Competition is not a panacea in banking

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Inquiry into com­pe­ti­tion with­in the Aus­tralian bank­ing sec­tor

Sub­mis­sion by Asso­ciate Pro­fes­sor Steve Keen, School of Eco­nom­ics & Finance, Uni­ver­si­ty of West­ern Syd­ney;

The Aus­tralian Sen­ate’s Stand­ing Com­mit­tee on Eco­nom­ics has estab­lished an inquiry into com­pe­ti­tion in the bank­ing sec­tor, and I was invit­ed by the Com­mit­tee to make a sub­mis­sion. Click here for the PDF of my sub­mis­sion. The RBA’s sub­mis­sion is linked here. All sub­mis­sions to the inquiry are avail­able here.

Request to submit

I thank the com­mit­tee for invit­ing me to make a sub­mis­sion. As not­ed below, the focus of my sub­mis­sion is point (m) in the terms of ref­er­ence, “any oth­er relat­ed mat­ter”, since as I argue below, past attempts to improve bank­ing via increased com­pe­ti­tion have actu­al­ly exac­er­bat­ed the main prob­lem in bank­ing: the ten­den­cy for banks to fund spec­u­la­tive bub­bles.

Executive Summary

The major prob­lems of the finan­cial sec­tor are macro­eco­nom­ic and relat­ed to the lev­el of debt, rather than micro­eco­nom­ic and relat­ed to the price of debt. These are that:

  1. Banks have an innate desire to issue more debt than is good for the econ­o­my as a whole, and increased com­pe­ti­tion tends to exac­er­bate this ten­den­cy rather than con­trol it;
  2. As a con­se­quence of (a), debt has grown inex­orably rel­a­tive to incomes until the finan­cial cri­sis began. This expan­sion of debt caused the appar­ent boom pri­or to the cri­sis, while the slow­down in the rate of growth of debt is the pre­dom­i­nant cause of the cri­sis itself;
  3. Banks are lend­ing too much to house­holds and too lit­tle to busi­ness; and
  4. Lend­ing has been ori­ent­ed towards financ­ing spec­u­la­tion rather than invest­ment and the work­ing cap­i­tal needs of busi­ness.

Increas­ing com­pe­ti­tion once again, with­out ensur­ing that lend­ing is restrained rel­a­tive to incomes, and that it is direct­ed away from house­holds and spec­u­la­tion and towards busi­ness and invest­ment, would only exac­er­bate prob­lems caused by ear­li­er intro­duc­tions of unbri­dled com­pe­ti­tion in the 1980s and 1990s.

The focus of pol­i­cy on bank­ing there­fore needs to shift from the micro­eco­nom­ic issues of the degree of com­pet­i­tive­ness and so on to the macro­eco­nom­ic issues of the impact of debt on the econ­o­my. In par­tic­u­lar, we need an effec­tive means to con­trol the bank­ing sec­tor’s ten­den­cy to cre­ate too much debt—a ten­den­cy that increased com­pe­ti­tion tends to make ampli­fy rather than atten­u­ate.

The one com­pet­i­tive reform I would sug­gest is to licence local banks to exclu­sive­ly lend to small busi­ness to pro­vide work­ing cap­i­tal, where lend­ing can­not be secured against mort­gaged prop­er­ty.


Econ­o­mists and politi­cians have a ten­den­cy to per­ceive prob­lems in bank­ing as being ones of micro­eco­nom­ics and effi­cien­cy, because stan­dard eco­nom­ic analy­sis regards bank­ing and the lev­el of pri­vate debt as hav­ing lit­tle or no macro­eco­nom­ic impli­ca­tions.

This belief is reflect­ed in the terms of ref­er­ence for this inquiry, which has arisen because the gen­er­al pub­lic and the non-bank busi­ness sec­tor have been com­plain­ing about the impact of the bank­ing sec­tor on their lives and liveli­hoods. All of the terms of ref­er­ence, save the catch-all final one of “(m) any oth­er relat­ed mat­ter”, con­sid­er micro­eco­nom­ic top­ics of such as “(a) … com­pe­ti­tion, (b) .. prod­ucts … fees and charges…” and so on. The focus is on com­pe­ti­tion and the prices of the prod­ucts that banks pro­vide, rather than on the macro­eco­nom­ic impact of banks and their fun­da­men­tal prod­uct, which is debt-based mon­ey.

I believe that this con­ven­tion­al view is mis­in­formed. Though the micro­eco­nom­ic issues are of some impor­tance, they are triv­ial com­pared to the issues of the vol­ume of debt that the banks cre­ate, and its effect upon macro­eco­nom­ic per­for­mance and asset prices.

To estab­lish this, I will first review the his­to­ry of two pre­vi­ous attempts to reform the bank­ing sec­tor by increas­ing the lev­el of com­pe­ti­tion. Both of these had only tran­sient impacts upon the price of debt, but caused a last­ing increase in the lev­el of debt, and made the Aus­tralian macro­econ­o­my even more sub­ject to the dele­te­ri­ous dynam­ics of debt than it had been pre­vi­ous­ly.

The past failures of increased competition in the finance sector

Recent crit­i­cism of banks has focused on the increase in vari­able mort­gage rates by more than the RBA’s increase in the cash rate since the “Glob­al Finan­cial Cri­sis” (GFC) hit in 2008. How­ev­er, while the mar­gin between mort­gage rates and the cash rate has risen com­pared to post-Wal­lis Com­mit­tee lev­els, it is still below the lev­el that applied pri­or to the Wal­lis reforms, which encour­aged a sub­stan­tial expan­sion in mort­gage lend­ing com­pe­ti­tion by secu­ri­tised lenders. As Fig­ure 1 indi­cates, after the econ­o­my had recov­ered from “the reces­sion we had to have”, but before the Wal­lis reforms were intro­duced, the mar­gin var­ied between a low of 3 per­cent and a high of 5. It is now back to 3 per­cent.

Thus though the mar­gin has increased sub­stan­tial­ly since the GFC hit (from 1.8 to 3 per­cent, a 67% increase in 2.7 years), this has only restored mar­gins to what they were pri­or to the last time the finance sec­tor was reformed to intro­duce more com­pe­ti­tion (in line with the rec­om­men­da­tions of the Wal­lis Com­mit­tee).

Fig­ure 1: Rela­tion­ship between mort­gage rates and RBA cash rate since 1990

Then, as now, increased com­pe­ti­tion was expect­ed to ben­e­fit cus­tomers via low­er costs. The Wal­lis Com­mit­tee described the com­pet­i­tive intent of its reforms in the fol­low­ing way:

The Inquiry has not pur­sued change for its own sake, but has sought an appro­pri­ate bal­ance between achiev­ing com­pet­i­tive out­comes and ensur­ing finan­cial safe­ty and mar­ket integri­ty. In par­tic­u­lar, its rec­om­men­da­tions seek to…:

  • ensure that reg­u­la­tion of sim­i­lar finan­cial prod­ucts is more con­sis­tent and pro­motes com­pe­ti­tion by improv­ing com­pa­ra­bil­i­ty;
  • intro­duce greater com­pet­i­tive neu­tral­i­ty across the finan­cial sys­tem;
  • estab­lish more con­testable, effi­cient, and fair finan­cial mar­kets result­ing in reduced costs to con­sumers;
  • pro­vide more effec­tive reg­u­la­tion for finan­cial con­glom­er­ates which will also facil­i­tate com­pe­ti­tion and effi­cien­cy; and
  • facil­i­tate the inter­na­tion­al com­pet­i­tive­ness of the Aus­tralian finan­cial sys­tem.

Pre­cise pre­dic­tion of the direc­tion and per­for­mance of the finan­cial sys­tem can­not be made. How­ev­er, the Inquiry is con­fi­dent that imple­men­ta­tion of its rec­om­men­da­tions will place Aus­trali­a’s finan­cial insti­tu­tions and mar­kets in a strong posi­tion to adapt to change and to respond to the ever increas­ing com­pet­i­tive pres­sures which lie ahead. (Stan Wal­lis et al., 1997, p. 2)

The main com­pet­i­tive impact of the Wal­lis Com­mit­tee rec­om­men­da­tions was to accel­er­ate the growth of secu­ri­tised lend­ing. As Fig­ure 1 indi­cates, this did indeed reduce costs for con­sumers, in terms of the mar­gin between offi­cial and mar­ket inter­est rates. But the tran­sient nature of this com­pet­i­tive ben­e­fit, the fact that its unwind­ing coin­cid­ed with the most severe inter­na­tion­al finan­cial cri­sis since the Great Depres­sion, and the pub­lic anger at banks today, indi­cates that com­pe­ti­tion did not func­tion entire­ly in the man­ner expect­ed by the Wal­lis Com­mit­tee.

The markup on the cost of funds itself was low­ered not so much by an increase in effi­cien­cy, as by a diminu­tion of qual­i­ty, as essen­tial costs were cut in a com­pet­i­tive race for mar­ket share—a com­pe­ti­tion which also increased the aggre­gate hous­ing loans to GDP ratio.

As the Nation­al Direc­tor of the Aus­tralian Prop­er­ty Insti­tute not­ed to the House of Rep­re­sen­ta­tives hear­ing into Home loan lend­ing prac­tices and process­es, detailed prop­er­ty val­u­a­tions have been replaced by “dri­ve by” checks that do no more than con­firm via a “cur­so­ry glance” that a prop­er­ty had a dwelling on it:

what we have seen, par­tic­u­lar­ly from a val­u­a­tion point of view, is that the asset test that many of the ADIs state they under­take, they quite lit­er­al­ly do not under­take. We do not have val­uers going out doing asset tests on all loans that are under­tak­en by finan­cial insti­tu­tions. Some banks get their own either ex-man­agers to dri­ve by to see if the actu­al house exists or we have a low­er form of val­u­a­tion being under­tak­en.

These days it is get­ting to the point where you actu­al­ly have the val­uer who would not actu­al­ly even see if the house or asset exist­ed in the first place. You have a dri­ve-by which is at best a cur­so­ry glance to see if there is a prop­er­ty on the lot that has been pur­chased. (Mr Warn­er, Stand­ing Com­mit­tee On Eco­nom­ics Finance And Pub­lic Admin­is­tra­tion, 2007, p. 34)

Sim­i­lar­ly, detailed eval­u­a­tions of the bor­row­er’s capac­i­ty to ser­vice a loan, and a com­mit­ment to keep loan repay­ments below 30% of gross bor­row­er income, were replaced by auto­mat­ed checks that the bor­row­er had suf­fi­cient income left after loan repay­ments to be just above the Hen­der­son pover­ty line. As APRA’s Gen­er­al Man­ag­er for Indus­try and Tech­ni­cal Ser­vices, Hei­di Richards, told the Com­mit­tee:

Our research has also con­firmed that ADIs have mate­ri­al­ly increased the max­i­mum amount they are will­ing to lend to a giv­en bor­row­er. The increase has come about in a shift away from tra­di­tion­al debt-ser­vic­ing ratios based on sim­ple gross bor­row­er income cal­cu­la­tions. In the new­er income sur­plus mod­els bor­row­ers are assumed to con­tin­ue repay­ing their mort­gage until they reach a min­i­mum lev­el of house­hold expen­di­ture, with these min­i­mum lev­els often based on pover­ty lev­el mea­sures.

