Economics without a blind-spot on debt

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I’m being inter­viewed by Paul Mason for the BBC Radio 4 pro­gram Analy­sis on April 3rd, in front of an audi­ence at the Lon­don School of Eco­nom­ics from 6.30–8pm. If you’d like to attend, you can book a place via this link (“Banks vs the Econ­o­my”). Book­ings are free but essen­tial, and will open on Mon­day March 26th at 10pm. More details are avail­able for the pub­lic from; email for media enquiries.

The LSE asked me to write this entry for their blog British Pol­i­tics and Pol­i­cy at LSE. It’s repro­duced here (along with the data) for Debt­watch read­ers.

 Click here for this post in PDF: Debt­watch Mem­bers; CfE­SI Mem­bers
Click here for the data in this post: Debt­watch Mem­bers; CfE­SI Mem­bers

As a car dri­ver, you have sure­ly had the expe­ri­ence of chang­ing lanes and being beeped by a car with which you were about to collide—but which you did­n’t see before the lane change. It’s because the car was clear­ly vis­i­ble in your rear-view mir­ror, but that part of the image fell on your reti­na’s blind-spot—so you did­n’t see it. For­tu­nate­ly most of us learn that we have a blind spot, and so we check care­ful­ly to avoid being fooled by it again—and caus­ing an avoid­able acci­dent.

If only econ­o­mists could learn the same way, we might not now be in the acci­dent of this nev­er-end­ing eco­nom­ic cri­sis. “Neo­clas­si­cal” econ­o­mists (who dom­i­nate both aca­d­e­m­ic eco­nom­ics and pol­i­cy advice to gov­ern­ments) have a blind-spot about the role of pri­vate debt in macro­eco­nom­ics, yet despite the econ­o­my crash­ing once before because of it dur­ing the Great Depres­sion, they con­tin­ue to argue that it’s irrel­e­vant now—during this lat­est crash.

First, let’s estab­lish that there was indeed a “car in the rear view mir­ror” in the 1930s and today. Data on long-term pri­vate debt lev­els is dif­fi­cult to find, but I’ve locat­ed it for both the USA from 1920 till today, and for Aus­tralia from 1880 (see Fig­ure 1). Clear­ly, there was a debt bub­ble before the Great Depres­sion, and a plunge in debt lev­els dur­ing and after it (and Aus­tralian data also shows the same phe­nom­e­non dur­ing an ear­li­er bub­ble and crash in the Depres­sion of the 1890s; see Fish­er and Kent 1999). The same process is clear­ly afoot again now.

Fig­ure 1


Now for the blind-spot. Any­one not blessed—or rather cursed—by an eco­nom­ics edu­ca­tion might think there was some­thing in that coin­ci­dence of debt and Depres­sions. But it’s noth­ing to wor­ry about, lead­ing Neo­clas­si­cal econ­o­mists assure us—thus con­firm­ing that either they know some­thing pro­found that proves that the coin­ci­dence is irrel­e­vant, or that they have a blind-spot which means that their judg­ment can’t be trust­ed.

The pro­found insight they believe they have is that the lev­el of debt does­n’t mat­ter, and that only the dis­tri­b­u­tion of debt can be impor­tant. Ben Bernanke reject­ed Irv­ing Fish­er’s “Debt Defla­tion” expla­na­tion for the Great Depres­sion on this basis; after not­ing that Fish­er did influ­ence Roo­sevelt’s poli­cies, Bernanke added that:

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)

One cri­sis lat­er, lead­ing Neo­clas­si­cals like Paul Krug­man con­tin­ue to argue that only the dis­tri­b­u­tion of debt can mat­ter:

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)

So can we ignore the lev­el of pri­vate debt? No—because this “pro­found insight” is in fact a blind-spot about the role of banks and debt in a cap­i­tal­ist econ­o­my. Neo­clas­si­cal econ­o­mists treat banks as irrel­e­vant to macroeconomics—which is why banks are not explic­it­ly includ­ed in their models—and regard a loan as mere­ly a trans­fer from a saver (or “patient agent”) to a bor­row­er (or “impa­tient agent”), as in Krug­man’s “New Key­ne­sian” mod­el of our cur­rent cri­sis:

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. (Krug­man and Eggerts­son 2010, p. 3)

With that mod­el of lend­ing, a change in the lev­el of debt has no inher­ent macro­eco­nom­ic impact: the lender’s spend­ing pow­er goes down, the bor­row­er’s goes up, and the two changes rough­ly can­cel each oth­er out.

How­ev­er, in the real world, banks lend to non-bank agents, giv­ing them spend­ing pow­er with­out reduc­ing the spend­ing pow­er of oth­er non-bank agents. The dif­fer­ence between the neo­clas­si­cal mod­el of lend­ing and the real world is eas­i­ly illus­trat­ed using trans­ac­tion tables. Fig­ure 2 illus­trates the neo­clas­si­cal mod­el (with an implic­it bank­ing sec­tor): in this world, a change in the lev­el of debt has no macro­eco­nom­ic impli­ca­tions.

Fig­ure 2: Neo­clas­si­cal per­spec­tive on lend­ing

Assets Deposits (Lia­bil­i­ties)
Action/Actor Patient Impa­tient
Make Loan +Lend -Lend


Fig­ure 3 illus­trates what actu­al­ly hap­pens: the bank cre­ates a new deposit and a new loan simul­ta­ne­ous­ly, adding to Impa­tien­t’s spend­ing pow­er with­out reduc­ing Patien­t’s.

