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 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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