Briefly, my paper explained how various conundrums that have stymied the development of Circuit Theory for 20 years were in fact the result of confusing a stock (an initial loan) with a flow (the economic transactions that loan could initiate over a year). With a proper dynamic approach, using the “tabular” method that I outlined here in “The Roving Cavaliers of Credit“, the conundrums are easily solved–watch the presentation to see how (click here for my Powerpoint presentation, and the two Vissim files that I ran are linked here and here (you will need to “right click” to download them, otherwise you’ll just get a text file). If you don’t have the free Vissim Viewer,  it is downloadable from here. This is one of the Mathcad files that I showed (use a right-click for this one too; it’s poorly structured–written for my use rather than public consumption–but if you have Mathcadyou’ll be able to follow your way around it).

I presented in a parallel session, the morning after the conference dinner, and had a predictably small audience. However that disadvantage had a fortunate side, because that tiny audience included the two conference organisers Louis-Philippe Rochonand Claude Gnos, as well as Basil Moore and Allin Cottrell. Basil is the venerable father of the proposition that the money supply is endogenously determined, rather than set exogenously by the Central Bank, as is still taught (in wild conflict with both the empirical data and actual Central Bank knowledge and practice) in almost all macroeconomics courses; Louis-Philippe and Claude are well-known and respected Post Keynesian monetary economists; Allin is a very capable exponent of Marxian economics, who unlike most Marxists uses computer modelling extensively in his analysis (I just wish he’d update his webpage, which doesn’t appear to have changed since 1997!).

The discussion was therefore possibly better than it would have been, had I presented in a plenary:

However though I was pleased with the way my paper was received by those present, I was very disappointed with most of the presentations at the conference. Though there were some notable exceptions–one of which I’ll comment on below–the papers were either non-analytic (“What Keynes said was…”, “Economists must take uncertainty seriously…”), bombastic (“The fatal flaw in the capitalist system is …”), or used graphical analytic methods that could not easily be distinguished from the content of an ordinary macroeconomic textbook. There were one or two block diagram expositions, but they too were graphical only–mere drawings, not influence diagrams, and certainly not systems dynamics models.

There are many leading Post Keynesians who weren’t at this conference–including quite a few who attended the Australian Society of Heterodox Economists conference that Peter Kriesler organises at much the same time every year–so I’m not claiming that the papers here are utterly representative of the general state of Post Keynesian economics today. Nevertheless, if they were even mildly representative of the work that Post Keynesian economists are doing in the midst of the biggest crisis that capitalism has faced in seventy years–and one which is causing a crisis in neoclassical economics as well–then they will fail to shift economic theory at all. After ten or fifteen years of economic pain, the neoclassical orthodoxy will be reassembled–since it will be true that “there is no alternative”–and Post Keynesians will remain a noisy and largely ignored minority.

Papers like these, though they are intended to criticise the unreality of neoclassical economics, or to point out issues (uncertainty, bounded rationality, open systems, non-ergodicity, whatever) that should be taken seriously in economics, actually strengthen the resolve of neoclassical economists to do nothing of the sort, since they lack any coherent alternative analytic approach.

Neoclassicals who attend such presentations–which almost always include disparaging remarks about the absurd assumptions neoclassical economists make–walk away quite justifiably thinking that “if that’s the best you can do with realism, then I’ll stick to my ‘absurd assumptions’!”

We can and must do better than that. But to do so, non-orthodox economists have to find tools that can express their vision of the economy analytically, either as mathematical or computer models. If we don’t, then whatever might be said by “Critical Realists” about the inappropriateness of mathematical analysis in economics, or how one can’t model open systems mathematically, the critics will be sidelined in a not too distant future by those who do use such models–and who care a good deal less about realism than the critics do. Yet again, the critics may win the philosophical battle, only to lose the methodological war.

That’s why I’ve put in the effort to learn the methods of dynamical analysis in mathematics (systems of differential equations), engineering (systems dynamics), and computing (multi-agent models), and it’s why I’m trying to develop alternatives to those which make sense in the context of economic modelling–notably my tabular method to develop systems models.

