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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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45(1): 11-16.
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58(58): 19-37.
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http://krugman.blogs.nytimes.com/2011/12/28/debt-is-mostly-money-we-owe-to-ourselves/ 2012.
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RJ –
In this world, it does still boil down to a very select group of people who control the majority of the world’s true wealth. Pension funds are not the owners of real wealth. That is paper wealth. It can be wiped out in a keystroke. MF Global was the canary in the coal mine here. The whole system is based soley on confidence.
I complete fail to see how massively expanding government debt would actually allow people around the world to save for retirement and provide interest bearing assets for them to invest in. This premise assumes all boats are lifted equally – which I believe is not possible in the real world which competes for resources from within different socio-economic systems.
Regarding war, the exact scenerio is unfolding before your very eyes. Ballooning government debts in less than all nations at once creates the unemployment, hunger – civil unrest. This is exactly how trade wars are initiated. This is how currency wars are initiated. This is how real wars are initiated. You can’t divorce monetary mechanics from social mechanics, politics, etc. I wager the cold war in post-soviet collapse continues today but in pen rather than sword.
The concept of a common human cultural heritage of productive potential monetized and distributed amounting to the difference between total individual purchasing power and total prices in a given period of time in a free and open market with a discount mechanism at retail sale to nullify any inflationary effect is a simple (but not simplistic) and elegant way to make the economic and monetary systems robust, with reasonable regulation of speculation and the elimination of dodgy accounting, kept in relative balance, democratically liberating to the individual, and redresses the long standing usurpation of the capital appreciation of progress that is largely responsible for enabling the Banking system to determine creditability and distribute money.
Rj :
A couple of quick points.
I put forward the info on govt/bank accounting to indicate generally how 95 % of the money gets created.(The Debt Money by financial institutions.) and abused by the shadow bankers (Almost all speculation ,not investment.)
I think Centerline has expressed the overview in a comprehensive manner.Yes there is a lot more to this than meets the eye.
One issue I dont understand is how the notion has developed that the total amount of Federal Govt Debt doesn’t matter.In America this was advanced as professional propaganda by Dick Cheny and others, as they didnt want the American Public to oppose the financing of the Iraq/Afghanistan Wars .
The Administration came up with a “Deal” whereby the Cheney office would keep track of the costs and forward them for payment every three months to the House for payment.
This had the political effect of adopting an annual budget without the matter of war cost estimates being in the Budget or being publicly discussed.
Straight Political manipulation.
After 25 years of deficit financing and zero bound National Debt interest ,Japan is now reaching the point where a 5% Interest rate hike would mean the interest on the National Debt would equal all federal taxes.
As a person who has actually been involved with Federal Financing ,
you are fully aware the National Debt is a revolving line of credit
with the individual bond issues constantly being rolled over,but what would you do when the interest on the bonds equalled your Annual federal Budget?
This is the Japanese reality.As a minimum the interest has to be paid.Now they issue bonds to pay the interest because they dont have the cash.You can see why the Minister of Finance position changes every 6 months.
I am not suggesting this is how the world should work.But trying to say this is how it currently is.Similarily with the USA .Its great for everyone to copy Dick Cheny and deny the interest on a 100% Debt to Gdp ratio for a country not having a Trade surplus or a country with a 200% Debt to gdp ratio and a trade surplus is NOT a problem ,however every day we see otherwise in Europe /Japan/USA.
Many Bond Owners seem to think differently and keep offsetting the perceived risk with credit default swaps.
I would appreciate your opinion and reasoning.
Farnorth5
The world includes Money Creating Entities.
Money Creating Entities create and destroy amounts of currency.
Currencies so created have Region [where that currency can be used as money; currency regions can overlap; can be physical and logical region].
Currencies have Exchange Paths [factors for a shops accounts receivables; international money market]
Primary Money Creating Entities “Initiate” amounts of currency.
Primary Money Creating Entities charge a fee for the creation.
Money in a particular currency can also be expanded or destroyed by Secondary Money Creation.
Standard Money Creation And Destruction Processes are evident.
They include:
- Money Creating Entities Printing [Creation] and Shredding [Destruction] notes and coins,
- Money Creating Entities Adding numbers to individuals currency tally’s in particular payment systems (Handouts, Electronic Money Printing) [Creation] ,
- Money Creating Entities selling rights to an interest stream lower than the sale price [Destruction],
- Money Creating Entities allowing others to add promises to pay to individuals currency tally’s in a particular payment system as long as the amounts so added isn’t bigger than a certain multiplier of an amount in a particular account known as a reserve.
