Deleveraging, Deceleration and the Double Dip

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Much optimism flowed from last week's declaration by the National Bureau of Economic Research that the US recession officially ended in June 2009. How nice of them to let us know.

Markets reacted warmly and the 8 per cent rally in US stocks through September seemed more important than the revelation that the US Fed is worried enough about deflation to be planning another round of quantitative easing - dubbed 'QE 2'.

I wish I could share the market's (and the NBER's) irrational exuberance, but the key indicator that explains where the US economy and its already disastrous employment situation is headed implies that even QE2 won't set the US on a course to renewed prosperity.

It's also important to note that the 'strong' Q2 US earnings figures seen in July are partly the result of dramatic cost-cutting in US firms – a nice way of saying mass lay-offs. Nonetheless the stronger bottom lines keep producing market exuberance, even if the factors behind those bottom lines will lead to future deflation rather than a boom. As Forbes writer Joshua Brown puts it "there is an effervescence in the air as we head into the Q3 reporting period (starting October 7)". He thinks the market will once again turn south, and based on that pesky fundamental called the real economy, it should.

So should it on the basis of the key indicator that explains the origins of the apparent stabilisation that led the NBER to declare that the recession was over in June 2009.

For a long time I've focused on the contribution that the change in debt makes to aggregate demand, in the relation that "aggregate demand equals the sum of GDP plus the change in debt". An obvious extension of that was that "change in aggregate demand equals change in GDP plus accel­er­a­tion in the level of debt”—which would imply that change in unem­ploy­ment is dri­ven by changes in the rate of growth of debt.

Though I was aware of this impli­ca­tion of my analy­sis, I held off from test­ing it because I was con­cerned that this was push­ing the data one step too far.

A phys­i­cal sys­tem with a sim­i­lar rela­tion­ship between veloc­ity (the rate of change of one vari­able) and accel­er­a­tion (whether the veloc­ity of another vari­able is increas­ing or decreas­ing) would gen­er­ate a large vol­ume of suf­fi­ciently detailed data that the rela­tion­ship could be empir­i­cally tested.

But the eco­nomic sys­tem, with the large time lags in data col­lec­tion, sur­vey meth­ods rather than direct mea­sure­ment, and the dodgy prac­tices sta­tis­ti­cians are forced into by politi­cians and eco­nomic bureau­crats who often don’t want raw infor­ma­tion to be avail­able? I just thought that the rela­tion­ship, even though it made sense, wouldn’t be dis­cernible from pub­lished sta­tis­tics. So I held off.

It turns out that I shouldn’t have been so cau­tious: the data well and truly sup­ports this, on the sur­face, weird causal rela­tion: the change in employ­ment is strongly affected by the accel­er­a­tion or decel­er­a­tion of debt. This can give the para­dox­i­cal result that the level of employ­ment can rise, even when the econ­omy is delever­ag­ing, if the rate of delever­ag­ing slows. This phe­nom­e­non has dri­ven the appar­ent sta­bil­i­sa­tion of the US unem­ploy­ment rate (though of course the more mean­ing­ful U-6 mea­sure has risen to 17 per­cent, and Shad­ow­stats puts the actual unem­ploy­ment level at 22.5 per­cent–well and truly in Depres­sion ter­ri­tory), and it is highly unlikely that it will last.

My unchar­ac­ter­is­tic timid­ity means that I have to doff my cap in the direc­tion of the three econ­o­mists who first pub­lished on this topic: Biggs, Mayer and Pick. They first showed the cor­re­la­tion between what they called “the credit impulse”—the rate of change of the rate of change of debt, divided by GDP—and both GDP and employ­ment (for those who have access to research from Deutsche Secu­ri­ties, they have a sim­pler expla­na­tion of their analy­sis in Global Macro Issues for Decem­ber 17 2009: “The myth of the credit-less recovery”).

The chart below shows my con­fir­ma­tion of the rela­tion­ship with the data on the annual change in unem­ploy­ment in the USA and the annual rate of accel­er­a­tion of pri­vate debt since 1955. The cor­re­la­tion is –0.67: a stag­ger­ing cor­re­la­tion of a first and a sec­ond order vari­able over such a period, and across both booms and busts.

The two dot­ted red lines labelled “S” and “E” show when the NBER thinks this reces­sion started and ended, and they neatly coin­cide with turn­ing points in the credit impulse—an indi­ca­tor that the NBER is not even aware of, let alone one that it con­sid­ers when attempt­ing to date reces­sions.