The tra­di­tion­al rule of thumb was that debt-ser­vic­ing expens­es should amount to no more than 30 per cent of gross bor­row­er income but, based on a review of lend­ing poli­cies that APRA con­duct­ed last year, we found that loans with debt-ser­vic­ing ratios above 30 per cent are now often well with­in ADIs’ pol­i­cy para­me­ters. (Ms Richards, Stand­ing Com­mit­tee On Eco­nom­ics Finance And Pub­lic Admin­is­tra­tion, 2007, p. 5)

The low­er mar­gins between mort­gage rates and the cash rate that con­sumers tem­porar­i­ly enjoyed between 1997 and 2008 were thus achieved large­ly through a drop in the qual­i­ty of the mort­gage prod­uct. This, and the dra­mat­ic increase in the lev­el of debt, allowed loan to val­u­a­tion ratios to blow out from the con­ser­v­a­tive 70% of the 1960s and ear­ly 1970s to the 97% lev­els on offer today. This dra­mat­ic increase in the size of mort­gages rel­a­tive to incomes (and con­se­quent drop in the ini­tial equi­ty that bor­row­ers have in their prop­er­ties) has meant an enor­mous increase in cost of ser­vic­ing mort­gages, despite low­er mar­gins. This is the main rea­son that banks are the sub­ject of such intense pub­lic oppro­bri­um today.

At the aggre­gate lev­el, the drop in mort­gage qual­i­ty caused an explo­sion in unpro­duc­tive lend­ing to the house­hold sec­tor, the same phe­nom­e­non that in the USA fuelled an appar­ent boom known as “The Great Mod­er­a­tion”, which end­ed in the finan­cial col­lapse that Amer­i­can econ­o­mists now call “The Great Reces­sion”. Though the mar­gin between mort­gage rates and the cash rate fell by 50 per­cent rel­a­tive to 1992 lev­els, the vol­ume of mort­gages rose four­fold (see Fig­ure 2). This increase in the vol­ume of debt rel­a­tive to GDP is the pri­ma­ry rea­son that bank prof­its have increased: had the impact of addi­tion­al com­pe­ti­tion only been to affect the mar­gin between the banks’ cost of funds and the RBA rate, then bank profits—and there­fore the cost of debt to consumers—would be low­er today than pri­or to the Wal­lis reforms.

Fig­ure 2: A halv­ing of mort­gage mar­gins, a four­fold increase in vol­umes

In the after­math of the finan­cial cri­sis, all the secu­ri­tised lenders have either col­lapsed, or have been tak­en over by the four major banks: com­pe­ti­tion has giv­en way to oligopoly—as it did in the 1980s. Mar­gins on all class­es of loans (except those to large busi­ness­es) have risen, but only in the case of per­son­al loans are these mar­gins gen­er­al­ly high­er than applied in the pre-Wal­lis peri­od. As Fig­ure 3 indi­cates, though the recent focus has been on the 1.1% increase in the mort­gage mar­gin, the mar­gin has risen most aggres­sive­ly on per­son­al loans—where it is up 3.7%–while the small busi­ness loan mar­gin has risen 1.8%.

Fig­ure 3: Mar­gin of aver­age loan rates above RBA rate

Falling margins and rising volumes—too much debt

Com­pe­ti­tion thus ini­tial­ly reduced mar­gins, only to have them rise once more—so that the ben­e­fits of com­pe­ti­tion proved tran­sient.

The drop in the qual­i­ty of loan assess­ment led to an explo­sion in the vol­ume of debt, most of which financed spec­u­la­tion rather than invest­ment. The last­ing impact of the reforms was to sus­tain the ten­den­cy that the bank­ing sec­tor had already demon­strat­ed even pri­or to the attempts by gov­ern­ments to reform it via increased com­pe­ti­tion, to increase the lev­el of pri­vate debt com­pared to income. While inter­est rates have var­ied wild­ly and wide­ly over time, the lev­el of debt com­pared to GDP has risen almost inex­orably pri­or to the Glob­al Finan­cial Crisis—after 20 years of sta­bil­i­ty between 1945 and 1965 (see Fig­ure 4).

Fig­ure 4: The real rea­son that bank­ing is a prob­lem today is the blowout in the ratio of debt to GDP

Though the drop in mar­gins was tran­sient, the increase in the vol­ume of debt car­ried by the hous­ing sec­tor was sub­stan­tial and, if not per­ma­nent, much more endur­ing: as Fig­ure 5 indi­cates, where­as it would have tak­en a mere 2 months of GDP to repay all out­stand­ing mort­gage debt in 1990, it would take more than 10 months of GDP to do the same today.

Fig­ure 5: Vary­ing sec­toral debt lev­els over time

This increase in debt could have been pro­duc­tive had it increased the stock of hous­ing, or improved its qual­i­ty sub­stan­tial­ly. How­ev­er though Aus­tralian hous­es have grown dra­mat­i­cal­ly in size—resulting in so-called “McMansions”—the pro­por­tion of mort­gage debt that has financed con­struc­tion of new homes has fall­en from 60 per­cent for investors in the late 1980s to bare­ly 5 per­cent today, while the pro­por­tion of own­er-occu­pi­er loans that financed con­struc­tion has fall­en from 20 per­cent to about ten per­cent (see Fig­ure 6; the recent increase was clear­ly due to the tripling of the First Home Own­ers Grant for new dwelling con­struc­tion, and that is now rapid­ly revers­ing since the Boost has ter­mi­nat­ed).

By impli­ca­tion, the vast major­i­ty of mort­gage finance has financed spec­u­la­tion on the prices of exist­ing prop­er­ties, dri­ving up house prices with­out adding to the hous­ing stock of the coun­try.

Fig­ure 6: Per­cent of hous­ing loans financ­ing con­struc­tion

Though the increase in prices has made house­holds feel wealth­i­er, the increase in the real debt per house has far exceed­ed the increase in the CPI-deflat­ed house price index. As Fig­ure 7 shows, though house prices have risen by a fac­tor of 2.5 in real terms since 1977, the CPI-deflat­ed debt lev­el has risen more than 4 times as much. The diver­gence between the debt lev­el per house and house prices began in 1990—before the Wal­lis reforms were introduced—but the rate of diver­gence increased after Wal­lis encour­aged the growth of secu­ri­tized lend­ing.

Fig­ure 7: Increase in debt per house and house price

Thus even though house prices have risen sub­stan­tial­ly, house­hold equi­ty in hous­es has fall­en over the last 2 decades—from above 90 per­cent in the late 1980s to under 70 per­cent (see Fig­ure 8; the sig­nif­i­cant rise in the last two years has been caused by the increase in house prices sparked by the First Home Own­ers Boost). This equi­ty is now extreme­ly depen­dent on house prices remain­ing high, since though debt has dri­ven house prices up, debt will not fall if house prices fall.

Fig­ure 8: Val­ue of house­hold assets minus mort­gage debt

As equi­ty has fall­en, the cost of enter­ing the mar­ket has risen. Those who have recent­ly entered the mar­ket have had to devote a pro­hib­i­tive por­tion of their incomes to ser­vic­ing their mort­gage, while those con­sid­er­ing enter­ing must con­tem­plate a daunt­ing lev­el of debt com­pared to their incomes.

As a result, hous­ing afford­abil­i­ty has dete­ri­o­rat­ed sharply: the claim that many prop­er­ty lob­by­ists and banks make that it has not is sim­ply absurd. Fig­ure 9 shows the ratio of the aver­age loan tak­en out by a first home buy­er to the aver­age wage, which has risen from just over 2.5 in 1992 to as much as 6 in 2009.

Some com­men­ta­tors have claimed that this rise in the size of mort­gages com­pared to incomes was just a con­se­quence of falling mort­gage rates: as rates fell, the lev­el of debt tak­en on rose, leav­ing the cost of ser­vic­ing the debt con­stant. RBA Gov­er­nor Glenn Stevens made pre­cise­ly this claim to the House of Rep­re­sen­ta­tives Stand­ing Com­mit­tee on Eco­nom­ics, Finance and Pub­lic Admin­is­tra­tion in 2007:

The rough sta­tis­tic that I have quot­ed many times was that the aver­age rate of inter­est was about half; that meant you could ser­vice twice as big a debt. Guess what? That is exact­ly what occurred, and that had a very pro­found effect on asset val­ues. (Glenn Stevens, remarks to the House of Rep­re­sen­ta­tives Stand­ing Com­mit­tee on Eco­nom­ics Finance and Pub­lic Admin­is­tra­tion, 2007, p. 26)

Though there were peri­ods where this was the case, Fig­ure 9 shows that in gen­er­al this was not true. Debt lev­els did rise as rates gen­er­al­ly fell from 1990–1998, but since then debt lev­els have almost dou­bled com­pared to incomes, while mort­gage rates are high­er now than then.

Fig­ure 9: Ratio of the aver­age first home loan to the aver­age year­ly wage

A focus on the inter­est costs of debt also under­states the prob­lem, since as debt lev­els rise rel­a­tive to income the cost of pay­ing down the prin­ci­pal over time ris­es more than the inter­est rate cost alone. On this basis it is unde­ni­able that the increase in the vol­ume of mort­gages, which was the main last­ing impact of increased com­pe­ti­tion, has made Aus­tralians worse off. Fig­ure 10 shows that in 1996, pri­or to the Wal­lis reforms, the aver­age first home loan could be ser­viced with 30 per­cent of the after tax salary of the aver­age wage earn­er; today, the fig­ure is 80 per­cent. It is no longer fea­si­ble for a sin­gle per­son on the aver­age wage to buy a dwelling today, and even a cou­ple has to devote more of their take home pay to ser­vic­ing a mort­gage than an indi­vid­ual did just 15 years ago.