These dynamic models enable us to put our thought processes into a systematic framework, and to explore relations that are simply too complex to follow verbally. This is a major benefit to mathematical analysis that is lost in the critiques non-orthodox economists tend to make of how neoclassicals abuse mathematics: when we outline a causal mechanism verbally, we are in fact stating a differential equation verbally. If we say that “Factor X causes changes in variable Y”, we are actually saying “the rate of change of Y is a function of (amongst other things) Factor X”. In mathematical notation, this is d/dt (Y) = F(X).

The advantage of expressing these concepts mathematically, as well as verbally, is that the mathematical rendition keeps track of all the feedbacks and complex interactions that simply overwhelm our capacity to follow a complex causal process verbally, and they give us a means to provide a rough quantification of how strong those feedback effects are.

The failure to do this within Circuit Theory is why a simple confusion of stocks with flows–mistaking the stock of money for the flows that are initiated by a given stock of money over a year–has stymied for twenty years the development of Graziani’s brilliant insights into a workable theory. As I show in the talk above, the simple expression of the flows initiated by a loan are sufficient to solve all the “conundrums” of Circuit Theory. The conundrums were simply the product of applying the wrong type of analysis–simultaneous equations, “period analysis” with its implicit difference equation form, or worse still mere words–to the issue. A simple application of flow analysis in continuous time shows up all those conundrums for what they really are: confusions resulting from bad analysis and inappropriate analytic methods.

Now I also have to exhort my fellow Post Keynesians to learn at least some of the appropriate methods. Get out of the comfort zone of verbal exposition, historiography, simultaneous equations and graphical analysis–and even the much more sophisticated stock-flow consistent framework of Godley and Lavoie (While this method is certainly a major step in the right direction, using it to try to explain where profit comes from was rather like trying to understand how a horse runs, using photographs of a running horse taken at one hour intervals)–and learn differential equations, or systems dynamics, or computer programming. It’s hard, but the effort is worth it. And if you don’t do it, then prepare to once again be dominated by neoclassical economists once the Global Financial Crisis has passed.

I’ll end on one very positive note: there was one exceptional piece of work done by a PhD student (who is also a full-time school teacher) Pascal Seppecher. He has developed a multi-agent model in Java that also simulates the monetary circuit, and reaches much the same result as I do from a differential equations perspective. His model is called Jamel: Java Agent-based MacroEconomic Laboratory. It’s a brilliant piece of work and I do recommend exploring it.

If a full-time school-teacher with a family can nonetheless acquire the skills and find the time needed to do quality work like this, then it’s high time academic Post Keynesians did the same. Sticking with what you are used to, when what you are used to merely lets you point out what “should be” done rather than actually doing it, is no longer good enough.

On tonight’s arrangements, since the meeting is free, there is no way to limit attendance other than by “first come, first served”. The organisers have now received more RSVPs–including Debtwatch donors–than there are seats, so please get there early: I have had the front rows reserved for Debtwatch donors, but since I am not the primary organiser of the event, if other people fill available seats before Debtwatch donors get there, there may not be seats left–and the hall has limited capacity (150 seats I believe).

So the best thing you can do if you are a donor and wish to attend (some donations were from interstate and overseas), please arrive early at Customs House tonight–preferably by 5.30pm.

I will attempt to record the event for both podcast and vidcast–though my usual means of so doing has hit a glitch (I’ll be spending this morning arranging what I can, and buying any hardware needed using other Debtwatch funds–or my own if they run out).  So hopefully in a few days I’ll have a blog entry of the event for those who can’t attend.

I have spoken with Michael at two events since his arrival, and we’d met earlier (in 2008 at a Post Keynesian conference in Kansas City) and corresponded regularly since then. I can vouch for him being an excellent speaker, and extremely incisive in his analysis. It will be a very good evening. Thanks again for your support of Michael’s visit.

To repeat the event details:

• Venue:  Level 1, Customs House, Circular Quay
• Time:
  • 5.45pm for 6pm kickoff–get there by 5.30pm if you can  to ensure seating
  • 7.30pm finish
• Format:
  • Introduction by Miriam Lyons, Centre for Policy Development (5 minutes)
  • Talk by Michael Hudson (40 minutes)
  • Panel discussion (Michael, myself, Adam Schwab)
  • Q&A

For those who have booked for dinner tonight, that will commence at 8pm–so there is some time to chat between the end of the evening’s event and dinner itself.