Super­fi­cially, one might think that since the credit impulse does indi­cate when unem­ploy­ment is going to rise or fall, then the cur­rent data implies that the reces­sion is indeed over—even if the NBER doesn’t under­stand the actual causal dynam­ics at play.

But the chart also shows that there has never been a turn­down in credit like this one—the peak rate of decel­er­a­tion of debt was over 25 per­cent, ver­sus a mere minus 6 per­cent in the deep reces­sion of the 1970s. And though the rate of accel­er­a­tion of debt has the most direct impact on employ­ment, ulti­mately all three factors—the level of debt (com­pared to GDP), its rate of change, and whether that rate of change is increas­ing or decreasing—must be taken into account.

It’s com­pli­cated, so an anal­ogy with dri­ving makes it eas­ier to comprehend.

Con­sider a drive from Los Ange­les to some des­ti­na­tion East (if you’re an Aus­tralian reader, con­sider a drive West from Syd­ney), where the drive out rep­re­sents increas­ing debt, and the drive back home rep­re­sents falling debt.

The level of debt com­pared to GDP is like the dis­tance to be trav­elled, and today the US has a lot fur­ther to travel than it did in the 1950s: 5 times as far, in fact. It’s like the dif­fer­ence between a drive to New York and back, ver­sus a return trip to Utah.

The rate of change of debt (with respect to GDP) is like your speed of travel—the faster you drive, the sooner you’ll get there—but there’s a twist. On the way up, increas­ing debt makes the jour­ney more pleasant—the addi­tional spend­ing increases aggre­gate demand—and this expe­ri­ence is what fooled neo­clas­si­cal econ­o­mists (who ignore the role of debt) into believ­ing in “the Great Mod­er­a­tion”. But it increases the dis­tance you have to travel when you want to reduce debt, which is what the USA is now doing. So it’s great when you’re dri­ving from LA East (increas­ing debt), but lousy when you want to head home again (and reduce debt).

With that far to travel back home, you might be tempted to accelerate—which is akin to increas­ing the rate of change of the rate of change of debt (it’s a mea­sure of the g-forces, so to speak, when they can be gen­er­ated by either rapid accel­er­a­tion or rapid decel­er­a­tion). Accel­er­a­tion in the debt level when it was ris­ing again felt great on the way out: booms in the Ponzi Econ­omy the US has become were dri­ven by accel­er­a­tions in the rate of growth of debt. Equally, accel­er­a­tion in the oppo­site direc­tion feels dread­ful: as the rate of decline of debt increases, aggre­gate demand col­lapses and unem­ploy­ment explodes.

What actu­ally feels bet­ter in the reverse direc­tion is deceleration—reducing the rate at which debt is falling—and that’s what’s been hap­pen­ing in the last year.

But here’s the prob­lem: too much decel­er­a­tion and you actu­ally reverse direc­tion: you start head­ing East again, rather than return­ing home. That wouldn’t be a prob­lem if all you’d done was drive to Utah, but instead you’ve hit New York instead: drive any fur­ther, and you’re in the Atlantic.


With the level of debt the USA has accu­mu­lated, the prospect that any sec­tor of it (apart from the gov­ern­ment) can be enticed to go back into accu­mu­lat­ing debt once again is remote. So the decel­er­a­tion in the rate of reduc­tion of debt that is occur­ring right now will ulti­mately give way to at best a con­stant rate of decline of debt, and at worst another acceleration—and the dreaded “dou­ble dip”.

These next two quar­terly charts empha­sise the dilemma: the sta­bi­liza­tion in employ­ment has occurred because the rate of delever­ag­ing has slowed, which reg­is­ters as a pos­i­tive in the “rate of change of the rate of change”:

But the rate of change of debt is still neg­a­tive: it’s just risen from a low of –6% to –2%. For the decel­er­a­tion effect to con­tinue, the US debt car would need to stop its return drive from New York to LA, and head back towards New York once more: the level of debt rel­a­tive to GDP would need to rise.

This is highly unlikely when all sec­tors of the Amer­i­can econ­omy bar one (non-financial busi­ness) are already car­ry­ing more debt than they were in the depths of the Great Depres­sion, when the debt ratio had been dri­ven higher by deflation.

So the decel­er­a­tion in delever­ag­ing should give way again at some point, and then the NBER may be forced to begin dat­ing the next recession—which is still a con­tin­u­a­tion of the cur­rent Depression.