Fig­ure 10: 80 per­cent of the aver­age wage need­ed to ser­vice a first home loan

The dele­te­ri­ous impacts of increased com­pe­ti­tion in lend­ing to the house­hold sec­tor have clear­ly out­weighed the ben­e­fits. The one ben­e­fit was that the mar­gin between mort­gage rates and the cash rate halved for a decade, but it has now revert­ed to three-quar­ters of the pre-Wal­lis val­ue. Real house prices have dou­bled, mak­ing some house­holds (espe­cial­ly those who own their hous­es out­right) wealth­i­er, but debt has increased four­fold, and in the aggre­gate house­hold equi­ty in prop­er­ty has fall­en.

Competition’s history of excess in banking

A sim­i­lar process applied the pre­vi­ous time that a mas­sive boost to com­pe­ti­tion was intro­duced into the finan­cial sector—in Feb­ru­ary 1985, when Paul Keat­ing per­suad­ed the Hawke Labor Gov­ern­ment to intro­duce not mere­ly 4 for­eign banks into the Aus­tralian mar­ket, but six­teen. Then, lend­ing to the busi­ness sec­tor explod­ed, ris­ing from 33% of GDP to 55% in just 4 years. Much of that lend­ing was unpro­duc­tive, financ­ing the spec­u­la­tive activ­i­ties of now acknowl­edged Ponzi mer­chants like Alan Bond, Christo­pher Skase and Lau­rie Con­nell.

In the after­math of the Stock Mar­ket Crash of 1987 and the real estate bub­ble and bust that pre­ced­ed the 1990s reces­sion, all the for­eign banks either with­drew from the mar­ket or had their oper­a­tions tak­en over by the Big Four—one of which, West­pac, almost col­lapsed itself in 1992 when it record­ed a $1.6 bil­lion loss.

Increased com­pe­ti­tion in the finan­cial sec­tor has thus failed on two pre­vi­ous occa­sions to achieve the results its advo­cates expect­ed. Instead on both occa­sions, the qual­i­ty of loan eval­u­a­tion dropped and the vol­ume of lend­ing increased dra­mat­i­cal­ly, with most of that lend­ing fund­ing spec­u­la­tion rather than invest­ment.

The sec­tor to which the lend­ing was direct­ed var­ied, as Fig­ure 5 indi­cates: busi­ness debt more than dou­bled between 1977 and 1987, and then oscil­lat­ed for the next twen­ty years, only to explode once more from 2005–2008 (when it fund­ed some pro­duc­tive invest­ment in min­er­als, but also the “lever­aged buy­out” fren­zy that end­ed when the stock mar­ket crash began). Mort­gage debt was con­stant through­out the late 70s and 80s, but then increased more than five­fold between 1990 and 2010.

The absence of any long term pat­tern in the sec­toral data masks a very clear pat­tern in the aggre­gate data. For the first 20 years after WWII, pri­vate debt was con­stant at rough­ly 25 per­cent of GDP. From then on, the lev­el of pri­vate debt com­pared to income has risen relent­less­ly, until a crit­i­cal turn­ing point was reached in ear­ly 2008. From mid-1964 until ear­ly 2008, the pri­vate debt to GDP ratio grew expo­nen­tial­ly, reach­ing a peak of 157 per­cent of GDP in mid-2008. As Fig­ure 11 indi­cates, call­ing this growth “expo­nen­tial” is not mere hyper­bole: the cor­re­la­tion of the actu­al ratio to a sim­ple expo­nen­tial growth rate of 4.2% p.a. is 0.993.

Fig­ure 11: An inex­orable increase in debt from 1965 until 2008

The only rea­son that this cor­re­la­tion is not even clos­er to a per­fect 1 is the exis­tence of two “super-bub­bles” in 1972–77 and 1985–1994, and the recent top­ping-out of the ratio in March 2008. This growth rate was sus­tained despite sig­nif­i­cant shifts in reg­u­la­to­ry regimes, dra­mat­ic volatil­i­ty in inter­est rates, and as not­ed ear­li­er, sig­nif­i­cant shifts in the sec­toral breakup of pri­vate debt.

This his­to­ry should give pause to the cur­rent renewed enthu­si­asm for intro­duc­ing more com­pe­ti­tion into the finan­cial sec­tor. If debt—the fun­da­men­tal out­put of the bank­ing sector—has grown inex­orably despite dra­mat­ic changes in the struc­ture of the finan­cial sec­tor and the econ­o­my over time, then is there some­thing inher­ent to bank­ing that leads to unre­strained growth in debt? And if increased com­pe­ti­tion had unin­tend­ed dele­te­ri­ous con­se­quences on pre­vi­ous occa­sions, what might be the con­se­quences of enhanc­ing com­pe­ti­tion again now, in the after­math of a finan­cial cri­sis? Is com­pe­ti­tion the panacea, as con­ven­tion­al eco­nom­ic analy­sis argues, or is it to some extent the prob­lem in the finan­cial sec­tor?

Funding bubbles rather than productive enterprise

Bank­ing is clear­ly a vital func­tion in a mar­ket econ­o­my, and much of what banks do is essen­tial for com­merce: pro­vid­ing work­ing cap­i­tal to firms, fund­ing invest­ment, enabling con­sumers to own their homes as an alter­na­tive to rent­ing, and so on.

How­ev­er bank­ing also has poten­tial­ly dam­ag­ing con­se­quences if it funds spec­u­la­tive activ­i­ties rather than gen­uine invest­ment on a large scale—as I argue that, based on the empir­i­cal data, it has. This neg­a­tive side of bank­ing is unlike­ly to be con­strained by competition—in fact it is like­ly to be made worse by more com­pe­ti­tion.

This is because bank­ing dif­fers from com­mod­i­ty production—to which stan­dard “sup­ply and demand” analy­sis is nor­mal­ly applied—in ways that mean that it has an innate ten­den­cy to try to pro­duce as much of its prod­uct (effec­tive­ly, debt that simul­ta­ne­ous­ly cre­ates cred­it mon­ey) as it can entice its cus­tomers to take on. The only fac­tor that can pre­vent this ten­den­cy lead­ing to exces­sive debt lev­els is a lim­it to the will­ing­ness of its cus­tomers to bor­row mon­ey.

If bor­row­ers base their desired lev­el of lend­ing on either enhanc­ing imme­di­ate con­sump­tion, or fund­ing activ­i­ties that may lead to income gen­er­a­tion in the future, then debt will gen­er­al­ly be con­strained to sus­tain­able levels—as occurred dur­ing the 1950s and ear­ly 1960s. If, how­ev­er, bor­row­ers go into debt to finance spec­u­la­tion about asset prices, then there is a poten­tial for the lev­el of bor­row­ing to grow out of pro­por­tion to incomes and lead to a finan­cial cri­sis.

An essen­tial side-effect of this process is the cre­ation of an asset price bub­ble from the pos­i­tive feed­back between ris­ing lev­els of lever­age and asset prices. Asset prices are dri­ven up by debt-financed pur­chas­es of assets, and this rise in price entices more bor­row­ers into debt. An increase in debt to income ratios there­fore goes hand in hand with an asset price bub­ble. These bub­bles ulti­mate­ly burst for three main rea­sons:

  1. Bor­row­ing to buy exist­ing assets adds to the debt bur­den of soci­ety with­out adding to its income gen­er­at­ing capac­i­ty. The indi­vid­u­als who prof­it from ris­ing asset prices are essen­tial­ly Ponzi spec­u­la­tors whose “enter­prise” is fun­da­men­tal­ly loss-mak­ing. Ulti­mate­ly they must fail, and this real­i­ty is masked only by ris­ing asset prices. As soon as they fal­ter, they are like­ly to go bank­rupt;
  2. Price to income ratios get dri­ven to lev­els that appear irra­tional even to insid­ers, lead­ing to greater volatil­i­ty, and even­tu­al­ly an asset price crash that ends the bub­ble; and
  3. The lev­els of debt that exist­ing spec­u­la­tors and new entrants need to under­take to con­tin­ue dri­ving the bub­ble becomes pro­hib­i­tive com­pared to their income lev­els. The bor­row­ing slows down, thus end­ing the pos­i­tive feed­back process that dri­ves the bub­ble.

The dan­ger in allow­ing increased com­pe­ti­tion in finance, with­out pro­vi­sions to ensure that the lend­ing is direct­ed to pro­duc­tive uses, is that the sec­tor’s innate ten­den­cy to fund Ponzi schemes will be ampli­fied by the pres­sure of com­pe­ti­tion.

Competition in the 1980s—the stock market bubble and bust

In ret­ro­spect, this is clear­ly what occurred dur­ing the 1980s. The ini­tial bub­bles then were in shares and com­mer­cial property—though any­one who claimed there was a bub­ble before Octo­ber 1987 was wide­ly derid­ed. The stock mar­ket bub­ble then burst spec­tac­u­lar­ly, as Fig­ure 12 indi­cates, but in the after­math, spec­u­la­tion shift­ed to res­i­den­tial prop­er­ty (thanks in no small mea­sure to the gov­ern­ment re-intro­duc­ing the First Home Own­ers Grant to ward off a feared reces­sion). Prices rose 36% in real terms between Octo­ber 1987 and March 1989, and then stag­nat­ed in real terms for the next decade.

Fig­ure 12: Stock mar­ket bub­bles of the 1980s and 2000s

Competition in the 1990s-2000s—housing and share market bubbles

The addi­tion­al com­pe­ti­tion from secu­ri­tized lenders that the Wal­lis Com­mit­tee cham­pi­oned has had a sim­i­lar effect, this time pri­mar­i­ly on house­hold debt and spec­u­la­tion on house prices. Increased com­pe­ti­tion in finance has once again had the dele­te­ri­ous effect of fund­ing spec­u­la­tion rather than pro­duc­tive invest­ment, dri­ving up debt lev­els and caus­ing asset bub­bles in both the share and the prop­er­ty mar­kets.

Pre­dictably, banks have denied that their activ­i­ties have fund­ed spec­u­la­tive bub­bles. With regard to hous­ing, they assert that house prices reflect fun­da­men­tal forces, on the basis of four propo­si­tions:

  1. That the house price to income ratio in Aus­tralia is not as high as those who assert that there is a house price bub­ble claim it to be;
  2. That there is an excess of demand for hous­ing over sup­ply in Aus­tralia, reflect­ing prob­lems with reg­u­la­tion that have pre­vent­ed the con­struc­tion of new hous­es in line with under­ly­ing demand;
  3. Strong pop­u­la­tion growth is dri­ving up prices; and
  4. That Aus­tralians have a pref­er­ence to live near the coast and are will­ing to pay a pre­mi­um to do so.

In order to estab­lish my posi­tion that the bank­ing sec­tor has once again fund­ed a spec­u­la­tive bub­ble, I need to con­sid­er these argu­ments in detail. As I show below, none of them stand up to close scruti­ny.

