Economics in the Age of Deleveraging

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The “Glob­al Finan­cial Cri­sis”, which began in late 2007, marked a turn­ing point in the nature of mar­ket economies. Their per­for­mance from at least the mid-1960s had been under-writ­ten by a faster growth of pri­vate debt than of GDP: this was the “Age of Lever­age”. In late 2007, the growth rate of pri­vate debt fell, and since then we have been in the Age of Delever­ag­ing.

The sta­tis­tics of the Ages are stark enough: pri­vate debt rose six­fold com­pared to GDP in Amer­i­ca from 1945, and six­fold in Aus­tralia from 1965. Pre-1988 fig­ures aren’t avail­able for UK debt, but clear­ly it has explod­ed since 1988. All three ratios peaked after 2007, and have since been falling. The fall in the US ratio is clear­ly unprece­dent­ed in the post-WWII peri­od: only the Great Depres­sion com­pares.

Fig­ure 1

The change in debt data is just as stark—and it points out one sub­stan­tive dif­fer­ence between Aus­tralia on the one hand and the USA & UK and most of the West­ern OECD on the oth­er. Aus­tralian pri­vate debt is still ris­ing (though more slow­ly than nom­i­nal GDP), where­as US pri­vate debt has been falling in absolute terms, and the UK has fluc­tu­at­ed between ris­ing and falling debt.

Fig­ure 2

Non-econ­o­mists might expect pro­fes­sion­al econ­o­mists to pay great heed to these indicators—after all, sure­ly pri­vate debt affects the econ­o­my? How­ev­er, the dom­i­nant approach to economics—known as “Neo­clas­si­cal Eco­nom­ics” —ignores them com­plete­ly, on the a pri­ori grounds that the aggre­gate lev­el of pri­vate debt does­n’t mat­ter: only its dis­tri­b­u­tion can have macro­eco­nom­ic impacts.

The argu­ment is that a rise in debt mere­ly indi­cates a trans­fer of spend­ing pow­er from a saver to a bor­row­er. The debtor’s spend­ing pow­er ris­es, but saver’s spend­ing pow­er also falls, so in the aggre­gate there will only be a macro­eco­nom­ic effect if there is a very large dif­fer­ence in behav­iour between the saver and bor­row­er. There­fore only the dis­tri­b­u­tion of debt mat­ters, not its lev­el or rate of change.

US Fed­er­al Reserve Chair­man Ben Bernanke pro­vid­ed pre­cise­ly this ratio­nale to explain why neo­clas­si­cal econ­o­mists ignored Irv­ing Fish­er’s “debt-defla­tion” expla­na­tion of the Great Depres­sion (Fish­er 1933), and he also assert­ed that the dif­fer­ences in behav­iour between saver and bor­row­er could not be large enough to explain the Great Depres­sion:

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 macro-eco­nom­ic effects… (Bernanke 2000, p. 24)

Sim­i­lar­ly, Nobel Prize win­ner Paul Krug­man argued recent­ly that the aggre­gate lev­el of pri­vate debt was not a fac­tor in the GFC: only its dis­tri­b­u­tion could be. He there­fore devel­oped a mod­el in which the dis­tri­b­u­tion of debt, rather than its lev­el, was the causal fac­tor:

Ignor­ing the for­eign com­po­nent, or look­ing at the world as a whole, the over­all lev­el of debt makes no dif­fer­ence to aggre­gate net worth — one per­son­’s lia­bil­i­ty is anoth­er per­son­’s asset…

In what fol­lows, we begin by set­ting out a flex­i­ble-price endow­ment mod­el in which “impa­tient” agents bor­row from “patient” agents, but are sub­ject to a debt lim­it. If this debt lim­it is, for some rea­son, sud­den­ly reduced, the impa­tient agents are forced to cut spend­ing… (Krug­man and Eggerts­son 2010, p. 3)

He reassert­ed this analy­sis in a recent blog, argu­ing that the lev­el of debt does­n’t mat­ter, because most debt is “mon­ey we owe to our­selves”:

Peo­ple think of debt’s role in the econ­o­my as if it were the same as what debt means for an indi­vid­ual: there’s a lot of mon­ey you have to pay to some­one else. But that’s all wrong; the debt we cre­ate is basi­cal­ly mon­ey we owe to our­selves, and the bur­den it impos­es does not involve a real trans­fer of resources.