Fig­ure 3: Real-world lend­ing

Bank Assets Bank Deposits (Lia­bil­i­ties)
Action/Actor Patient Impa­tient
Make Loan +Lend -Lend


This case has been made the­o­ret­i­cal­ly and empir­i­cal­ly by non-neo­clas­si­cal econ­o­mists for decades. Schum­peter argued it was the pri­ma­ry source of invest­ment (Schum­peter 1934, p. 73), Basil Moore showed empir­i­cal­ly that this endoge­nous cre­ation of cred­it, and not the “mon­ey mul­ti­pli­er”, was the expla­na­tion for mon­ey growth (Moore 1979), and most suc­cinct­ly, a Senior Vice-Pres­i­dent of the New York Fed assert­ed it when argu­ing against the Mon­e­tarist exper­i­ment of the 1970s:

In the real world, banks extend cred­it, cre­at­ing deposits in the process, and look for the reserves lat­er. (Holmes 1969, p. 73)

Unfor­tu­nate­ly, Neo­clas­si­cals con­tin­ue to ignore it because it does­n’t fit their mod­el. Well it’s time to ignore them—because their mod­el does­n’t fit the real world. Once we take the endoge­nous cre­ation of mon­ey by banks into account, ris­ing debt has a macro­eco­nom­ic impact because it adds to aggre­gate demand. It also is the pri­ma­ry way in which spec­u­la­tion on asset prices is financed, as Min­sky empha­sised (Min­sky 1982, p. 24).

The cri­sis we are in sud­den­ly becomes entire­ly explicable—and pre­dictable before the event—when the blind-spot on debt is removed. Because the change in debt adds to aggre­gate demand (and is spent on assets as well as goods and ser­vices), there is a strong causal link between ris­ing debt and both falling unem­ploy­ment and ris­ing asset prices. This is evi­dent in the UK data: unem­ploy­ment fell as the debt-financed com­po­nent of aggre­gate demand rose, and unem­ploy­ment is now ris­ing as the growth in pri­vate debt sub­sides (see Fig­ure 4, where unem­ploy­ment is invert­ed to make the cor­re­la­tion more obvi­ous).

Fig­ure 4: Change in Debt & UK Unem­ploy­ment

The rea­son that our eco­nom­ic cri­sis is a finan­cial one as well is that chang­ing debt dri­ves not just demand for goods and ser­vices, but asset prices as well. And since chang­ing debt is a major source of demand for share and prop­er­ty pur­chas­es, for asset prices to rise, the lev­el of debt must not mere­ly grow but accel­er­ate. Accel­er­at­ing house­hold debt clear­ly drove the UK’s prop­er­ty bub­ble, and that bub­ble is now vul­ner­a­ble as house­hold debt decel­er­ates (see Fig­ure 5).

Fig­ure 5: Rela­tion­ship between accel­er­at­ing house­hold debt and change in house prices

Ignor­ing the role of pri­vate debt in the econ­o­my is thus as dan­ger­ous as dri­ving a car while ignor­ing the fact that your vision has a blind-spot. It’s why neo­clas­si­cal eco­nom­ics has to be con­signed to the dust­bin of his­to­ry (Keen 2011), and a real­is­tic, cred­it based eco­nom­ics must take its place.

Oh, and as pas­sen­gers in the UK eco­nom­ic car, are you hop­ing that your econ­o­mists are bet­ter dri­vers? Fig­ure 6 shows the lev­el of UK pri­vate debt com­pared to that of the USA and Aus­tralia. I sug­gest that you tight­en your seat-belts.

Fig­ure 6: Aggre­gate pri­vate debt lev­el

Bernanke, B. S. (2000). Essays on the Great Depres­sion. Prince­ton, Prince­ton Uni­ver­si­ty Press.

Fish­er, C. and C. Kent (1999). Two Depres­sions, One Bank­ing Col­lapse. Reserve Bank of Aus­tralia Research Dis­cus­sion Papers. Syd­ney, NSW, Aus­tralia, Reserve Bank of Aus­tralia. 1999: 54.

Holmes, A. R. (1969). Oper­a­tional Con­straints on the Sta­bi­liza­tion of Mon­ey Sup­ply Growth. Con­trol­ling Mon­e­tary Aggre­gates. F. E. Mor­ris. Nan­tuck­et Island, The Fed­er­al Reserve Bank of Boston: 65–77.

Keen, S. (2011). Debunk­ing eco­nom­ics: The naked emper­or dethroned? Lon­don, Zed Books.

Krug­man, P. (2011). “Debt Is (Most­ly) Mon­ey We Owe to Our­selves.” The Con­science of a Lib­er­al 2012.

Krug­man, P. and G. B. Eggerts­son (2010). Debt, Delever­ag­ing, and the Liq­uid­i­ty Trap: A Fish­er-Min­sky-Koo approach [2nd draft 2/14/2011]. New York, Fed­er­al Reserve Bank of New York & Prince­ton Uni­ver­si­ty.

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

Moore, B. J. (1979). “The Endoge­nous Mon­ey Stock.” Jour­nal of Post Key­ne­sian Eco­nom­ics
2(1): 49–70.

Schum­peter, J. A. (1934). The the­o­ry of eco­nom­ic devel­op­ment : an inquiry into prof­its, cap­i­tal, cred­it, inter­est and the busi­ness cycle. Cam­bridge, Mass­a­chu­setts, Har­vard Uni­ver­si­ty Press.



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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.