No house price bubble (and “Coastal living”)

The Com­mon­wealth Bank made the fol­low­ing asser­tions that com­bine argu­ments 1 and 4 above:

  • Aus­tralia the 4th least dense­ly set­tled coun­try in the world—83% live with­in 50 kms of the coast.
  • Coastal loca­tions demand a premium—Australia’s pop­u­la­tion con­cen­tra­tion in capital/coastal cities dis­torts com­par­isons to oth­er, more dense­ly set­tled coun­tries.
  • Aus­trali­a’s cap­i­tal city house price to income ratio of 5.6 is con­sis­tent with coastal city met­rics glob­al­ly (Com­mon­wealth Bank, 2010, p. 4)

These asser­tions were sup­port­ed by the table shown in Fig­ure 13:

Fig­ure 13: Com­mon­wealth Bank coastal cities com­par­i­son table

This table is a piece of bla­tant sophistry. Note that there are 2 sources giv­en: Demographia (Wen­dell Cox and Hugh Pavletich, 2010) and UBS. All of the over­seas city data points are tak­en from the Demographia sur­vey, while all of the Aus­tralian cities are derived from UBS research. The dif­fer­ences between the Demographia data for all the cities in this table and the UBS-CBA data are shown in Table 1

Table 1: CBA (Com­mon­wealth Bank, 2010) and Demographia (Wen­dell Cox and Hugh Pavletich, 2010pp. 36–37) house price ratio com­par­i­son

House Price to Income Ratios

Unaf­ford­abil­i­ty Rank­ings

Coun­try City







Aus-tralia Syd­ney







Aus-tralia Mel­bourne







Aus-tralia Bris­bane







US San Fran­cis­co







US Los Ange­les







US New York







Cana­da Van­cou­ver







UK Bris­tol-Bath







NZ Auck­land







NZ Welling­ton







The UBS-CBA doc­u­ment thus under­states the house price to income ratio for Aus­tralian cities by 30 to 38 per­cent com­pared to the orig­i­nal Demographia doc­u­ment. It por­trays Aus­tralian cities as falling in the mid­dle of the range when, accord­ing to Demographia, Aus­tralian cities are amongst the most unaf­ford­able in the world—in fact in Demographi­a’s com­par­i­son of 272 cities around the world, Syd­ney was the 2nd most expen­sive, behind only Van­cou­ver.

There are, I believe, two main rea­sons why the CBA-UBS fig­ures for Aus­tralia are so much low­er than Demographi­a’s. First­ly, the Demographia sur­vey com­pares medi­an house prices to medi­an incomes, where­as the CBA-UWS study com­pares medi­an house prices to aver­age incomes. Since income dis­tri­b­u­tion is skewed, the aver­age income sub­stan­tial­ly exceeds the medi­an. Sec­ond­ly, the Aus­tralian Bureau of Sta­tis­tics includes income from prop­er­ty (includ­ing the imput­ed rental income from own­er-occu­pied dwellings) when cal­cu­lat­ing the aver­age income, where­as the medi­an income relies on wage income only.

Had the CBA-UBS study applied the same trans­for­ma­tions to the over­seas data, then their fig­ures for those cities would also have been sub­stan­tial­ly low­er than the Demographia fig­ures, and the rel­a­tive expen­sive­ness of Aus­tralian cities com­pared to coastal cities around the world—let alone land-locked ones—would have been obvi­ous.

Includ­ing income from prop­er­ty in the income to which one com­pares prop­er­ty prices is also an inher­ent­ly flawed approach: it will under­state the price to income ratio when prices are ris­ing (and, con­verse­ly, exag­ger­ate the ratio when prices are falling). Prop­er­ty income derives pri­mar­i­ly from the change in price, and this will be pos­i­tive when prices are rising—making income larg­er than it would oth­er­wise be. Using this data to con­clude that there is not a house price bub­ble is turn­ing a Nel­son­ian eye to the prob­lem.

When one is not try­ing to not see a bub­ble, sta­tis­ti­cal evi­dence of it abounds. I will present three mea­sures: the ratio of house prices to dis­pos­able income per head; the ratio of house prices to GDP per head; and the gross rental yield on Aus­tralian rental prop­er­ties.

The house price to dis­pos­able income data shows a slow upward drift in this ratio from 1960 till 1997 (see Fig­ure 14), and then a take­off of the ratio since then to ten stan­dard devi­a­tions above its mean.

Fig­ure 14: House prices to dis­pos­able income–upward trend then bub­ble since 1997

It could be argued that this series always shows a ris­ing trend, and the accel­er­a­tion in that trend is not con­clu­sive evi­dence of a bub­ble. The house price to GDP per capi­ta cal­cu­la­tion, on the oth­er hand, shows no trend between 1953 and 2000, but an explo­sion in the ratio since 1997 that has tak­en the ratio from under the mean to more than 7 stan­dard devi­a­tions above the mean (see Fig­ure 15). This and sev­er­al oth­er met­rics indi­cate that (a) the house price bub­ble began in 1997 and (b) it has dri­ven Aus­tralian house prices to a lev­el at least 50% high­er than his­toric lev­els.

Fig­ure 15: House prices to GDP per capi­ta

The low return on rent­ing in Aus­tralia makes it obvi­ous that “investors” in this indus­try are seek­ing cap­i­tal gain rather than income—and are there­fore pri­mar­i­ly spec­u­la­tors rather than gen­uine investors (see Fig­ure 16). The rental yield hov­ered around 3.5 percent—low, but not trivial—between 1998 when records became avail­able, and 1997, when the pre­vi­ous two mea­sures also indi­cate that the most recent bub­ble began. Since then the aver­age yields fell to a low of under 2 per­cent as house prices rose far more than did rents—and the recov­ery in the ratio to a not quite so abysmal 2.5% was entire­ly due to the fall in house prices that pre­ced­ed the Rudd Gov­ern­men­t’s intro­duc­tion of the First Home Own­ers Boost.

Fig­ure 16: Rental yields are well below deposit rates, let alone loan rates

There­fore, to put it polite­ly, bank argu­ments that there is no house price bub­ble in Aus­tralia (and the CBA-UBS table in par­tic­u­lar) are duplic­i­tous and misleading—even when one makes an “apples to apples” com­par­i­son of Aus­tralian house prices to coastal cities over­seas, we still have amongst the most expen­sive hous­ing in the world. But the argu­ment that we should only con­sid­er coastal cities is also non­sense.

The propo­si­tion that coastal cities com­mand a pre­mi­um begs the ques­tion: com­pared to what? In coun­tries like the USA, the answer is easy: com­pared to land-locked cities where the vast major­i­ty of the pop­u­la­tion lives. But in Aus­tralia, there is no inland mar­ket over which a pre­mi­um can be charged (apart from Can­ber­ra, which, at a price to income ratio of 5.8, is the 228th least afford­able city in the world out of the 272 in the on the Demographia sur­vey). In Aus­tralia, if you live in a city, then you either live on the coast or in Can­ber­ra: there is no non-coastal city mar­ket over which coastal cities can com­mand a pre­mi­um.

Underlying demand”

The argu­ment that there is an under­ly­ing short­age of hous­ing, and that this is why house prices are high, is also eas­i­ly dis­missed. The sup­ply short­age is derived from esti­mates devel­oped by the Nation­al Hous­ing Sup­ply Coun­cil.

the Coun­cil esti­mat­ed a gap of around 85,000 dwellings between under­ly­ing demand for and sup­ply of hous­ing at 30 June 2008. The Coun­cil devel­oped a method­ol­o­gy for mea­sur­ing the gap based on select­ed mea­sures of home­less­ness, includ­ing the num­ber of mar­gin­al res­i­dents of car­a­van parks and the under­sup­ply of pri­vate rental dwellings indi­cat­ed by the rental vacan­cy rate. The mea­sures used in the 2008 report were: 2008 gap size =

  • addi­tion­al pri­vate rental dwellings required in 2008 to increase the num­ber of vacant pri­vate rental dwellings to 3 per cent of the total pri­vate rental stock

These measures—especially the last two—express a social need for addi­tion­al hous­ing. But they are in no way express a mar­ket demand for hous­ing, Frankly, if you believe that house prices are being dri­ven up by either home­less peo­ple or “mar­gin­al res­i­dents of car­a­van parks”, then I have a Bridge or two I’d like to sell you.

Population pressure

The pop­u­la­tion pres­sure argu­ment does appear super­fi­cial­ly convincing—like any sto­ry that gives rise to a Ponzi Scheme—but it is sim­ply not sup­port­ed by the data. While the asser­tions that Aus­tralia did­n’t have an over­build­ing spree like those in the USA or Chi­na, that our pop­u­la­tion growth rate exceeds the OECD aver­age, and that it spiked recent­ly when house prices were ris­ing sharply are all true, pop­u­la­tion growth per se bears no cor­re­la­tion to changes in house prices.

Fig­ure 17: Absolute growth lev­els of pop­u­la­tion, immi­gra­tion and dwellings

If the argu­ment that a short­age of new hous­es rel­a­tive to pop­u­la­tion growth is the cause of ris­ing house prices were true, then Aus­tralia should have expe­ri­enced falling house prices between 1955 and 2006—because for this entire peri­od the rate of growth of new dwellings exceed­ed the rate of growth of pop­u­la­tion (see Fig­ure 18).

Fig­ure 18: Falling ratio of pop­u­la­tion to dwellings for all years except 2006–2010

Over the long term, the cor­re­la­tion between pop­u­la­tion growth and change in house prices is effec­tive­ly zero. Lag­ging house price change behind pop­u­la­tion change—to test the argu­ment that pop­u­la­tion growth caus­es price change, but with a lag—does not improve the cor­re­la­tion (see Fig­ure 19). The cor­re­la­tion between change in pop­u­la­tion and change in house prices remains neg­a­tive.

Fig­ure 19: There is no cor­re­la­tion between pop­u­la­tion growth and house prices, even when time lags are con­sid­ered

Even dur­ing the one peri­od when the rate of growth of pop­u­la­tion exceed­ed the rate of growth of pop­u­la­tion, the change in house prices is uncor­re­lat­ed with the change in pop­u­la­tion and pop­u­la­tion den­si­ty (see Fig­ure 20).

Fig­ure 20: A neg­a­tive cor­re­la­tion between pop­u­la­tion and house prices

The sim­ple rea­son that pop­u­la­tion change does­n’t deter­mine house price move­ments is that the real mar­ket demand for hous­ing is giv­en fun­da­men­tal­ly by the num­ber of peo­ple who have recent­ly tak­en out a mort­gage, This can vary rad­i­cal­ly as a pro­por­tion of the pop­u­la­tion, swamp­ing vari­a­tions in the rate of pop­u­la­tion growth itself (see Fig­ure 21).

