How I learnt to stop worrying and love The Bank

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Having just read the World Economic Forum‘s Report on sustainable credit, I now realise that I was wrong to worry about the growth in debt. After all, since 1932, the US’s debt to GDP ratio has actually fallen at a rate of 0.2% per year!

How could I ever have thought that the growth of credit could have caused the Great Recession, when in fact the growth rate of debt has been negative?

I am also chastened to realise that credit is only used for good purposes. As the report notes:

In the long run, the scale and distribution of credit is only economically sustainable if it also meets society’s broader social objectives. Credit is linked to social objectives during all stages of a country’s economic development. In early stages of development, credit is used to support family-owned businesses; next, it supports small and large corporations; and finally it is used to smooth consumption. Muhammad Yunus, founder of Grameen Bank, goes so far as to say that credit is a human right, and adds: “If we are looking for one single action which will enable the poor to overcome their poverty, I would focus on credit.” (p. 39)

Foolish me: here was I, thinking that credit might also be used to fund Ponzi Schemes.

OK, enough with the irony. The WEF’s report is not all bad—there are some very good bits that I’ll get on to later—but it commits at least three fundamental errors: it uses a questionable base year for its analysis, it omits a crucial variable, and it maintains a wholly benign view of a factor that experience indicates has both benign and malignant attributes.

A Questionable Base Year: why 2000?

The questionable base year is 2000. The WEF team, working with McKinsey & Company, have put together an impressive database on debt levels in 79 countries, with debt disaggregated into 3 sectors:

  • Retail credit: All household credit stock (loans outstanding), including mortgages and other personal loans such as credit cards, auto loans and other unsecured loans
  • Wholesale credit: All corporate and SME credit stock (loans and bonds outstanding)
  • Government credit: All public sector credit stock (including loans and bonds outstanding) (p. 19)

But to start in 2000? That was just before the last big credit bust, when the DotCom fiasco came crashing down. Why not—at least for the countries where debt data is readily available—go back a bit further? Debt data for the USA is readily available to 1952 from the Flow of Funds, and historical data for earlier years can be derived from the US census. Australia’s Reserve Bank publishes reliable aggregate credit data till 1976, and earlier data is available to take it back to 1953. As a sole individual, I’ve been able to acquire data till 1920 for the USA and 1860 for Australia. Surely the WEF and McKinsey and Co, with the resources they had to throw at this project, could have done better than 2000.

Why omit financial sector debt?

The report omits borrowing by within the financial sector from its record of total debt, when this has been a major component of the growth of debt (certainly in the USA) in the last 60 years. I include financial sector debt in my analysis for two reasons:

  • The initial borrowing by the shadow banking sector from the banks creates both money and debt;
  • The money onlent by the shadow banking sector to other sectors of the economy creates debt to the shadow banking sector, but not money

I frequently get the argument that debt within the financial sector can be netted out to zero, but I think this ignores those two factors above: the creation of additional debt-backed money by the initial loan, and the creation of further debt to the financial sector—most of which has been used to fund asset bubbles rather than productive investment.

Just for comparison, here’s that same 1932 to 2010 comparison, but with the financial sector’s debt included:

Even with the same nonsense base year, and even with combining private and public debt—factors that I believe should be kept separate—this paints a somewhat different picture.

And a focus on total private sector debt during and after the Great Depression also conveys a somewhat different perspective.

Which raises the third issue…

Why ignore Ponzi Schemes—and Minsky?

The report’s listing of the uses to which credit is put is so innocent as to make me wonder whether one of the author’s primary school children wrote the relevant paragraph:

In early stages of development, credit is used to support family-owned businesses; next, it supports small and large corporations; and finally it is used to smooth consumption.

But maybe I’m being harsh: it could, after all, have been written by a neoclassical economist.

