GDP ratio to the pre-boom level, but the period of relative stability after the crisis leads to expectations–and debt–taking off once more.

Ultimately, such an extreme level of debt is accumulated that debt servicing exceeds available cash flows, and a permanent slump ensues–a Depression.

There are 4 behavioural functions in the model that mimic the behaviour of the major private actors in the economy–workers, capitalists and bankers. Workers wage rises are related to the level of employment and the rate of inflation; capitalists investment and debt repayment plans are related to the rate of profit; and the willingness of banks to lend is also a function of the rate of profit.

The model is explicitly monetary–with bank accounts for workers, bankers and capitalists–and the crisis is marked by a collapse in deposits and a rise in inactive bank reserves.

The same phenomenon is evident in the data, though the sharpness of the turnaround is far greater than can be replicated by the smooth functions in my model.

There’s a lot more work to do before the model is complete–notably including the impact of a goverment sector that can add its own spending power to a depressed economy–but its basic features fulfil Minsky’s challenge:

Can “It”-a Great Depression-happen again? And if “It” can happen, why didn’t “It” occur in the [first 35] years since World War II? These are questions that naturally follow from both the historical record and the comparative success of the past thirty-five years. To answer these questions it is necessary to have an economic the¬ory which makes great depressions one of the possible states in which our type of capitalist economy can find itself.

This is the first economic model ever that meets Minsky’s standards for realism. Its final stage emphasises a message that Michael Hudson, one of the very few others to see this crisis coming, puts very simply: “Debts that can’t be repaid, won’t be repaid”. As Americans now seem to be realising, the financial crisis has not gone away, because the debt that caused it is still there.

Having got ourselves into a debt-induced economic crisis, the only permanent way out is to reduce the debt–either directly by abolishing large slabs of it, or indirectly by inflating it away. I have very little confidence in the ability of the Federal Reserve to do the latter, while the former will take a level of political fortitude that is far beyond our current politicians.