That’s not to say that high debt can’t cause prob­lems — it cer­tain­ly can. But these are prob­lems of dis­tri­b­u­tion and incen­tives, not the bur­den of debt as is com­mon­ly under­stood. (Krug­man 2011)

Bizarre as it may sound, these argu­ments by lead­ing econ­o­mists ignore decades of empir­i­cal research into and prac­ti­cal knowl­edge on bank­ing, which have estab­lished that their fun­da­men­tal premise is false: a new debt is not a trans­fer from one bank cus­tomer’s account to another’s—which is effec­tive­ly what Krug­man mod­els and Bernanke assumes above—but a simul­ta­ne­ous cre­ation of both a deposit and a debt by the bank. A bank loan thus gives a bor­row­er addi­tion­al spend­ing pow­er with­out forc­ing savers to reduce their spend­ing pow­er to com­pen­sate. As Joseph Schum­peter put it dur­ing the Great Depres­sion:

It is always a ques­tion, not of trans­form­ing pur­chas­ing pow­er which already exists in some­one’s pos­ses­sion, but of the cre­ation of new pur­chas­ing pow­er out of noth­ing…’ (Schum­peter 1934, p. 73; see Keen 2011 , pp. 154–157, for more detail on this issue)

From this empir­i­cal­ly con­firmed per­spec­tive (Holmes 1969; Moore 1979; Kyd­land and Prescott 1990; Car­pen­ter and Demi­ralp 2010), the change in debt there­fore does have seri­ous macro­eco­nom­ic con­se­quences, since an increase in debt adds to aggre­gate demand—and it is the pri­ma­ry means by which both invest­ment (Fama and French 2002) and spec­u­la­tion (Min­sky 1982, pp. 28–30) are fund­ed.

In a cred­it-based econ­o­my, aggre­gate demand is there­fore the sum of income plus the change in debt, with the change in debt spend­ing new mon­ey into exis­tence in the econ­o­my. This is then spent not only goods and ser­vices, but on finan­cial assets as well—shares and prop­er­ty. Changes in the lev­el of debt there­fore have direct and poten­tial­ly enor­mous impacts on the macro­econ­o­my and asset mar­kets, as the GFC—which was pre­dict­ed only by a hand­ful of cred­it-aware econ­o­mists (Beze­mer 2009)—made abun­dant­ly clear.

If the change in debt is rough­ly equiv­a­lent to the growth in income—as applied in Aus­tralia from 1945 to 1965, when the pri­vate debt to GDP ratio fluc­tu­at­ed around 25 per cent (see Fig­ure 1)—then noth­ing is amiss: the increase in debt main­ly finances invest­ment, invest­ment caus­es incomes to grow, and the econ­o­my moves for­ward in a vir­tu­ous feed­back cycle. But when debt ris­es faster than income, and finances not just invest­ment but also spec­u­la­tion on asset prices, the vir­tu­ous cycle gives way to a vicious pos­i­tive feed­back process: asset prices rise when debt ris­es faster than income, and this encour­ages more bor­row­ing still.

The result is a super­fi­cial eco­nom­ic boom dri­ven by a debt-financed bub­ble in asset prices. To sus­tain a rise in asset prices rel­a­tive to con­sumer prices, debt has to grow more rapid­ly than income—in oth­er words, if asset prices are to rise faster than con­sumer prices, then rather than mere­ly ris­ing, debt has to accel­er­ate. This in turn guar­an­tees that the asset price bub­ble will burst at some point, because debt can’t accel­er­ate for­ev­er. When debt growth slows, a boom can turn into a slump even if the rate of growth of GDP remains con­stant.

This process is eas­i­ly illus­trat­ed in a numer­i­cal exam­ple. Con­sid­er an econ­o­my with a GDP of $1 tril­lion that is grow­ing at 10% per annum, with real growth of 5% and infla­tion of 5%, and in which pri­vate debt is $1.25 tril­lion and grow­ing at 20% p.a. Total spend­ing on both goods & ser­vices and finan­cial assets is there­fore $1.25 tril­lion: $1 tril­lion is financed by income, and $250 bil­lion is financed by the 20% increase in debt.