Fig­ure 21: Volatil­i­ty of new own­er occu­pi­er loans as per­cent of pop­u­la­tion

The two fac­tors that do have a strong causal cor­re­la­tion with changes in house prices are the vol­ume of new lend­ing, and gov­ern­ment manip­u­la­tion of the mar­ket via the First Home Own­ers Grant. The lat­ter will—I hope—be the sub­ject of a sep­a­rate inquiry one day. The for­mer demon­strates that the key fac­tor in deter­min­ing house prices is the growth rate of mort­gage debt: the cor­re­la­tion is strong (0.56), and new lend­ing leads price change by about 3–6 months (see Fig­ure 22).

Fig­ure 22: The growth in mort­gage debt is the key deter­mi­nant of house price changes

Unregulated banking has financed Ponzi Schemes rather than investment

The data thus clear­ly shows that, on the two pre­vi­ous occa­sions where com­pe­ti­tion in bank­ing was inten­si­fied, the result was an increase in lend­ing for spec­u­la­tive rather than pro­duc­tive pur­pos­es.

While the boost in lend­ing was tak­ing place, aggre­gate demand increased—as explained later—which made the econ­o­my appear buoy­ant. But when the buoy­ant lend­ing came to an end, an eco­nom­ic cri­sis ensued, since the lend­ing pre­dom­i­nant­ly drove asset prices high­er (rather than adding to the lev­el or pro­duc­tiv­i­ty of assets).

The end result was an increased lev­el of debt com­pared to income, with lit­tle to show for the increased gear­ing save more expen­sive assets. That is the main rea­son why banks are “on the nose” today. To ampli­fy com­pe­ti­tion a third time, with­out heed­ing these lessons of the past, would be a seri­ous mis­take.

What we should do instead is:

  1. Prop­er­ly iden­ti­fy the prob­lems in the sec­tor, rather than assum­ing that, what­ev­er the prob­lems might be, more com­pe­ti­tion will fix them; and
  2. Tai­lor the reforms to the prob­lems, so that there is at least some chance the pro­posed solu­tions will make things bet­ter rather than worse.

The macro-dynamics of debt

As out­lined above, the key prob­lem with the bank­ing sec­tor is that it has cre­at­ed too much debt, and that the major­i­ty of this debt has fund­ed spec­u­la­tion rather than pro­duc­tive invest­ment.

This prob­lem has been exac­er­bat­ed by reforms that have been based on a naïve faith in dereg­u­lat­ed mar­kets, but the prob­lem itself is an endem­ic one, as the his­tor­i­cal record attests. As Fig­ure 23 empha­sis­es, the pri­vate debt to GDP lev­el today dwarfs any­thing pre­vi­ous­ly expe­ri­enced in Aus­tralia, but there have also been two pre­vi­ous less­er debt bub­bles that both end­ed in seri­ous Depres­sions (Chay Fish­er and Christo­pher Kent, 1999).

Fig­ure 23: Aus­trali­a’s pri­vate debt to GDP ratio over the very long term

Most econ­o­mists pay lit­tle if any atten­tion to this ratio—and most were there­fore caught com­plete­ly unawares when the Glob­al Finan­cial Cri­sis hit. By way of con­trast, this ratio and its deriv­a­tives are cru­cial to my analy­sis (Steve Keen, 1995), and to that of the hand­ful of oth­er econ­o­mists around the world who antic­i­pat­ed the GFC (Dirk J Beze­mer, 2009, Dirk J. Beze­mer, 2010, Edward Full­brook, 2010).

An instance of the san­guine way that most econ­o­mists think about pri­vate debt is giv­en by RBA Deputy Gov­er­nor Ric Bat­telli­no’s obser­va­tions on the extra­or­di­nary lev­el of house­hold debt as at Sep­tem­ber 2007 (when it was 94% of GDP):

The fac­tors that have facil­i­tat­ed the rise in debt over the past cou­ple of decades – the sta­bil­i­ty in eco­nom­ic con­di­tions and the con­tin­ued flow of inno­va­tions com­ing from a com­pet­i­tive and dynam­ic finan­cial sys­tem – remain in place. While ever this is the case, house­holds are like­ly to con­tin­ue to take advan­tage of unused capac­i­ty to increase debt. This is not to say that there won’ t be cycles when cred­it grows slow­ly for a time, or even falls, but these cycles are like­ly to take place around a ris­ing trend. Even­tu­al­ly, house­hold debt will reach a point where it is in some form of equi­lib­ri­um rel­a­tive to GDP or income, but the evi­dence sug­gests that this point is high­er than cur­rent lev­els.” (Ric Bat­telli­no, 2007, p. 20)

I am not so san­guine, first­ly because the his­tor­i­cal record shows that when pri­vate debt reach­es a peak, it does not remain at an equi­lib­ri­um lev­el but goes into reverse (see Fig­ure 23), and sec­ond­ly because even if debt did reach “some sort of equi­lib­ri­um rel­a­tive to GDP or income”, this would cause a large fall in aggre­gate demand.

This point is not con­sid­ered by the vast major­i­ty of econ­o­mists because they believe that the lev­el of debt has no impact on macro­eco­nom­ic out­comes. Ben Bernanke pro­vides a good illus­tra­tion of this in his dis­missal of Fish­er’s argu­ment (Irv­ing Fish­er, 1933) that the Great Depres­sion was caused by “debt-defla­tion”:

Fish­er’ s idea was less influ­en­tial in aca­d­e­m­ic cir­cles, though, because of the coun­ter­ar­gu­ment that 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. ” (Ben S. Bernanke, 2000, p. 24)

Bernanke’s con­ven­tion­al argu­ment is false because it ignores the role that changes in debt play in deter­min­ing aggre­gate demand. In the equi­lib­ri­um per­spec­tive that vir­tu­al­ly defines con­ven­tion­al eco­nom­ic the­o­ry (known as “neo­clas­si­cal eco­nom­ics”), debt is mere­ly a redis­tri­b­u­tion of spend­ing pow­er from one per­son (the lender) to anoth­er (the bor­row­er). But in the real world (and in the non-ortho­dox “Finan­cial Insta­bil­i­ty Hypoth­e­sis”: Hyman P. Min­sky, 1982), the aggre­gate lev­el of debt can expand or con­tract, and this change in the aggre­gate lev­el of debt does have macro­eco­nom­ic effects because it alters aggre­gate spend­ing pow­er.

In a nut­shell, aggre­gate demand is the sum of GDP plus the change in debt (Steve Keen, 2009a, c, d), and for this rea­son a sim­ple sta­bi­liza­tion of the debt to GDP ratio can cause a reces­sion.

This can be illus­trat­ed using a sim­ple exam­ple. Con­sid­er an econ­o­my with a nom­i­nal GDP of $1 tril­lion, which is grow­ing at 10% per annum, where half (5%) is real growth and half is infla­tion. The econ­o­my also has a pri­vate debt lev­el of $1.25 tril­lion that is grow­ing at 20% p.a. Total spend­ing in the econ­o­my that year will there­fore be $1.25 tril­lion, con­sist­ing of $1 tril­lion from GDP and $250 bil­lion from the increase in debt.

Then assume that GDP con­tin­ues to grow at the same rate, so that it is $1.1 tril­lion the year after, and that the rate of growth slows down to 10% per annum—the same speed as the rate of growth of nom­i­nal GDP, so that the debt ratio remains con­stant at 150%, the lev­el it reached in Year 1.

Total aggre­gate demand will there­fore be $1.25 trillion—the sum of the $1.1 tril­lion GDP and the 10% increase in debt from its lev­el of $1.5 tril­lion. This is the same lev­el of nom­i­nal demand as the year before—but since there has been 5% infla­tion, the lev­el of real demand has fall­en by $60 bil­lion. This is enough to cause a reces­sion (if the impact is felt entire­ly by the sale of goods and ser­vices), or a sharp fall in asset prices, or some com­bi­na­tion of the two.

This hypo­thet­i­cal example—summarised in Table 2—is a milder ver­sion of what actu­al­ly occurred in 2008 and caused the Glob­al Finan­cial Cri­sis. The actu­al expe­ri­ences of the USA and Aus­tralia are sum­ma­rized in Table 3 and Table 4 respec­tive­ly.

Table 2: Hypo­thet­i­cal exam­ple of impact of debt to GDP ratio reach­ing equi­lib­ri­um

Variable/year Year 1 Year 2
Nom­i­nal GDP



Growth rate of nom­i­nal GDP (%)



Real growth rate (%)



Infla­tion rate (%)



Pri­vate debt



Growth rate of pri­vate debt (%)



Change in pri­vate debt



Nom­i­nal aggre­gate demand (GDP + change in debt)



Real aggre­gate demand (in Year 1 terms)



In the USA, the rate of growth of debt did not mere­ly slow but actu­al­ly turned neg­a­tive: there­fore the change in debt actu­al­ly sub­tract­ed from aggre­gate demand, rather than adding to it. But as illus­trat­ed by the hypo­thet­i­cal sit­u­a­tion in Table 2, the mere slow­down in the rate of growth of debt pri­or to the year end­ing in Jan­u­ary 2010 was enough to start “The Great Reces­sion” in 2008-09.

In the year end­ing in 2008, Amer­i­ca’s GDP was $14.34 tril­lion, and the growth in pri­vate debt was $4.04 tril­lion, so that pri­vate sec­tor aggre­gate demand was $18.38 tril­lion. In the year end­ing in 2009, nom­i­nal GDP was slight­ly high­er at $14.35 tril­lion, but the growth in debt was only $1.45 tril­lion (the rate of growth of debt had slowed from 11.1% p.a. to 3.6% p.a.). Pri­vate sec­tor aggre­gate demand was thus $15.8 trillion—a four­teen per­cent fall from the year before.

The increase in gov­ern­ment debt atten­u­at­ed the fall in total aggre­gate demand to some extent, but this still fell 9% over the year, and Amer­i­ca’s asset mar­kets, com­mod­i­ty mar­kets, and unem­ploy­ment took a huge hit.

The fol­low­ing year saw the slow­down in the rate of growth of debt turn into absolute delever­ag­ing, with pri­vate debt falling by $1.86 tril­lion (falling mort­gage debt con­tributed $220 bil­lion of this). Pri­vate sec­tor aggre­gate demand was thus $12.55 tril­lion, com­pared to $18.38 tril­lion just two years ear­li­er.