See you tonight, Steve

Title: Museum Australia Monthly Talk
Location: Australian Museum (entry via William Street)
Start Time: 18:30
Date: 2009-08-25
End Time: 20:00

Bookings and prepayment are essential: call 02 9320 6225 to book.

The cost is $20 for members  of the Australian Museum and $30 for non-members. The event begins with light refreshments, followed by a one-hour talk, and then an open question time.

I’d like to give more details, but as noted in earlier posts, my lecture-writing load doesn’t allow time for lengthy blog posts right now.

I’ll take a long view of the financial data–going back to 1890–and explain the booms and crashes of stock markets as symptoms of debt bubbles and their bursting. From that point of view, this is the largest asset-price bubble in the last 120 years–and probably in all of history. The prognosis for the market is therefore grim, despite the current rally.

The venue is the Wesley Centre Theatre, downstairs at 220 Pitt Street, Sydney. The seminar is free for members of the ASA, and $5 at the door for others. Click here for further information.

Professor Quiggin will present his paper “After the Crisis” for about 30-40 minutes, after which there will be a 20 minute question and answer session with the audience.

Guy Debelle and I will then present our analyses and respond to Quiggin’s paper for about 15 minutes each.

The evening will conclude with a final 30 minute Q&A with all three speakers.

Seating is limited, and places should be booked in advance. The cost if $10 per person, and can be booked either online at the Riverside Theatre or by ringing the theatre on (02) 8839 3399.

School groups bookings can be made by contacting the Whitlam Institute directly on 02 9685 9187.

The talk will start at 5pm and conclude at 7pm.

In this event to celebrate the publication of Political Economy Now!–the history of the Political Economy struggle at Sydney University–Evan Jones, Frank Stilwell and Steve Keen will discuss the struggles inside the university economics departments and their significance, not only for teaching, but for the world economy itself.

Political Economy Now! by Gavan Butler, Evan Jones and Frank Stilwell is the story of one of the most substantial and enduring conflicts in the history of Australian universities. Beginning in the late 1960s, it pitted those committed to the teaching of mainstream economics at the University of Sydney against the proponents of an alternative program in political economy. It explores issues such as

• Why all the fuss over the teaching of economics?
• Why were the disagreements so deep and protracted?
• What has been at stake?
• Why did dissident staff and students commit so much time and energy to establishing and developing alternative courses?
• Does it matter in the broader world? (Hint: naive neoclassical economic theories helped create the Global Financial Crisis)

Location: Gleebooks, 49 Glebe Pt. Rd, Glebe

Start Time: 18:30

Date: Tuesday 16th June 2009

Link out: Click here

Cost: $10 ($7 concession). Booking is essential.

Click here for the event poster.

The topic will be rather apposite to the most recent blog entry: “The Rudd-Swan Budget 2009 – Whose Interests Will It Serve?”

The event starts at 6pm and finishes at 7.45pm, after which anyone who wants to soldier on can join us for dinner at a nearby restaurant.

A major impetus here, as I note in Debunking Economics, was a lecture by the then newly appointed Dr Frank Stilwell which explained a concept known as the “theory of the second best“. Developed in the 1950s by Canadian economist Richard Lipsey and Australian-American economist Kelvin Lancaster, this theory argued that a single movement closer to what economic theory described as a better world could in fact reduce welfare rather than increasing it (Lipsey, R. G. and K. Lancaster (1956). “The General Theory of Second Best.” The Review of Economic Studies 24(1): 11-32).

Frank’s explanation of the theory involved a labour market in which a monopoly supplier of labour (a trade union) was negotiating with a concentrated buyer of labour (a major firm or perhaps an oligopolistic cartel). Unqualified neoclassical economics argued that the trade union would reduce welfare by forcing employers to pay a wage that exceeded the (marginal) productivity of the workers.  Welfare would therefore be increased if the union was abolished–and this argument is the major reason that neoclassical economists are so generally anti-union.

But Frank pointed out that the same model that argued that trade unions alone would set wages “too high”–compared to the neoclassical measure of social welfare–led to the conclusion that a monopoly buyer  (or “monopsony”) of labour facing disorganised workers would result in wages that were “too low” compared to that same measure. On the other hand, with both unions and monopsony buyers of labour present, the wage would end up somewhere between these two extremes.