About Steve Keen

I am a professional economist 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 debts accumulated in Australia, and our very low rate of inflation.
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200 Responses to Deleveraging, Deceleration and the Double Dip

  1. Steve Keen says:

    On an unre­lated issue(!), Aus­tralian read­ers may have seen the crit­i­cisms of the Aus­tralian Research Council’s fund­ing process that I made in an arti­cle pub­lished in The Age and the Syd­ney Morn­ing Her­ald in the last week:

    http://www.smh.com.au/national/education/show-us-the-money-20101024-16z9c.html

    For more on why Australia’s research fund­ing sys­tem is flawed, check out Geoff Davies’ excel­lent swipe at the sys­tem from two years ago in The Australian:

    http://www.theaustralian.com.au/higher-education/opinion-analysis/system-based-on-caprice/story-e6frgclo-1111115710688

    And a pro­fes­sor of astron­omy who has done very well out of the ARC has referred me to a paper of his in which he too points out that the sys­tem rewards con­ven­tional thought rather than innovation:

    http://www.control.com.au/bi2008/299conscience.pdf

    If I get the OK from Bryan, I’ll put a short blog entry up on this topic, link­ing to these three papers.

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  3. Alex Barton says:

    A US dou­ble dip is cer­tain. Not likely for Australia.

  4. aangel says:

    Thanks, Steve. I think your com­ments are spot on. I have a longer video on my site for peo­ple to watch that goes through the whole oil story, includ­ing the Hub­bert curve. In this case I was speak­ing to a knowl­edge­able audi­ence so I could cut some cor­ners. I will be redo­ing that video, how­ever, because I’ve needed a shorter piece for a while now and will make sure your points make it in.

    I’ve been asked to coau­thor a paper for a Euro­pean finan­cial jour­nal with an econ­o­mist at Moscow Uni­ver­sity and Mikael Höök, who has done some of the best work out there on giant oil field deple­tion rates and global coal reserves. He’s at the Upp­sala Global Energy Sys­tems Group in Swe­den. As an aside, it’s inter­est­ing to note that that Bei­jing Uni­ver­sity has part­nered with the GESG so rest assured that the Chi­nese are well-versed in fos­sil fuel deple­tion since they are work­ing with the world’s pre-eminent group on the topic.

    The paper is ten­ta­tively titled “Risks to the Global Energy Sys­tem in the Early 21st Cen­tury.” I greatly respect your insight and work and assign your Rov­ing Cav­a­liers of Credit piece as home­work to one of my classes.

    Because we are talk­ing to money peo­ple, I would very much appre­ci­ate your com­ments on a draft ver­sion of the paper so that our lan­guage speaks in a way they can hear. My com­mit­ment is that we get the money peo­ple to wake up to our con­verg­ing crises and this paper will be a small but solid step for­ward with that. The draft should be ready early next year, pos­si­bly sooner. If you are open to that, please do let me know.

    BBB, oil from algae is sim­ply the lat­est in a long string of “solu­tions” that aren’t solu­tions and, in fact, often are not even net-energy pos­i­tive. Read any of the pieces by Robert Rapier and you will see that algal oil has for­mi­da­ble chal­lenges that, like fusion, are unlikely to be over­come at a price our civ­i­liza­tion can afford.

    P.S. it’s a pity there is no func­tion to sub­scribe to posts with this blog­ging software.

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  9. TheOC says:

    Hi Steve,

    All this ongo­ing talk of cov­ered bonds is mak­ing me ner­vous. Its like we’re play­ing the game “what mis­takes did US/Europe/Ireland make and lets copy that”. Do we really want to risk end­ing up like the US or more likely, Ireland?

    Every­one has blamed the US banks for screw­ing up the west­ern world, but I think it has more to do with edu­ca­tion — on debt and on hous­ing. You need a roof over your head to live… you don’t need to live in the trendy areas or have a big­ger house than your friends — espe­cially when that extra (above neces­sity hous­ing) means you have to bor­row more than you can ever rea­son­ably afford.

    Is there any “no to cov­ered bonds” rally hap­pen­ing any­time soon? Please start one — I mean bet­ter rally now, than riot later, right?

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  13. Steve Keen says:

    Agreed TheOC,

    But I’m not in a posi­tion to do so with my time con­straints. I’m about to put out an appeal for assis­tance from blog mem­bers on a range of fronts–including for­mal­is­ing the Cen­ter for Eco­nomic Sta­bil­ity that we formed early last year. Per­haps such a rally could be a first activ­ity, if oth­ers can come for­ward to organ­ise it.

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