Table 3: Delever­ag­ing in the USA

Variable\Year 2006 2007 2008 2009 2010






Change in Nom­i­nal GDP






Change in Real GDP






Infla­tion Rate






Pri­vate Debt






Debt Growth Rate






Change in Debt






GDP + Change in Pri­vate Debt






Change in Pri­vate Aggre­gate Demand






Gov­ern­ment Debt






Change in Gov­ern­ment Debt






GDP + Change in Total Debt






Change in Total Aggre­gate Demand






Mort­gage Debt






Change in Mort­gage Debt






Aus­tralia suf­fered a reduc­tion in aggre­gate demand as well from the slow­down in the rate of growth of pri­vate debt in the year end­ing in 2008. GDP was $1.13 tril­lion, while the increase in pri­vate debt that year was $260 billion—so that pri­vate sec­tor aggre­gate demand was $1.39 tril­lion. GDP grew to $1.24 tril­lion the next year, while the growth of debt slowed sub­stan­tial­ly to $134 bil­lion. The sum was $1.37 tril­lion, slight­ly less in nom­i­nal terms than the year before.

Table 4: Avoid­ing delever­ag­ing in Aus­tralia

Variable\Year 2006 2007 2008 2009 2010






Change in Nom­i­nal GDP






Change in Real GDP






Infla­tion Rate






Pri­vate Debt






Debt Growth Rate






Change in Debt






GDP + Change in Pri­vate Debt






Change in Pri­vate Aggre­gate Demand






Gov­ern­ment Debt






Change in Gov­ern­ment Debt






GDP + Change in Total Debt






Change in Total Aggre­gate Demand






Mort­gage Debt






Change in Mort­gage Debt






The implications for economic performance of excessive private debt

From this debt-dri­ven per­spec­tive, these macro-eco­nom­ic impli­ca­tions of debt are far more impor­tant than the micro­eco­nom­ic issue of the cost of debt. But since Aus­tralia has appar­ent­ly done so well dur­ing the GFC, these macro­eco­nom­ic issues have been far less dom­i­nant here than in the rest of the world. It is there­fore impor­tant to con­sid­er why Aus­tralia dif­fered from the rest of the world: was there some­thing unique about Aus­tralia which meant the GFC did­n’t hap­pen here, or are the macro­eco­nom­ic impli­ca­tions of the GFC still rel­e­vant to us? We can get some guid­ance from com­par­ing the Aus­tralian expe­ri­ence to the US one.

There are three major dif­fer­ences between Aus­tralia and the USA, which in turn are by far the major rea­sons why Aus­trali­a’s eco­nom­ic per­for­mance was so much bet­ter than Amer­i­ca’s:

  1. While Aus­trali­a’s debt to GDP lev­el is unprece­dent­ed in its own his­to­ry, the USA’s is high­er still;
  2. Delever­ag­ing as such did not occur in Australia—though this almost guar­an­tees that it will occur in the future; and
  3. Growth in mort­gage debt con­tin­ued, large­ly under the influ­ence of gov­ern­ment pol­i­cy.

Were the cur­rent pri­vate debt to GDP ratio unre­mark­able, these fac­tors would be gen­er­al­ly positive—a handy boost to cred­it-dri­ven demand would have helped us side­step a reces­sion, with only minor long term con­se­quences. But since pri­vate debt is at unprece­dent­ed lev­els, these short term gains in 2009–2010 imply that a rever­sal of our eco­nom­ic for­tunes in 2011 is pos­si­ble, if pri­vate sec­tor delever­ag­ing com­mences here. To explain why, I need to pro­vide more detail on each of those three dis­tin­guish­ing fac­tors between the USA and Aus­tralia.

Level of Debt

Fig­ure 24 shows both how much greater Amer­i­ca’s pri­vate debt lev­el is that Aus­trali­a’s, and also shows that Amer­i­ca is rapid­ly delever­ag­ing now. Thus even though Aus­trali­a’s debt-dri­ven boost to aggre­gate demand was larg­er in 2008 than America’s—since pri­vate debt grew 17.2% that year in Aus­tralia, ver­sus 11.1% in the USA—the sheer scale of the USA’s debt com­pared to its GDP means that its depen­dence on ris­ing debt was even more extreme than ours. It also meant that when the debt went into reverse, the depress­ing impact of this was greater for the USA than Aus­tralia.

Fig­ure 24: The USA’s pri­vate debt to GDP ratio is sig­nif­i­cant­ly larg­er than Aus­trali­a’s

The rate of change of debt—no deleveraging here

The fun­da­men­tal cause of the GFC was the burst­ing of a glob­al debt bub­ble. With the growth of debt going from pos­i­tive to negative—so that we went from ris­ing debt adding to aggre­gate demand, to falling debt sub­tract­ing from aggre­gate demand (see Fig­ure 25)—what had appeared to be a peri­od of stel­lar eco­nom­ic per­for­mance gave way to the biggest eco­nom­ic cri­sis since the Great Depres­sion.

Fig­ure 25: The GFC was the first time the change in debt reduced aggre­gate demand since the Great Depres­sion

Aus­tralia, on the oth­er hand, avoid­ed a seri­ous down­turn because delever­ag­ing was stalled, and in fact turned around—so that ris­ing debt once again added to aggre­gate demand. While Amer­i­ca and the rest of the world had a delever­ag­ing-dri­ven cri­sis, Aus­tralia avoid­ed the cri­sis by relever­ag­ing on the back of a renewed prop­er­ty bub­ble (see Fig­ure 26).

Fig­ure 26: Aus­tralia abrupt­ly stopped delever­ag­ing in 2010

Since eco­nom­ic activ­i­ty and employ­ment in a mar­ket econ­o­my is demand-dri­ven, delever­ag­ing in the USA (and else­where in the OECD) caused a seri­ous reces­sion, while Aus­trali­a’s relever­ag­ing boost­ed aggre­gate demand and result­ed in it expe­ri­enc­ing only a very mild down­turn.

The piv­otal role of the change in pri­vate debt in deter­min­ing eco­nom­ic activ­i­ty is eas­i­ly seen in Fig­ure 27, which cor­re­lates the debt-dri­ven frac­tion of aggre­gate demand with the unem­ploy­ment rate. This fig­ure shows why it is not hyper­bole to com­pare the cur­rent cri­sis to the Great Depres­sion, since this is the only time since then that the debt-con­tri­bu­tion to aggre­gate demand has turned neg­a­tive (the appar­ent neg­a­tives in 1945 were due respec­tive­ly to the end­ing of WWII, and a break in the sta­tis­ti­cal series). The cor­re­la­tion with unem­ploy­ment points out the “Ponzi” nature of the US’s eco­nom­ic per­for­mance in both the Great Depres­sion and recent­ly: when debt grew, unem­ploy­ment fell, and vice versa—with dis­as­trous consequences—when delever­ag­ing struck. In the Great Depres­sion the cor­re­la­tion was ‑0.76; across the whole of 1955 till now, the cor­re­la­tion was ‑0.36; and in the last 20 years, when the pri­vate debt has sur­passed the Great Depres­sion lev­el, the cor­re­la­tion was ‑0.9.

Fig­ure 27: Debt dri­ven-demand and unem­ploy­ment, USA

I’ve used the same ver­ti­cal scales for the Aus­tralian data (Fig­ure 28) as the Amer­i­can to empha­sise both dif­fer­ences and sim­i­lar­i­ties between the two coun­tries.

First­ly, both GDP and the change in debt deter­mine aggre­gate demand, and with its low­er lev­el of debt dur­ing the 1950s and 1960s, the debt-dri­ven frac­tion of aggre­gate demand was far less impor­tant in Aus­tralia than in Amer­i­ca. The cor­re­la­tion over 1955–2010 was 0.25, which is both small and the wrong sign, show­ing that the debt con­tri­bu­tion to demand was swamped by that of GDP—which is the sign of a well-func­tion­ing econ­o­my.

Sec­ond­ly how­ev­er, this dif­fer­ence dis­ap­peared as Aus­trali­a’s debt to GDP ratio grew expo­nen­tial­ly from 1965. Between 1990 an today, the cor­re­la­tion is sig­nif­i­cant, the cor­rect sign for the causal argu­ment I am mak­ing here, and large at ‑0.82. So by the time the GFC hit, the debt-dri­ven com­po­nent of aggre­gate demand was almost as dom­i­nant in Aus­tralia as it was in the USA.

Third­ly, we avoid­ed a seri­ous down­turn, not by hav­ing an econ­o­my that was fun­da­men­tal­ly dif­fer­ent to the USA’s, but by pre­vent­ing delever­ag­ing. Where­as dur­ing the 1990s reces­sion, absolute delever­ag­ing did occur (and unem­ploy­ment exceed­ed 10 per­cent) dur­ing the GFC, delever­ag­ing was pre­vent­ed sole­ly because a gov­ern­ment policy—the First Home Own­ers Boost—encouraged Aus­tralian house­holds to go on a debt-binge.

Fig­ure 28: Debt-dri­ven demand and unem­ploy­ment, Aus­tralia

The busi­ness sec­tor, whose debt had been grow­ing strong­ly in the lead­up to the GFC, delev­ered at a faster pace than it did dur­ing “the reces­sion we had to have”, when the debt frac­tion of aggre­gate demand briefly turned neg­a­tive. On the oth­er hand, mort­gage debt rose strong­ly. Aus­trali­a’s avoid­ance of delever­ag­ing was there­fore entire­ly due to the growth in mort­gage debt (see Fig­ure 29).

Fig­ure 29: Debt-dri­ven demand by sec­tor

This growth in mort­gage debt would not have come about with­out the First Home Own­ers Boost (see Fig­ure 30). Pri­or to that pol­i­cy being intro­duced, mort­gage debt was on track to fall by about 2% of GDP between mid-2008 and March 2010. Instead, it rose by over 6% of GDP. This effec­tive­ly added $100 bil­lion in debt-financed expen­di­ture to the Aus­tralian economy—a larg­er boost to aggre­gate demand than either the Rudd Gov­ern­men­t’s stim­u­lus pro­gram, or the impact on house­hold dis­pos­able income of the RBA’s rate cuts.

Fig­ure 30: The impact of the FHOB on the trend in mort­gage debt

The great dan­ger for the future is that this pol­i­cy suc­cess in 2008-09 has set Aus­tralia up for a greater pol­i­cy dilem­ma in future when the house­hold sec­tor joins the busi­ness sec­tor in delever­ag­ing. That this may already be hap­pen­ing can be seen by con­sid­er­ing the third aspect of pri­vate debt, the “cred­it impulse”: the impact of the accel­er­a­tion or decel­er­a­tion of debt on the change in aggre­gate demand.