In the fol­low­ing year, if the growth of debt sim­ply slows down to the same rate at which nom­i­nal GDP is grow­ing (with­out affect­ing the rate of eco­nom­ic growth), then the growth in debt will be $150 bil­lion (10% of the $1.5 tril­lion lev­el reached at the end of the pre­vi­ous year). Total spend­ing will there­fore be exact­ly the same as the year before: $1.25 tril­lion, con­sist­ing of $1.1 tril­lion in GDP plus a $150 bil­lion growth in debt. How­ev­er, since infla­tion is run­ning at 5%, this amounts to a 5% fall in the real lev­el of eco­nom­ic activity—which would be spread across both com­mod­i­ty and asset mar­kets.

If instead the growth of debt stopped, then total spend­ing the next year will be $1.1 tril­lion, a 15% fall from the lev­el of the pre­vi­ous year in nom­i­nal terms, and 20% in real terms. This would cause a mas­sive slump in demand for goods & ser­vices, assets, or both, even with­out a slow­down in the rate of growth of GDP.

This hypo­thet­i­cal exam­ple is not far removed from the actu­al expe­ri­ence of the GFC. As the US expe­ri­ence illus­trates most clear­ly, the switch from ris­ing to falling pri­vate debt ush­ered in the biggest eco­nom­ic down­turn since the Great Depres­sion, a pro­longed peri­od of high unem­ploy­ment, and sharp falls in asset markets—all of which are plot­ted in Fig­ure 3.

Fig­ure 3

This is why the shift from the Age of Lever­age to the Age of Delever­ag­ing was so dra­mat­ic, and yet so unfore­seen by con­ven­tion­al econ­o­mists: it was caused by a huge reduc­tion in aggre­gate demand from a fac­tor they ignore. This debt-induced reduc­tion in aggre­gate demand will per­sist as long as pri­vate debt lev­els are falling—as they still are in the USA, though at a much reduced rate from the peak rate of fall in ear­ly 2010.

Until pri­vate debt lev­els are sub­stan­tial­ly reduced, the econ­o­my will always tend towards what Richard Koo called a “bal­ance sheet reces­sion” (Koo 2009), where the desire of the pri­vate sec­tor to reduce its lever­age will sup­press aggre­gate demand, caus­ing both reces­sions and falling asset prices. The West­ern OECD is thus “turn­ing Japanese”—replicating the cri­sis that led to Japan’s “Lost Decade”, which is now two decades old.

Koo argues that whether the world expe­ri­ences the rel­a­tive­ly minor decline in Japan­ese eco­nom­ic per­for­mance or achieves some­thing much worse depends in part on whether the world mim­ics Japan’s pol­i­cy response or not. But where­as con­ven­tion­al wis­dom argues that Japan has failed by run­ning huge gov­ern­ment deficits, Koo argues that with­out these deficits, Japan­ese GDP would have fall­en far more.

His rea­son­ing is that, just as pri­vate sec­tor bor­row­ing spends addi­tion­al mon­ey into exis­tence, so too does a gov­ern­ment deficit. But if the pri­vate sec­tor is deleveraging—as it has done in Japan since 1991 and is now doing in the USA—then the change in pri­vate debt is actu­al­ly sub­tract­ing from demand. Japan’s pub­lic sec­tor deficits there­fore atten­u­at­ed the decline in aggre­gate demand:

Although this fis­cal action increased gov­ern­ment debt by … 92 per­cent of GDP dur­ing the 1990–2005 peri­od, the amount of GDP pre­served by fis­cal action com­pared with a depres­sion sce­nario was far greater. For exam­ple, if we assume, rather opti­misti­cal­ly, that with­out gov­ern­ment action Japan­ese GDP would have returned to the pre-bub­ble lev­el of 1985, the dif­fer­ence between this hypo­thet­i­cal GDP and actu­al GDP would be over 2,000 tril­lion yen for the 15-year peri­od. In oth­er words, Japan spent 460 tril­lion yen to buy 2,000 tril­lion yen of GDP, mak­ing it a tremen­dous bar­gain. And because the pri­vate sec­tor was delever­ag­ing, the gov­ern­men­t’s fis­cal actions did not lead to crowd­ing out, infla­tion, or sky­rock­et­ing inter­est rates. (Koo 2011, p. 23)