Money Creating Entities allowing others to add promises to pay to individuals currency tally’s in a particular payment system as long as those others have property rights over particular things at particular valuations that are in total at least a particular ratio to amounts so created.
Farnorth5 and others,
Shadow Banking:
I am a bank and have 10 million in loans, 1 million in my own banks deposits, 1 million in my banks deposits down at the Reserve, and 10 million in customers deposits accounts.
Shadow banking is borrowing 5 million from the Federal Reserve [the guys that will issue you with as much payment system currency as you want as a loan] and then construct something interesting that my bank can sell them that will give me room to expand my loan book and still have 10% of deposits at the Reserve.
Is that what we are talking?
I mean I am just trying to hammer down this payment system currency rights thing.
If a transaction does not move amounts legally in the payments system then the only way it can be of value to you is if it gives you the right to create money as a result of it’s influence on valuations and categorization of things that impact legal ratios that limit money creation and so on.
For example, if you and I agree that I will loan you $1,798 trillion for 45 days at 10% interest, and that you will loan me $1,798 trillion and 10 cents for 30 days at 10%, with a rollover option at my discretion for a further 15 days at 10%, then yes we could argue about how we value the net benefits amongst us, and the probability of me not taking up the additional 15 days you offer [as if I wouldn't], and that can effect valuations on balance sheets and so on.
But at the end of the day after 45 days I am giving you 10.12 cents!
Aren’t I?
I’m curious what you all think about Krugman’s contention that what really matters is non-financial debt. From his blog a few days ago:
“I focus on nonfinancial debt — that’s because money that banks owe to each other is more a reflection of the structure of the financial system than of the degree of overborrowing more broadly.”
Seems like this observation is particularly pertinent to the situation in the UK, where banking and finance are a very large disproportionate share of the economy.
I could see this as two separate risk pools, one with loans and bets on solvency between banks, and the other risk pool between banks and their customers. The fear, of coarse, is that these are not decoupled.
I think it’s typically ill-informed nonsense by Krugman on the nature of private debt Gary. All private debt matters, certainly from the initial creation of debt perspective on which I focus, since that causes an increase in money creation and a rise in aggregate demand–the topic Krugman fails to understand because of his “lending is a transfer from a saver to a borrower” false a priori perspective on debt.
Clicking on the QED tab and listening to Steve’s walk through and then Michael Hudson’s AMI talk several things struck me. First of all how the QED model worked so well to result in what happened with the GFC.
Then in Hudson’s talk he suggested that a separate mass social movement was needed to get actual reforms implemented which I completely agree with.
He also refers to China’s financial system as the government collecting all of the rent before hand while we in the west have allowed the private banking system to do the same.
In either process the individual gets ignored, exploited by wage slavery i.e. insufficient individual purchasing power via the enforcement of cost accounting conventions, then suckered into indebtedness on asset bubbles and finally forced to pay the bill for a couple of austere decades.
Both the western and oriental duality oppresses the individual with wage slavery and the western misses the crisis by ignoring/dismissing individual build up of debt leading to even more than normal insufficient purchasing power.
I say it is time for opting out of the false dualistic systemic “solutions” both the west and China say are necessary. Let us try something actually different like the Distributist solution for the financial system which empowers the individual called Social Credit.
If one looks objectively at Social Credit I think it can be concluded that it offers workable solutions that make for more humane conditions to traditional capitalist culture and that avoid both Marxist and capitalist centralizing tendencies (and also the re-distributive nature of both welfare capitalism and social democracy)…..and, along with sane and reasonable regulation of speculation, would create a system which was much more stable and individually liberating, and finally truly enabling technological innovation to be freed to serve Mankind.
I can easily understand the increase in spending power that accompanies creation of money when a bank provides a loan to a young family for a new house. It’s less clear how spending power is created when a second bank (say a mortgage aggregator) generates a debt for the purpose of acquiring that home loan from the first bank.
Does the activity of the second bank effectively double the amount of total debt outstanding? (There is always the possibility that this is just a problem of not counting things twice.)
Does such an exchange within the banking sector really create spending power in the same way the first mortgage did? (other than by providing jobs for the clerks that record transactions.)
Steve, you’ve shown how you need to have a bank as an intermediary in just about any real transaction between any pair of actors, but how about when the actors are banks themselves?
I could see even within your framework that Krugman might have a point, which is why I seek clarification!