The credit impulse

The fact that aggre­gate demand is the sum of GDP plus the change in debt means that the change in aggre­gate demand is the sum of the change in GDP plus the accel­er­a­tion of debt. Just as the debt con­tri­bu­tion to demand is high­ly cor­re­lat­ed with the lev­el of employ­ment, the accel­er­a­tion of debt—or the cred­it impulse, which is defined as the change in the change in debt divid­ed by GDP (Michael Big­gs et al., 2010)—is high­ly cor­re­lat­ed with the change in employ­ment.

In stark con­trast to the assump­tion made by Bernanke and most neo­clas­si­cal economists—that debt only has macro­eco­nom­ic impli­ca­tions if the dis­tri­b­u­tion of debt affects con­sump­tion (to cite a recent paper by Krug­man, “It fol­lows that the lev­el of debt mat­ters only if the dis­tri­b­u­tion of that debt mat­ters, if high­ly indebt­ed play­ers face dif­fer­ent con­straints from play­ers with low debt”, Gau­ti B. Eggerts­son and Paul Krug­man, 2010, p. 3)—the sheer scale of debt, its rate of change, and whether it is accel­er­at­ing or decel­er­at­ing, have very sig­nif­i­cant impacts on the macro­econ­o­my. If Bernanke, Krug­man and oth­er neo­clas­si­cals were cor­rect, the cor­re­la­tions between the accel­er­a­tion in debt and the change in unem­ploy­ment should be insignif­i­cant.

Instead, the cor­re­la­tion is high­ly sig­nif­i­cant, large, per­sis­tent, and causal, since it leads changes in employ­ment and GDP by about 3 months. The cor­re­la­tion dur­ing the Great Depres­sion was ‑0.72; over the whole post-WWII peri­od from 1955 the cor­re­la­tion was ‑0.59, and since 1990 it was ‑0.82 (see Fig­ure 31).

Fig­ure 31: Decel­er­a­tion of US debt in the GFC more extreme than in Great Depres­sion

The com­par­i­son of Aus­tralia with the USA dur­ing the GFC con­firms that Aus­tralia had a milder GFC by hav­ing a milder neg­a­tive cred­it impulse, and by revers­ing it before the USA did (Fig­ure 32).

Fig­ure 32: Aus­trali­a’s cred­it impulse was milder and reversed ear­li­er than did the USA’s

The size of the neg­a­tive cred­it impulse in 2008–2010 in Amer­i­ca was the major cause of the sharp increase in unem­ploy­ment, and the recent improve­ments have been due to the cred­it impulse turn­ing less neg­a­tive (see Fig­ure 33).

Fig­ure 33: The USA’s large neg­a­tive cred­it impulse caused a large increase in unem­ploy­ment, since mild­ly reversed

Aus­trali­a’s milder reces­sion and current—though appar­ent­ly faltering—recovery has been due to its neg­a­tive cred­it impulse being small­er than in the USA, and being reversed ear­li­er (see Fig­ure 34).

Fig­ure 34: Aus­trali­a’s small­er neg­a­tive cred­it impulse meant a small­er down­turn

At a super­fi­cial lev­el, this implies an easy solu­tion to an eco­nom­ic down­turn: if the econ­o­my slows down, encour­age the growth of cred­it, and the econ­o­my will recov­er. Effec­tive­ly, this is how Aus­tralia and most of the OECD has over­come past reces­sions: by expand­ing the lev­el of pri­vate debt even more and caus­ing a new debt-dri­ven boom to replace the old one.

The prob­lem with this solu­tion is that it nec­es­sar­i­ly involves a ris­ing lev­el of debt com­pared to income over time. At some point, this will result in a lev­el of debt which is so large com­pared to income that many eco­nom­ic agents refuse to take on any more debt. The cred­it impulse there­fore turns neg­a­tive and a major cri­sis ensues—a Depres­sion.

In late 2005, I formed the belief that we had reached such a point in the cred­it cycle, which is why I went pub­lic with my views that a seri­ous eco­nom­ic cri­sis was immi­nent (along with a hand­ful of oth­er non-ortho­dox econ­o­mists; for details see Dirk J Beze­mer, 2009, Dirk J. Beze­mer, 2010, Edward Full­brook, 2010). The occur­rence of the Glob­al Finan­cial Cri­sis, against the expec­ta­tions of the vast major­i­ty of econ­o­mists, vin­di­cat­ed my analy­sis.

Aus­trali­a’s appar­ent avoid­ance of the cri­sis has led to my analy­sis car­ry­ing less weight in Aus­tralia than over­seas. How­ev­er as out­lined above, Aus­trali­a’s avoid­ance of a seri­ous down­turn to date has large­ly occurred because it delayed the process of delever­ag­ing. In effect, we avoid­ed the GFC by recre­at­ing the con­di­tions that caused it: an asset price bub­ble caused by ram­pant lend­ing to the house­hold sec­tor.

Implications for competition policy

Attempt­ing to increase com­pe­ti­tion in the bank­ing sec­tor once more could risk con­tin­u­ing this process of an ever-increas­ing lev­el of debt caus­ing appar­ent pros­per­i­ty, at the expense of guar­an­tee­ing a future severe delever­ag­ing-dri­ven con­trac­tion.

How­ev­er an equal­ly prob­a­ble out­come, giv­en the exces­sive and unprece­dent­ed lev­el of house­hold debt (high­er than that pre­vail­ing in the USA—see Fig­ure 35—and with a much high­er debt ser­vic­ing cost—see Fig­ure 36), is that new com­peti­tors will fail to gain a foothold in the mar­ket, because the mar­ket will now shrink rather than expand as the house price bub­ble deflates.

The like­li­hood that the lev­el of house­hold debt will fall is rea­son enough to be less than enthu­si­as­tic about the ben­e­fits of increased com­pe­ti­tion in the bank­ing sector—since in the past this has led to ris­ing lev­els of debt. It is also hard to con­tem­plate how increased com­pe­ti­tion could be con­sis­tent with falling debt volumes—such a phe­nom­e­non is more like­ly to mean con­sol­i­da­tion in the sec­tor rather than an increased num­ber of play­ers fight­ing over a small­er pie.

Fig­ure 35: Aus­tralian house­hold debt com­pared to GDP is now 5% high­er than Amer­i­ca’s

Fig­ure 36: Inter­est on mort­gages cost 6.5% of GDP here ver­sus under 4% in the USA

A lack of competition, or a lack of control?

The pre­ced­ing analy­sis shows that the prob­lem with bank­ing is not so much a lack of com­pe­ti­tion, as a lack of con­trol over the lev­el of lend­ing. The ques­tion then is whether increased com­pe­ti­tion would pro­vide the con­trol need­ed over the lev­el of lend­ing.

The his­tor­i­cal record is decid­ed­ly that it will not: as shown above, both pre­vi­ous pol­i­cy-inspired increas­es in com­pe­ti­tion caused a blowout in debt lev­els. Com­pe­ti­tion is not the solu­tion to the social and eco­nom­ic prob­lems caused by the bank­ing sec­tor.

Why then are politi­cians and econ­o­mists rec­om­mend­ing more com­pe­ti­tion for bank­ing? To some degree this is because of they tend to apply the stan­dard “sup­ply and demand” mod­el to banking—and there­fore to argue that if the indus­try is the sub­ject of com­plaints, it must be because it is too monop­o­lis­tic. Unfor­tu­nate­ly how­ev­er, the “sup­ply and demand” mod­el is a false guide to the oper­a­tions of the bank­ing sec­tor. So too is the “mon­ey mul­ti­pli­er” the­o­ry of how cred­it mon­ey is cre­at­ed that is still taught in eco­nom­ics text­books, despite being found to be empir­i­cal­ly false over the last 3 decades.

One of the main rea­sons that the world is now mired in a seem­ing­ly nev­er-end­ing series of finan­cial crises is because of the appli­ca­tion of appeal­ing but false mod­els of how bank­ing behaves. It is there­fore impor­tant for policy-makers—like the mem­bers of this Committee—to have an accu­rate under­stand­ing of how the sec­tor they are attempt­ing to reform actu­al­ly oper­ates.

The con­ven­tion­al “mon­ey mul­ti­pli­er” mod­el argues that the cre­ation of cred­it mon­ey begins with an injec­tion of gov­ern­ment-cre­at­ed “Base Mon­ey”, which is then deposit­ed by an indi­vid­ual in a bank account. The bank then retains a por­tion of this—the so-called Reserve Ratio—and lends the rest. A process of re-deposit­ing and re-lend­ing then occurs, at the end of which the total amount of mon­ey cre­at­ed is equal to the Base Mon­ey injec­tion divid­ed by the Reserve Ratio.

Were this mod­el accu­rate, then we would find that there was a time lag between the cre­ation of Base Mon­ey (M0) and the cre­ation of Cred­it Mon­ey (M2-M0). But in fact the lag has been found to be the oth­er way around: cred­it mon­ey is cre­at­ed first, fol­lowed by changes in base mon­ey. As Nobel Prize win­ners Kyd­land and Prescott put it:

There is no evi­dence that either the mon­e­tary base or M1 leads the cycle, although some econ­o­mists still believe this mon­e­tary myth. Both the mon­e­tary base and M1 series are gen­er­al­ly pro­cycli­cal and, if any­thing, the mon­e­tary base lags the cycle slight­ly… The dif­fer­ence of M2 — M1 leads the cycle by even more than M2, with the lead being about three quar­ters. (Finn E. Kyd­land and Edward C. Prescott, 1990, p. 12)

A more real­is­tic per­spec­tive on bank­ing is the “endoge­nous mon­ey” the­o­ry, and its impli­ca­tions are that dereg­u­lat­ed, com­pet­i­tive bank­ing has an innate ten­den­cy to cause finan­cial crises of the kind the glob­al econ­o­my is now expe­ri­enc­ing. As Basil Moore put it, the essence of this mod­el is the obser­va­tion that

In the real world banks extend cred­it, cre­at­ing deposits in the process, and look for the reserves lat­er” ((Basil J. Moore, 1979, p. 539) cit­ing (Alan R. Holmes, 1969, p. 73); see also more recent­ly (Piti Disy­atat, 2010, “loans dri­ve deposits rather than the oth­er way around”, p. 7)).

This empir­i­cal real­i­ty makes it easy to under­stand a fun­da­men­tal point: that banks have an innate ten­den­cy to want to cre­ate as much debt as pos­si­ble, and the only effec­tive stop to this is not com­pe­ti­tion between banks, but insti­tu­tion­al reforms that lim­it the will­ing­ness of bor­row­ers to take on debt for spec­u­la­tive pur­pos­es.