So abolishing the union–or drastically weakening its capacity to bargain while doing nothing to reduce the power of the buyers of labour–would actually reduce welfare. The standard anti-union line that many neoclassical economists (and conservative politicians influenced by them) trot out is therefore not supported by a more general neoclassical perspective.

This caveat to the standard “Economics 101″ anti-union position is not something that students normally encounter until well into their Honours or even PhD education. By then, most students who have delved that deeply into the neoclassical mindset can’t see any other way to think about the economy. They either ignore “curlies” like this one (and many, many others), or they take the zealot’s approach (“we should abolish monopolies as well–hey, let’s form a Consumer and Competition Commission to campaign for just that”), or they accept patently absurd assumptions to sidestep obvious problems in applying neoclassical economic theory to the real world.

Having learnt this particular curly “out of sequence”, I was instead struck with how fragile the theory was: admit one aspect of reality–that there are both unions and concentrated buyers of labour–and a straightforward proposition from the theory is turned on its head. That didn’t strike me as a particularly robust theory: a robust one would instead need just some attenuation of its conclusions as more realism was introduced, not a wholesale “Do the opposite of the advice given in the simplest case if its conditions don’t apply precisely in the real world”.

My disenchantment with economic theory grew as I learnt more, so that I dropped out of the Honours stream in second year, and ultimately played a leading role in the dispute that erupted in 1973. At the year’s end, I was one of two students who were invited to address the Faculty of Economics when it met to consider whether there should be an Inquiry into the Department of Economics (the other was Richard Osborne).

Despite our victory at Sydney University, neoclassical economics grew even more dominant as the years wore on, something that both perplexed and worried me (and many others who developed a career in academic economics while refusing to worship at the neoclassical altar). How could something so wrong be so successful? We knew that the grounds on which its many interventions in public policy–from competition policy to industrial relations to macroeconomic management and monetary policy–were shonky. How come the economy nonetheless seemed to be booming?

The answer, as is now becoming obvious to everyone except diehard neoclassical economists, was that underlying this apparent economic prosperity was a growing pile of debt. Economic prosperity now was being borrowed from the future, as a mountain of debt was accumulated, and the money generated by it spent on an orgy of speculation on share and property markets.

Fortunately, as well as rejecting neoclassical economics, I had also become a fan of Hyman Minsky’s “financial instability hypothesis”. In my PhD I constructed biology and engineering-inspired mathematical models of Minsky’s hypothesis that, unfortunately, proved to be very accurate predictors of what the ultimate outcome of this speculative bubble would be.

In doing this work, I have moved light years away from neoclassical economics, but also some distance from what Political Economy has become. The faux-mathematics practiced by neoclassical economics persuaded a lot of critics that mathematics was part of the problem, but I was always of the mind that neoclassical economics either used the wrong mathematics–algebra and comparative statics versus differential equations and dynamic analysis–or made mathematical errors, or both. Since Political Economy has shied away from mathematics, I therefore stand somewhat outside my old stamping ground these days.

But I wouldn’t be who I am, nor could I have made the contributions that I have to economics, without those beginnings in the stirring days of the early 1970s. So I owe a great debt to Political Economy at Sydney University, one I am happy to acknowledge.

Unfortunately, I won’t be able to attend the book launch next week–I am already committed to attending a workshop with the CSIRO on melding dynamic models of the ecology with the same from economics. But I’ll be there in spirit as Frank Stilwell, Evan Jones, Gavan Butler and many “once-were-activists” ex-students commemorate a proud entry in the larrikin history of Australian economics. If you’re interested in the story, and especially if you were part of it, see if you can make it along to the launch:

• Location: Syney University Fisher Library, Level 5
• Date: Tuesday May 5th
• RSVP: by Friday 1 May 2009 to events@sup.usyd.edu.au or 02 9036 9958
• Start Time: 17:30

Frank invited myself and several other leading activists from that time to write some reflections on Political Economy for the book.  My entry is reproduced below.

From Activist to Associate Professor…

Like many of those who got involved in the Political Economy struggle at Sydney University, I began as a believer in what I simply thought was economics. There is a first year tutorial paper, hopefully long lost, in which I bemoan the existence of both monopolies and trade unions.