Please, let’s get real: yes credit can do all of those things, but it can also fund asset bubbles and Ponzi Schemes, and that has been by far the dominant aspect of credit growth since the report’s base year of 2000, and arguably since the 1987 Stock Market Crash. To ignore this aspect of credit after the biggest financial crisis since the Great Depression is simply puerile.

So is ignoring the one academic who analysed the dynamics of credit long before it was fashionable—Hyman Minsky. The report makes much of it academic research:

Finally, the research was underpinned by an extensive review of the key academic and industry literature. (p. 19)

Prior to 2008, such ignorance was excusable simply because it was so widespread, as the dominant neoclassical school simply ignored dissidents like Minksy. After the crisis, he is receiving long overdue respect for focusing on the importance of credit in a capitalist economy while neoclassical economists effectively ignored it.

This is why Minsky-oriented researchers like myself, Michael Hudson and the late Wynne Godley were able to see the Great Recession coming while neoclassical economists from Ben Bernanke down were denying that anything untoward was untoward. Publishing a major report on credit now, while ignoring the only significant research done into credit dynamics, is a sign of continued ignorance rather than wisdom.

Its overall conclusion—the only part of the report that is likely to get an airing in the general media—should therefore be taken with a truckload of salt:

The rapid expansion of credit in recent decades has enabled unprecedented levels of economic development, business activity, home ownership and public sector spending. Yet, excess lending in some markets and sectors sparked a global crisis which brought the entire financial system to its knees. Not surprisingly, many commentators believe credit should be scaled back, even at the expense of economic growth.

The analysis in this report suggests the opposite is true. There are major pockets of the world economy, particularly in developing markets, whose growth has been held back by credit shortages, even over the past 10 years. To unlock development in these areas, and to meet consensus forecasts of world economic growth, credit levels must grow substantially over the next decade. At the same time, public and private decision-makers must avoid a repeat of the credit excesses that have caused so much damage in recent years. (p. 19)

Like a Curate’s Egg

However, despite its deficiencies, the report is not all bad—but its good bits are too conservative. It proposes a number of “rules of thumb” to indicate whether credit levels and credit growth are sustainable or not:

These are related to the measures that I have been putting forward on this site for years—the debt to GDP ratio, the rate of change of debt, and recently the “Credit Impulse” as defined by Biggs, Mayer and Pick (see also this paper), the rate of change of the rate of change of debt, divided by GDP. I’ll come back to these later as alternate indicators, but it’s worth noting the guidance these rules of thumb gave for where credit crises might occur in the near future. Their Exhibit 15 showed a “local sustainability” index for their sample of countries in 2006, with the sample sorted by the aggregate level of debt (hence Japan is at the top). The guide is laid out according to this legend:

And the countries identified using 2006 data as potential trouble spots were those with one or more red cells next to their names:

The same analysis on 2010 data yields the following table of suspects:

The rules of thumb themselves are pretty good. The weaknesses with their analysis are (a) that they allow the thumbs to be much too large, and (b) that they underplay the role of the banking sector in causing these problems in the first place.

As regular readers would know, I site responsibility for this crisis on the lenders themselves, and not the borrowers, on a number of grounds (see my Roving Cavaliers of Credit post if you haven’t seen these arguments before, and this paper for a more technical argument). The financial sector makes money by creating debt, and has funded a series of speculative bubbles since the early 1980s since that is the best way to encourage borrowers to take on more debt.

Minsky himself argued that the major objective of economic management should be to maintain a “robust financial structure”:

, in order to do better than hitherto, we have to establish and enforce a “good financial society” in which the tendency by business and bankers to engage in speculative finance is constrained.

The financial instability hypothesis has policy implications that go beyond the simple rules for monetary and fiscal policy that are derived from the neo-classical synthesis. In particular the hypothesis leads to the conclusion that the maintenance of a robust financial structure is a precondition for effective anti-inflation and full employment policies without a need to hazard deep depressions. This implies that policies to control and guide the evolution of finance are necessary… (Minsky 1982, pp. 69, 112)

He asserted that the US passed from such a structure to a fragile one with the Penn State crisis in 1966.