Steve
“I think it’s typically ill-informed nonsense by Krugman on the nature of private debt Gary.”
And what comment is this. Could you provide a link please as the comment discussed above is on GOVT DEBT
Here’s a post by krugman. I 100% agree with his comment here on Govt debt
http://krugman.blogs.nytimes.com/2011/12/28/more-on-the-burden-of-debt/
He is mostly referring to GOVT DEBT. And finishes with this
“The general point is that the analogy with a family that owes too much is all wrong. Unfortunately, this dumb analogy dominates our national discourse.”
This is what he said on private debt but it is not the comment that has caused so much discussion
“Private debt, by the way, creates a different kind of problem: again, it doesn’t directly make us poorer, but it increases our macroeconomic vulnerability.”
rj
An illustration
I save $200 a month toawards a holiday; one month I have an expected bill and ‘borrow’ from that account $100 for one month and pay back the ‘liability’ next month.
I owe it to myself.
Not all liabilities are debt based liabilities enforceable by contract. Double entry is a means of recording debt based transactions and all other non debt based transactions – transfer payments. These payments matter for total demand but not for total debt.
Gary – I would think there is no way to truly decouple the risk categories. Anything that challenges bank solvency challenges all. MF Global illustrated how no one was safe and interbank obligations took precedence over customer obligations.
For an interesting read, check out articles on bilateral netting. The essence of the topic is that when systemic leverage is cranked up so high, when any significant failure occurs within the system the net exposure CAN become gross exposure. The entire premise upon which the banking system relies for its perceived stability is a farce due to the extensive (and growing) counterparty exposure. A circular firing squad if you will.
Centerline – Can’t agree with you more… Big banking is like a game of musical chairs. Case in point is MF Global where it is reported that the billions in customer funds just happened to be parked at JP Morgan, and for some reason, they just sat there a little too long… Possession is 9/10th of the law! So certainly I can see how this house of cards can fall, but a big question is why it hasn’t already in the UK with the extremely high debt to GDP numbers there.
In Steve’s model you have various classes engaged in commerce. Workers, Capitalists, Firms, Banks, Government, etc. with the interactions between players – so that’s is what is modeled. Loans between banks are all within the banking sector, so not really modeled in the Keenian universe. Hence the question. The real question is if by creating debt within the financial sector you also create spending power in the external economy. Do you?
I find Krugman to be basically a bright guy with his heart in the right place. Indeed he is probably mired in old-school economic thought – but we all have our prejudices to contend with. My guess is that he is on to something by considering financial debt separately.
RJ – here is the original link: http://krugman.blogs.nytimes.com/2012/01/20/debt-and-transfiguration-2/
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)
Krugman, P. (2011). “Debt Is (Mostly) Money We Owe to Ourselves.” The Conscience of a Liberal http://krugman.blogs.nytimes.com/2011/12/28/debt-is-mostly-money-we-owe-to-ourselves/ 2012.
But contra that, he’s just published this:
http://krugman.blogs.nytimes.com/2012/01/30/eurozone-problems/
And he appears to be talking about the aggregate level of debt (and changes in it), which previously he has argued doesn’t matter.
He could be putting this within a distributional framework still–with households as one group, government as the other–but this is definitely better than I’ve seen him do previously.
Gary,
I’ll have a crack.
I can of course give you my house for your license to make sell Bucky Balls.
But if we restrict ourselves to the payments system then the question becomes:
“If I have $ 1million in reserves in my bank. I lend you $1 million for your bank if you pay me $50,000 a month for 12 months and at the end of 12 months pay the $1 million back. Is their more money on day 1 of the loan than at the end?”
$1 million in Reserves flow from me to you.
My Balance sheet now has an Asset of Loan To Gary Bank.
My Revenue account [and thus my capitol] has a capacity to acknowledge the interest you will pay dependent upon rules.
I am restricted on how many loans I can write because of rules.
One path to consider is capitol ratio restrictions. I am not totally across the exact ratios and so on this is a “model” case but lets say that banks need to Capitol to Risk weighted assets of 8% and that a loan to another bank has a risk weighting of 0.2.
This means that on the basis of the Capitol ratio restriction, if I am going to expand the ability for me to create deposits by making loans then I need to get revenue from that deal on the loan that I can bring to account for the calculation *now* of 0.2 * $1million being $200,000.
If the rule was say that future revenue up to 12 months out from today I can bring to account as revenue, then after taking out say $40,000 for expenses I can book Revenue when I write the loan of $560,000 [12 * $50k - $40k].