On the oth­er hand, Koo cau­tions that if the gov­ern­ment attempts to run a sur­plus while the pri­vate sec­tor is delever­ag­ing, there will be two fac­tors reduc­ing eco­nom­ic activ­i­ty at the same time. He there­fore argues that deficits are sen­si­ble when the pri­vate sec­tor is delever­ag­ing, while attempt­ing to run sur­plus­es will make a bad sit­u­a­tion worse:

Although shun­ning fis­cal profli­ga­cy is the right approach when the pri­vate sec­tor is healthy and is max­i­miz­ing prof­its, noth­ing is worse than fis­cal con­sol­i­da­tion when a sick pri­vate sec­tor is min­i­miz­ing debt. (Koo 2011, p. 27)

How­ev­er, fis­cal con­sol­i­da­tion is the pol­i­cy pre­scrip­tion that is being applied in the Euro zone and the UK, and sup­port­ed by politi­cians in both Aus­tralia and the USA. The like­ly out­come of pub­lic aus­ter­i­ty is thus a fur­ther decrease in the growth rate of coun­tries prac­tic­ing it. Giv­en that most of the West­ern OECD is already under severe eco­nom­ic stress, the pain that aus­ter­i­ty inflicts upon already stressed soci­eties is like­ly to mean dras­tic polit­i­cal change.

The most obvi­ous loca­tion for polit­i­cal tur­moil is Europe, where the Maas­tricht Treaty’s rules force coun­tries to attempt to restrain fis­cal deficits to 3% of GDP. This was always a bad idea, pred­i­cat­ed on the belief that severe eco­nom­ic crises could not occur. Though the treaty was applaud­ed by neo­clas­si­cal econ­o­mists, I was far from the only non-neo­clas­si­cal econ­o­mist to observe that this treaty could lead to the breakup of Europe when a reces­sion hit, since “Europe’s gov­ern­ments may be com­pelled to impose aus­ter­i­ty upon economies which will be in des­per­ate need of a stim­u­lus” (Keen 2001, pp. 212–13; see also Keen 2011, pp. 2–3).

Though con­ti­nen­tal Europe is the most obvi­ous loca­tion for eco­nom­i­cal­ly inspired polit­i­cal insta­bil­i­ty in 2012, anoth­er dark horse may also be the UK. As Fig­ure 1 shows, its pri­vate debt lev­el is stag­ger­ing­ly high—one and a half times the peak lev­el of the USA’s—and yet it did not suf­fer as severe a down­turn as the USA when the cri­sis began because, as Fig­ure 2 indi­cates, it did not fall as deeply into delever­ag­ing. The max­i­mum decline in aggre­gate demand caused by falling pri­vate debt in the UK was only 6 per­cent of GDP, ver­sus 20 per­cent in the USA.

How­ev­er the rate of delever­ag­ing in the UK has again hit this lev­el, while the USA has recov­ered from the worst of the ini­tial down­turn and is delever­ag­ing at a rate of only 3% of GDP. Gov­ern­ments in both the USA and the UK are favour­ing aus­ter­i­ty poli­cies, but the UK is already impos­ing them—with thus far neg­a­tive results—and is far more like­ly to be able to main­tain them than the polit­i­cal­ly ham­strung USA. This means that pri­vate sec­tor delever­ag­ing and pub­lic sec­tor aus­ter­i­ty may coin­cide in the UK in 2012, which from a “bal­ance sheet reces­sion” per­spec­tive indi­cates that the UK could fall into reces­sion from an already depressed lev­el of eco­nom­ic activ­i­ty. This is espe­cial­ly like­ly if the rate of pri­vate sec­tor delever­ag­ing accel­er­ates.

What could the future hold for Aus­tralia? To date, sangfroid has dom­i­nat­ed Aus­tralian atti­tudes towards the GFC—based part­ly on our avoid­ance of a deep down­turn in 2008, which was unique amongst OECD nations, and part­ly on our lucky depen­dence on Chi­na. At the begin­ning of 2011, the RBA expect­ed to be rais­ing rates to restrain infla­tion in a boom­ing econ­o­my, while Trea­sury expect­ed unem­ploy­ment to fall towards full employ­ment lev­els. Eco­nom­ic poli­cies pro­posed by the major polit­i­cal par­ties were based on expec­ta­tions of man­ag­ing a boom, and the only debate was over how quick­ly the Bud­get should return to sur­plus.