Such naivety did not last. In late 1971, one Frank Stilwell drove an intellectual bulldozer through it with an untimely illustration during a First Year of the “theory of the second best” (in a “proper” economics education, such things are really best left to graduate school when the few survivors are fully committed to neoclassisicm). Learning about this wrinkle on the seemingly flawless neoclassical skin shook my world view substantially (with a little bit of help from the Vietnam Moratorium), and the second thing I did after signing on for a vacation job was to join the union.

The following year, along with a newfound radical friend Richard Fields, I organised (if that is the right word!) a “Radical Economics” conference. It was attended by a handful, with the Henry George League making up a sizeable fraction of the audience and only Bruce McFarlane providing any real intellectual spark.

As my “gut-feeling” disgust for economics grew, I became progressively more disillusioned both with economics and with the bulk of my fellow students, who seemed to tolerate this bunk (though they, like me, chatted away all through Professor Simkin’s incredibly boring 2nd Year Macroeconomics lectures). Attempts to challenge the staff on the “hidden assumptions” of economics met with friendship from a minority who would, some time later, form the nucleus of the Political Economy Department, but outright hostility from the majority (notably the main 1st Year Microeconomics lecturer, whom we had long ago nicknamed Mean Mr Mustard Man after his peculiar taste in clothing). It seemed that this mediocre hegemony — that I now knew to call “neoclassical” — would forever dominate economics forever.

All that changed in 1973, when the Philosophy Department at Sydney University initiated a strike over the University’s refusal to endorse a new subject on “Philosophical Aspects of Feminist Thought”. As then President of the Arts Society (my degree was Arts/Law, not Economics) and therefore an ex-officio member of the Faculty of Arts, I took an active role in this at both official and street protest level, and found the vigour of the Philosophy students a welcome contrast to the passivity I thought characterised their Economic colleagues.

All this changed when Gavan Butler informed me that students in Frank’s 1st Year lecture had voted to strike in sympathy with Philosophy. The aura of passivity had only been one of resignation: like me, many were fed up with the pseudo-numerate nonsense that permeated our subjects, and leapt at the chance to do something to change it.

A lunchtime meeting about “The Problem in Economics” drew over 450 students. While we ranted, little direction existed until an until-then unknown Government student, Richard Osborne, sprang to his feet to suggest that we should organise a “Day of Protest”. Over ten per cent of the audience volunteered to help, and though we didn’t quite realise it then, the Political Economy Movement was born.

The Day of Protest was a huge success from the moment that Bill Nichol’s 25 metre banner was strung out across the Merewether Building. The adrenalin rush of the event gave our protest a momentum that pushed through a Faculty vote to investigate the affairs of the Department of Economics. We also developed an alternative economics curriculum that became Political Economy I (in response to a challenge from Professor Hogan to “do better”  if we didn’t like the current syllabus). And, though we didn’t appreciate it at the time, we gave birth to a tradition of student activism that, while it has waxed and waned at times, has lived on for fully thirty years. That is a remarkable achievement.

Looking back on those days from my position as an Associate Professor of Economics & Finance, I think we did only one thing wrong. Because so much of the nonsense of neoclassical economics is dressed up in apparently sophisticated mathematical dress, we identified mathematics and rigorous analysis as at least part of “the enemy”.

Knowing what I know today, I realise that it was not real mathematics but appallingly bad mathematics that clothed this naked emperor of the social sciences. It of course remains true that much of economics cannot be put into mathematical form, as Hugh Stretton’s Economics makes clear with its plea for “barefoot economists”. But truly rigorous mathematics demolishes neoclassical economics, while modern mathematics and computing offer the possibility of a truly dynamic economics that can at least partially explain the behaviour of the unstable economic system in which we live.

Thirty years on, the battle to develop that real economics is still an uphill one. The majority of economists still fall prey to the seductive ideology of neoclassicism, while only a handful of the perhaps 20 per cent of academic economists who are non-neoclassical have the intellectual armory needed to develop an alternative. They struggle on with limited funding while comparative abundance is wasted on those who continue to push the prevailing paradigm forward.

So is the PE struggle ultimately futile? No: we know so much more now about the deficiencies of neoclassical economics than we knew thirty years ago, and perhaps economic circumstances will one day give us the opportunity to shake the hegemony as Keynes tried to do seventy years ago. Until that day, we can at least revel in poking fun at the naked emperor.