The first twenty years after World War II were characterized by financial tranquility. No serious threat of a financial crisis or a debt-deflation process (such as Irving Fisher described15) took place. The decade since 1966 has been characterized by financial turmoil. Three threats of financial crisis occurred, during which Federal Rserve interventions in money and financial markets were needed to abort the potential crises.

The first post-World War II threat of a financial crisis that required Federal Reserve special intervention was the so-called “credit crunch” of 1966. This episode centered around a “run” on bank-negotiable certificates of deposit. The second occurred in 1970, and the immediate focus of the difficulties was a “run” on the commercial paper market following the failure of the Penn-Central Railroad. The third threat of a crisis in the decade occurred in 1974-75 and involved a large number of over-extended financial positions, but perhaps can be best identified as centering around the speculative activities of the giant banks. In this third episode the Franklin National Bank of New York, with assets of $5 billion as of December 1973, failed after a “run” on its overseas branch.

Since this recent financial instability is a recurrence of phenomena that regularly characterized our economy before World War II, it is reasonable to view financial crises as systemic, rather than accidental, events. From this perspective, the anomaly is the twenty years after World War II during which financial crises were absent, which can be explained by the extremely robust financial structure that resulted from a Great War following hard upon a deep depression. Since the middle sixties the historic crisis-prone behavior of an economy with capitalist financial institutions has reasserted itself. The past decade differs from the era before World War II in that embryonic financial crises have been aborted by a combination of support operations by the Federal Reserve and the income, employment, and financial effects that flow from an immensely larger government sector. This success has had a side effect, however; accelerating inflation has followed each success in aborting a financial crisis. (Minsky 1982, pp. 62-63)

On that basis, the correct time period from which to derive rules as to how big the “sore thumbs” of finance should be is the 1960s, and not 2000. That implies alternative figures for the WEF’s indicators that would have most of its indicator table in red—certainly the first column for household sector debt.

My three indicators are the deb t to GDP ratio (which tells you how many years it would take to repay debt and is a measure of the degree of pressure debt is exerting on the economy), the rate of change of debt as a percentage of GDP plus the change in debt (which tells you how much of aggregate demand is debt-financed, and therefore whether you are in danger territory for a financial crisis), and the credit impulse—the rate of change of the rate of change of debt as a fraction of GDP, which tells you whether a crisis is imminent and how deep it is when it strikes.

My thumb size rules, based on these indicators and for the USA only, are the following:

The US was financially robust when the total private sector debt to GDP ratio was below 100%; it was approaching potential Depression-level fragility when this ratio exceeded 175% of GDP.

When debt-financed demand accounts for more than 10 percent of aggregate demand, trouble is afoot (again for the USA—other countries may have different thresholds):

Finally, and somewhat tentatively, I’d see danger coming when the Credit Impulse exceeds 3% in either direction: 3% plus indicates a bubble, and 3% minus indicates that you are in a bust. On that metric, this is the biggest bust of all (the 1945 figure was an aberration as we moved from a war economy to a peacetime one).

On all three indicators, the USA has been in a financially fragile state since the early 1970s—a conclusion that accords with Minsky’s decision to date the transition to a fragile financial structure in 1966—rather than the year 2000. The WEF’s report, while it does perform a useful service in finally recommending that credit and credit growth be taken seriously in economic management, will ultimately be seen as an indicator of just how seriously economists underestimated the role of credit in causing economic crises, even when they were in one.

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

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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46 Responses to How I learnt to stop worrying and love The Bank

  1. Re: the amendment thing

    Could you at least offer an opinion about the jubilee, and specifically the debts I exempted from being canceled: FRN’s and demand deposits?

    I understand you’re not a fan of the gold standard. I’m re-thinking some aspects of that anyway. But I really would like some feedback on the idea that IF we have a jubilee, those two things would have to be an exception to the debt relief.