Fig­ure 4: Trea­sury fore­casts (& pro­jec­tions of a return to equi­lib­ri­um) in the 2011-12 bud­get

Unfor­tu­nate­ly, recent eco­nom­ic data has­n’t fol­lowed the sangfroid script. Inflation—as mea­sured by the RBA’s pre­ferred indi­ca­tors, the weight­ed and trimmed means—has fall­en rather than risen, while unem­ploy­ment has risen from a low of 4.9% to 5.3% (ver­sus expec­ta­tions of 4.75% in June 2012) and appears like­ly to trend up rather than down in com­ing months.

If this does hap­pen, it will not be an indi­ca­tion that Gov­ern­ment deficits are the problem—or even that they have failed to stim­u­late the economy—but a cau­tion that Aus­tralia is not so dif­fer­ent after all. Though it was delayed by pol­i­cy and the min­ing boom, Aus­tralia is now on the cusp of a bal­ance sheet reces­sion too.

To see this, we need to take a clos­er look at the Aus­tralian pri­vate debt lev­el. Fig­ure 5 con­sid­ers both the lev­el (com­pared to GDP) and rate of change of Aus­tralian pri­vate debt since 2000.

Fig­ure 5


After ini­tial­ly falling in 2008, Aus­trali­a’s pri­vate debt to GDP ratio actu­al­ly rose from mid-2009 till mid-2010; so Aus­tralia re-lev­ered while the USA in par­tic­u­lar de-lev­ered. This ris­ing debt boost­ed aggre­gate demand after its ini­tial fall dur­ing the GFC, but the growth of debt is now at lev­els well below the pre-GFC peak.

Antic­i­pat­ing what might hap­pen from now on involves con­sid­er­ing one of the trick­i­est aspects of debt, its accel­er­a­tion. Since aggre­gate demand is income plus the change in debt, the change in aggre­gate demand is the change in income plus the accel­er­a­tion of debt. I define the “Cred­it Accel­er­a­tor” (ini­tial­ly called the “Cred­it Impulse” by Big­gs and May­er 2010; Big­gs, May­er et al. 2010) as the ratio of the accel­er­a­tion of debt to GDP, and use this as an indi­ca­tion of how strong­ly the dynam­ics of pri­vate debt are going to impact upon eco­nom­ic per­for­mance and asset mar­kets.

Fig­ure 6 illus­trates why the “GFC” (which Amer­i­cans call the “Great Reces­sion”) was so much more dev­as­tat­ing in the USA than Aus­tralia: the decel­er­a­tion of debt was far more extreme, and last­ed for much longer.

Fig­ure 6

Fig­ure 7 shows the rela­tion­ship between cred­it accel­er­a­tion and change in employ­ment in Aus­tralia since 2000. Though the dif­fer­ence between the mild Aus­tralian and the severe Amer­i­can down­turn was due to the much more severe decel­er­a­tion of debt in Amer­i­ca, pri­vate debt is now decel­er­at­ing in Aus­tralia, and the lev­el of employ­ment is falling as a result.

Fig­ure 7 (Mea culpa–R^2 should be “Cor­re­la­tion Coef­fi­cient”)

A sim­i­lar phe­nom­e­non applies to the most impor­tant asset class in Aus­tralia, hous­ing. Mort­gage debt was the only com­po­nent of pri­vate debt to rise dur­ing the GFC—under the influ­ence of what I call the First Home Ven­dors Boost. Mort­gage debt is now decel­er­at­ing, and house prices are falling as a result. As expe­ri­ence has shown in the USA and Japan, this tends to be a run­away process, as falling house prices encour­age fur­ther falls in debt.

Fig­ure 8 (R^2 should be “Cor­re­la­tion Coef­fi­cient”)

Clear­ly, eco­nom­ic pol­i­cy is now far more com­plex than it appeared to be before the GFC. As we enter this Age of Delever­ag­ing, the worst thing we can do is apply poli­cies that appeared to work dur­ing the pre­ced­ing Age of Leverage—but were in fact pred­i­cat­ed on ever-ris­ing pri­vate sec­tor indebt­ed­ness. Politi­cians should be scep­ti­cal of con­ven­tion­al eco­nom­ic advice at this time; it would be much wis­er to study the his­to­ry of the 1930s instead.

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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.