I have con­struct­ed mod­els of a pure cred­it econ­o­my to illus­trate this point (Steve Keen, 2009a, b, c, d, 2008, 2010); rather than repro­duc­ing these here I have put a mod­el which enables these points to be illus­trat­ed in a dynam­ic sim­u­la­tion (see Fig­ure 37 for a sam­ple out­put) on my blog at the page The mod­el and mod­el­ing soft­ware can be down­loaded direct­ly from the fol­low­ing link:

Fig­ure 37: Sam­ple out­put from dynam­ic mod­el­ling pro­gram with vari­a­tions in lend­ing vari­ables

Fig­ure 38 illus­trates the basic insight of this endoge­nous mon­ey per­spec­tive: bank income increas­es if more debt is cre­at­ed. This ten­den­cy will not be reduced by increas­ing com­pe­ti­tion: instead, as the his­tor­i­cal record of Aus­tralian bank­ing has illus­trat­ed, an increase in com­pe­ti­tion will often ampli­fy this ten­den­cy as the com­pe­ti­tion for mar­ket share leads all banks to search out avenues to mar­ket debt.

Fig­ure 38: Bank income increas­es with faster lend­ing, more rapid mon­ey cre­ation, and slow­er loans repay­ment

The eas­i­est way to do so is to fund spec­u­la­tion on asset prices, since that weak­ens the one effec­tive con­trol on the amount of debt that banks can cre­ate, the will­ing­ness of firms and house­holds to go into debt.

If firms and house­holds lim­it their bor­row­ing to what they can rea­son­ably antic­i­pate ser­vic­ing from income, then broad­ly speak­ing debt would not become a prob­lem. Though there will always be firms who bor­row with unre­al­is­tic expec­ta­tions of prof­it, and prodi­gal house­holds who live beyond their means, by and large these will be periph­er­al issues if bor­row­ing is income-based.

But when bor­row­ing becomes based instead on expec­ta­tions of prof­it­ing from ris­ing asset prices (“asset-based lend­ing”), then a pos­i­tive feed­back loop is set up that, almost inevitably, leads to a blowout in debt lev­els and an even­tu­al finan­cial cri­sis. Ris­ing debt lev­els them­selves dri­ve up asset prices, indi­vid­u­als accept a high­er debt to income ratio than they oth­er­wise would in the belief that debt can be repaid from the pro­ceeds of asset sales, and an actu­al boom is gen­er­at­ed in the econ­o­my as the increase in debt spurs aggre­gate demand. Once such an appar­ent “vir­tu­ous cir­cle” is in train, it is almost impos­si­ble to stop, since vir­tu­al­ly every­one in soci­ety has an inter­est in its con­tin­u­ance: the banks, stock­bro­kers and real estate agents because their prof­its are high­er, the gen­er­al pub­lic because they feel wealth­i­er as asset prices rise (and some of them do prof­it from buy­ing and sell­ing on a ris­ing mar­ket), and even the gov­ern­ment because the Ponzi boom gen­er­at­ed by ris­ing pri­vate debt makes it seem to be a “good eco­nom­ic man­ag­er”.

But the boom must ulti­mate­ly end in a cri­sis, because it dri­ves up debt lev­els with­out adding to the econ­o­my’s income-gen­er­at­ing capac­i­ty. Ulti­mate­ly, a lev­el of debt will be incurred that can­not be ser­viced, and the econ­o­my will col­lapse into a Depres­sion. I have mod­eled this process in anoth­er more tech­ni­cal paper (Steve Keen, 2009d). Two sam­ple out­puts from this mod­el are shown in Fig­ure 39 and Fig­ure 40. With­out asset-based lend­ing, though the debt lev­el ris­es, it does not get out of hand and cause a cri­sis.

Fig­ure 39: a debt-financed pure cred­it econ­o­my with­out asset-based lend­ing

With asset-based lend­ing how­ev­er, spec­u­la­tive lend­ing even­tu­al­ly pre­dom­i­nates over pro­duc­tive invest­ment and even­tu­al­ly, after a series of finan­cial cycles, the lev­el of debt over­whelms the econ­o­my.

Fig­ure 40: a debt-financed pure cred­it econ­o­my with asset-based lend­ing

Conclusion: the problem is not microeconomic, and competition is not the solution

Since the main prob­lems with the bank­ing sec­tor relate to the amount of debt it gen­er­ates and the macro­eco­nom­ic prob­lems these cause, the solu­tion lies not with micro­eco­nom­ic reforms—and espe­cial­ly not with increased com­pe­ti­tion, which exac­er­bates the under­ly­ing prob­lem of exces­sive debt—but with insti­tu­tion­al reforms and macro­eco­nom­ic pol­i­cy.

From the expe­ri­ence of the Great Depres­sion itself, it is clear that reg­u­la­to­ry reform is not enough to pre­vent bank lend­ing get­ting out of hand. Reforms such as the Glass Stea­gall Act may tem­porar­i­ly ush­er in a peri­od of sta­bil­i­ty. But if the reforms leave open the pos­si­bil­i­ty of fund­ing asset-price spec­u­la­tion, then banks will do this and in the process, under­mine the reforms. The pub­lic will gain a tem­po­rary ben­e­fit from the lend­ing as it expands eco­nom­ic activ­i­ty, bank pow­er will rise with ris­ing debt, and ultimately—as we saw in 1999—the very reforms them­selves will be abol­ished.

Some­thing more per­ma­nent is required, and it has to, in my opin­ion, tack­le the will­ing­ness of bor­row­ers to take on debt, rather than attempt­ing to lim­it bank will­ing­ness to lend—since I see this as rather like try­ing to stop the tides com­ing in.

I have devel­oped two basic reform ideas, both of which I know I have Buck­ley’s Chance of hav­ing imple­ment­ed at present—especially in Aus­tralia, since the dom­i­nant per­cep­tion here is that we have in fact avoid­ed the prob­lems that have beset the rest of the world. How­ev­er unless I put these ideas into cir­cu­la­tion now, there will nev­er be any chance of hav­ing them imple­ment­ed, even when atti­tudes to the finan­cial cri­sis are much more melan­choly than today.

Reform Proposals

My pro­pos­als are, in one sense, “micro­eco­nom­ic reforms”, since they are rede­f­i­n­i­tions of fun­da­men­tal com­po­nents of every­day con­tracts rather than grand reg­u­la­to­ry schemes to con­trol bank­ing, or fis­cal or mon­e­tary pol­i­cy rec­om­men­da­tions to counter the excess­es of the bank­ing sec­tor. How­ev­er, I am sure they are not the kind of micro­eco­nom­ic reforms the Com­mit­tee had in mind—and nor are they like­ly to be adopt­ed.

These pro­pos­als are:

  1. To rede­fine shares so that, when pur­chased from a com­pa­ny, they last indef­i­nite­ly as they do today, but once they are sold to a sec­ondary pur­chas­er, they have a defined life­time of 50 years, after which they expire (I call this a Jubilee Share pro­pos­al); and
  2. To base lend­ing for prop­er­ty on the rental income (actu­al or imput­ed) of the prop­er­ty being pur­chased, and to lim­it the debt that can be secured against a prop­er­ty to ten times its annu­al rental income.

The object of both reforms is to make lever­aged spec­u­la­tion on asset prices much less like­ly than it is today.

The vast major­i­ty of trades on share mar­kets are of spec­u­la­tors sell­ing to oth­er spec­u­la­tors, with val­u­a­tions osten­si­bly based on the net present val­ue of expect­ed future div­i­dend flows, but in real­i­ty based on the “Greater Fool” prin­ci­ple, where ris­ing debt funds the Greater Fool. If instead shares on the sec­ondary mar­ket pro­vid­ed div­i­dends for up to 50 years, but after that date had a val­ue of zero, it is far less like­ly that share pur­chas­es would be under­tak­en with bor­rowed mon­ey. Val­u­a­tions would then be actu­al­ly based on con­ser­v­a­tive esti­mates of future div­i­dend flows up until expiry, lead­ing to much less volatile share prices and much less spec­u­la­tion.

Such a change would also encour­age cap­i­tal for­ma­tion via the share mar­ket, since the only means to secure a per­pet­u­al div­i­dend flow would be to pro­vide mon­ey direct­ly to a com­pa­ny via an ini­tial pub­lic offer­ing.

The prop­er­ty reform would break the pos­i­tive feed­back loop that cur­rent­ly exists between lever­age and prop­er­ty prices: prices rise because some bor­row­ers are will­ing to take on more lever­age to trump oth­er bor­row­ers, and the increased lever­age dri­ves prices up, feed­ing back into the lever­age-price bub­ble process.

With this reform, all would-be pur­chasers would be on equal foot­ing with respect to their lev­el of debt-financed spend­ing, and the only way to trump anoth­er buy­er would be to put more non-debt-financed mon­ey into pur­chas­ing a prop­er­ty.

Though I know there is no prospect of these reforms being adopt­ed, I nonethe­less rec­om­mend that Sen­a­tors at least pon­der them. The Glob­al Finan­cial Cri­sis is not going away any time soon, because its fun­da­men­tal cause is still with us—an exces­sive lev­el of pri­vate sec­tor debt, gen­er­at­ed by a finan­cial sec­tor that was hap­pi­er fund­ing Ponzi Schemes than it was doing the more dif­fi­cult work of financ­ing pro­duc­tive invest­ment. Only when the intractabil­i­ty of the cri­sis with­out fun­da­men­tal reforms becomes appar­ent, will pro­pos­als like these that actu­al­ly go to the heart of the prob­lem be con­sid­ered.

In the mean­time, I expect that mis­tak­en ideas—such as that the prob­lem is exces­sive mar­gins rather than exces­sive debt, and that addi­tion­al com­pe­ti­tion will solve this problem—are more like­ly to be pro­posed by Inquiries such as this one. I remain opposed to unstruc­tured attempts to increase com­pe­ti­tion in the bank­ing sec­tor, but there is one com­pet­i­tive reform that I would sup­port: intro­duc­ing lenders whose sole pur­pose is to pro­vide small busi­ness with work­ing cap­i­tal. At present, small busi­ness is being squeezed by high­er loan mar­gins more than all oth­er sec­tors, and much small busi­ness lend­ing is actu­al­ly secured against and based on the prop­er­ty owned by small busi­ness own­ers, rather than on their busi­ness­es and cash flows,as it should be.

A com­pet­i­tive reform that encour­aged lend­ing to this sector—to finance actu­al busi­ness activity—would be worth­while. Any oth­er approach that relied sim­ply on increased com­pe­ti­tion to fix the sec­tor’s ills would either fail to work—given the cur­rent exces­sive lev­el of debt—or make our prob­lems worse.


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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.