    Sorry if that’s a pain in the neck. Thanks anyway even if you can’t get to it.

  2. sirius says:

    The system has now been repaired so that it will deliver the true justice demanded of it (I am being sarcastic)….but truth to say who really can rule over such a system when “the rules” are changed so frequently?

    “”
    “Could the Fed go broke? The answer to this question was ‘Yes,’ but is now ‘No,'” said Raymond Stone, managing director at Stone & McCarthy in Princeton, New Jersey. “An accounting methodology change at the central bank will allow the Fed to incur losses, even substantial losses, without eroding its capital.”

    This enhances transparency by providing clearer, more frequent, snapshots of the central bank’s finances, analysts say. The bonus: the number can now turn negative without affecting the central bank’s underlying financial condition.
    “””

    http://www.cnbc.com/id/41198789

    This appears typical of the U.S. system each component is setup so that it “cannot fail” – one other example – the primary dealers for Treasury Bonds are forced to buy any bonds that would not be sold ensuring that all sales “succeed”.

  3. Ramanan says:

    Thanks nice.

    Yes of course, not comparable to other nations which are vulnerable.

  4. yoganmahew says:

    I think you are missing the risk that overseas funding represents. The level doesn’t matter as much as the replacement likelihood – if there is lots of liquidity sloshing around in Australia, then it doesn’t matter if overseas funding dries up. If there is not, it is a problem.

    Look at it this way – the RBOC raises rates sharply to head off food inflation. China imports tank. The ‘markets’ reckon this will have a deep negative effect on Australia. Speculative-boosted commodity prices tank.

    Rumours abound about a single over-leveraged property-developer-lending bank that is reliant to a large degree on both overseas funding and short-term interbank lending (it is both borrowing short and from ‘over there’). Rumours spread to the other banks that the first bank has an active derivates desk that has insured much of their covered bond issuance. Propery prices are diving, unemployment is rising and mortgage defaults (despite recourse and draconian bankruptcy laws) are rising – they are not resulting in repossessions, but no payments are being made on the mortgages. In particular, developers and commercial property owners are effectively going bankrupt, with only bank forbearance stopping this being a mass extinction event.

    In the midst of this, bank A, a large bank, suddenly finds it can no longer borrow unsecured. Its secured repo has reduced from six months to three months to one month to one week and is threatening to go over-night. It has a large yen bond redemption coming soon that it has to roll over. The redemption is large for the bank, but small in the overall scheme of things. The government, paniced by the implications of a large bank failing, queues forming, ATMs empty, guarantees everything. Two years later, the country calls in the IMF…

    What happens? The whole system is illiquid, foreign lenders are running scared. Once the trust in a system breaks down, the system tends goes with it. PS the previous two paragraph are one read on what happened in Ireland (in case you hadn’t guessed)… (there are many other factors to include (!)).

  5. yoganmahew says:

    PS really enjoying your responding to comments Mr. Keen! Thank you so much.

  6. Steve Keen says:

    Oh, I’m not missing the point Yogan, I just didn’t make it in my reply to you. Your analysis of what could happen is spot on.

    My starting point on this is the “loans create deposits” perspective, combined with a country running a chronic current account deficit. This means that (say) only 85% of the money created as loans comes back as deposits to the national banking system. They therefore have to raise the remaining 15% overseas. If there is a Ponzi scheme behind the lending they are doing, rather than lending to finance productive investment in the future that will in turn eliminate that current account deficit, then disaster lies ahead.

    The Australian system was complicated by the fact that a lot of the lending to finance property speculation came from non-bank lenders that borrowed offshore to lend locally–in which case there was a different mechanism afoot with the foreign borrowing funding profligate/Ponzi behavior here. Then the non-banks failed and got taken over by the banks during the GFC, and now the banks have to roll over that hypothetical 15% gap between loans and deposits as outlined above. Should a crack occur in the Ponzi scheme–the housing bubble–then the credit crunch scenario you outline is highly likely–if not downright inevitable.