This would give me $560,000 over $1million in Capitol Ratio, being 56%. I only need 8%. This gives me room to create higher risk assets to go for a bigger return. My shareholders are probably telling me my job is on the line.
However, for the payments system to honor my banks orders for payments I still need the Reserves no matter how many loans I write.
How do you get around the Reserves and the Payments system?
This is the type of calculations I think you are looking to get across Gary with your question?
Hi Cliffy – My question is less complex than you are making it. One of the most important points that Steve has made is that the process of creating a loan also creates spending power – ‘money’ in practice, and along with it, aggregate demand. That is easy to understand – see my example above. Steve also points out that debt creation is what drives banks’ acquisition of reserves – not the other way around. Lets just ignore whether the bank makes money or not, reserve requirements, etc. The point is that when you have a three party transaction – buyer, seller and bank, the bank effectively creates money – spending power – by generating loans.
Question is, does this same thing happen with a two party bank-to-bank transaction? Krugman, in considering the potential fallout from too much private debt, chooses to ignore the financial sector debt. I’m wondering if his intuition about this is because inter-bank loans don’t really create (or destroy when they are paid off) spending power the same way loans to firms or individuals do.
Steve, I’m just hitting Part 3 of your book, so probably shouldn’t comment on anything yet, but with regards to a “distributional framework”, seems to me this is the crux of the modeling problem. If you don’t have classes such as workers, capitalists, firms, banks, government, etc. you miss much of the flavor of the economy. But, really you have households with a distribution of wealth, income, and education, an age distribution, etc. Some are capitalists, some are workers some are both. However, it is very difficult to advance a distribution from one time step to the next! So we make classes. Have you ever considered doing the harder problem with distributions?
Yes Gary, but you have to start somewhere. So the easiest starting point is a single entity for each class. The framework I’m developing though can be extended to allow for a distribution as well. Hopefully others will build that into the analysis, starting from the simple foundation I’m constructing.
Hi Gary,
Long answer:
Basically without more anyone can create money if others accept that money as legal tender.
Banks create $US by writing loans. Full stop.
If Bank A lends Fred $US 1 million, banks write on a piece of paper “I Bank A will pay anyone who holds this piece of paper $US 1 Million if you pop on down to the bank.”
If Bank A lends Bank B $IS 1 million it is exactly the same.
That is the simple answer.
But there is more, it’s not too complex, but it is unfortunately complex enough.
And that complexity includes the rules amongst all the various players in the system.
You need to read the rules that are the system. Rules like this:
http://ecfr.gpoaccess.gov/cgi/t/text/text-idx?c=ecfr&sid=635f26c4af3e2fe4327fd25ef4cb5638&tpl=/ecfrbrowse/Title12/12cfr204_main_02.tpl
You would be interested for example to read things in that set of regulations like:
204.121 Bankers’ banks
“… however, a depository institution is not required to maintain reserves if it:
(i) Is organized solely to do business with other financial institutions;
(ii) Is owned primarily by the financial institutions with which it does business; and
(iii) Does not do business with the general public.”
Money supply numbers [defined by can spend tomorrow if I choose - your low number M's] move with loans. They are by definition joined at the hip.
However spending does not move with a correlation coefficient of 1 with money supply.
And thus except for a freak of nature where velocity bounces equally and opposite to money supply, neither can GDP.
I know we all just want a simple “whack X in get 2/3 Y” but this is not the beast we are talking about here.
But if you question is “can bank loans to banks be the same output wise as bank loans to punters then the answer is Yes.
If your question is “can bank loans to banks create money?” then I think you are pretty safe saying “Yes”.
The argument you will get against same is “Netting Off”.
Of course, mate, I am just one bloke taking a good look at something he has no inside knowledge about so think it through for yourself.
Short answer:
Yes
Steve, is that UK private debt figure right? What comprises private debt? The Morgan Stanlay chart had UK household debt at about 100% of GDP not 500%! Or does the private debt figure include other sectors of the economy. Would be helpful to clarify as I will be doing a presentation next week that raises the UK debt issue with colleagues and I want to get my figures right.
Ah. I think I get it now. The private debt being everything except the public debt.
Private is all non-government debt AvJoe: household+business+finance. The spreadsheet linked to the post has all the data.
Morgan Stanley’s figure for private debt is about twice what I’m using, with a much higher reading for financial sector debt. My figures come from the ONS, courtesy of Neil W, and are the same as those used in the Treasury’s budget papers.