  7. peterjbolton says:

    An example of applied “economic theory”: it’s called ‘economic entanglement’

    http://blog.littlesis.org/2011/01/10/evidence-of-an-american-plutocracy-the-larry-summers-story/

  8. mahaish says:

    hi yoganmahew,

    “In the midst of this, bank A, a large bank, suddenly finds it can no longer borrow unsecured. Its secured repo has reduced from six months to three months to one month to one week and is threatening to go over-night”

    yes a wallerstinian dilema, capital flows to the periphery dry up, just like in the 30’s,
    but they had the gold standard. things are different, we have a sovereign currency, and a freely floating on at that, sort of.

    the government can provide the funding vehicle, or more specifically the central bank can provide the liquidity, and make a market, in its own currency.

    precicely what the fed did in the dark days after lehmans,

    “What happens? The whole system is illiquid, foreign lenders are running scared. Once the trust in a system breaks down, the system tends goes with it. PS the previous two paragraph are one read on what happened in Ireland (in case you hadn’t guessed)… (there are many other factors to include (!)).”

    again the government and the central bank can provide the liquidity. we can have debate about the pricing of that liquidity, even though thats at the descretion of the government as well, me thinks

    irelands a bad example, cant really compare it with the sitch in oz

    ireland has signed up to the modern day equivilent of the gold standard, emu(european monetary union) and the mastreicht treaty(almost as bad as the treaty of versaille).

    so not only do they have a common currency , the euro, they have signed up to artificial budgetary constraints as well. stay tuned for the revolutions

    we have a floating sovereign currency, they dont. its a big difference.

    and the imf, no chance, we are not ireland or iceland, or any other country in that god forsaken sodom call the european union.

    cheers

  9. mahaish says:

    “This appears typical of the U.S. system each component is setup so that it “cannot fail” – one other example – the primary dealers for Treasury Bonds are forced to buy any bonds that would not be sold ensuring that all sales “succeed”.”

    the problem is sirius,

    that the US treasury cannot run an over draft at the fed, so they have to issue treasuries to cover their appropriations.

    congress need to change the rules get rid of the debt ceiling and over draft rules, and hence take the bond traders out of the game, instead of relying on the fed to manipulate the market, and indirectly bringing the bond traders to heal, through their assett purchase programs

  10. Steve Keen says:

    Will do Atticus: as you know, I agree with you on the need for a Jubilee.

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  15. djc says:

    “When debt-financed demand accounts for more than 10 percent of aggregate demand, trouble is afoot (again for the USA—other countries may have different thresholds):”

    It seems to me that there is likely to be general agreement that debt is good up to a point but no general agreement what that point is. One objective measure is that the latest round of loans are to borrowers with no chance of repaying. But apart from special cases like subprime surely that would be at much higher levels than 10-20% GDP.

    So presumably the peak values are determined by behavioural factors, a “concern there is too much debt”. If that’s the case the limit is strongly time-dependent, from about 8% around 1960 to 20% most recently. And why does the curve drop sharply after most peaks, rather than stay roughly constant? Bankers are no more rational than most people? What is it about “this time” that has caused the curve to fall way below the most recent minimum, unlike for most earlier periods when each minimum was roughly the same as previous ones?

    Is the entire curve a series of Minsky Moments (at each peak), each at a higher debt level, until the most recent which has totally scared the bejesus out of eveyone?

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  17. Steve Keen says:

    You misread me djc: I didn’t say that the debt to GDP ratio should top out at 10%, but that when the debt-financed proportion of aggregate demand exceeds 10%, trouble is ahead. That could happen at a debt ratio of 1% to 300%, depending on the rate of growth of debt. But yes, the entire curve is a series of Minsky moments happening at higher and higher debt to GDP ratios.

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