A footnote: How true that last paragraph turned out to be

Upon re-reading that last paragraph–”perhaps economic circumstances will one day give us the opportunity to shake the hegemony as Keynes tried to do seventy years ago”–I was curious about when I could have written it.

Some books take a long time to go from idea to hard copy: I penned those lines on January 1st 2003.

The statement itself underscores why this struggle was and is important, and why also it had no chance of success until the economy itself was in crisis. Though there were plenty of anti-capitalist radical amongst those who campained for Political Economy, the unifying theme of the movement was that neoclassical economics was bad theory. Just as following a bad theory of navigation–such as Ptolemy’s earth-centric view of the universe–can lead a ship into disaster, following bad economic theory ultimately had to lead to an economic calamity.

But just as it’s hard to convince a believer that the earth-centric model of the universe is false until his ship is wrecked on a reef that his model says wasn’t there, we couldn’t convince the wider world of the errors in neoclassical thought until the economy itself was in crisis. We have now hit that economic reef, and therefore the opportunity to reform economics is finally with us.

It is an opportunity that I have no intention of wasting–hence the formation of this blog, and the public information and policy campaign I have waged over debt. But it’s one that could pass us by too, as it did in the 1930s, when Keynes’s attempt to reformulate economics without Say’s Law was undermined by Hicks’s reinterpretation of Keynes as a neoclassical “marginalist”. Academic economics is incredibly resistant to reform, and left to their own devices, economics departments will go on teaching neoclassical economics and attempt to develop “a neoclassical Minsky” as they once concocted “a neoclassical Keynes”.

There can be no such creature. Essential aspects of Minsky’s theory–especially his direct incorporation of uncertainty, and his vision of destabilising forces so that no equilibrium will ever persist–are utterly antithetical to the neoclassical way of thinking. But I have no doubt that there will be attempts to reformulate his ideas in a neoclassical guise.

For that reason, my main argument for the reform of academic economists is to remove the monopoly that economics departments currently have over the word “economics”. Let Engineering and Physics and Biology and Sociology and Psychology departments teach Economics as well–and label it as such. With their very different foundations, there is a prospect that in those courses a new, realistic, dynamic approach to economics will finally evolve.

Tax, social policy, the global financial crisis and climate change will be pulled apart by impressive policy minds including Ann Pettifor from Advocacy International in the UK. Ann has written extensively on debt and finance, climate change and international development and was one of the authors of the UK national economic foundation’s Green New Deal.

Local speakers include CPD fellows Steve Keen, David McKnight and Mark Davis.

The event coincides with the half way point of federal Labor’s term, and is one year on from the 2020 Ideas Summit. It will provide an opportunity to consider the impact of the global financial crisis and to discuss the values that should drive future policy.
Start Date: 2009-04-22
Start Time: 9:00
End Date: 2009-04-23
End Time: 17:00

I will contribute to one workshop (3.10-4.30pm on Wednesday 22nd) on ”Responsible Markets”, along with Dr Lindy Edwards, Australian National University, and Dr John Quiggan, Queensland University (by videolink).

A blog member has kindly produced a transcript of the off-the-cuff talk I gave at this forum. I’ve made minor corrections to the punctuation below, but the text is otherwise as delivered on the night without speaking notes–so there are some grammatical slips. For those who want to listen to this alone–without also listening to Bernie Fraser beforehand–here is a link to the MP3 of my talk.

I might start with when I started issuing the warnings. That was in December of 2005. I’d started researching what I’d call the debt deflation theory of great depressions in my PhD, working on the advances done by a guy called Hyman Minsky, who’s somebody who the economic students in the back row should definitely start looking up as soon as they get back to the library. Because answering one of the questions Bernie posed, “Who saw this coming?”, the only answer is Hyman Minsky in the most recent history, and before him, Irving Fischer during the Great Depression.

Those two men, and the theoretical history they are part of, really gives us a far better explanation of what we’ve got ourselves into. Indeed if they’d been heeded, we wouldn’t be having this meeting.

So, I think one of the reasons we’re having the crisis now is not entirely caused by the economics profession; but I believe by the direction economics took after the second world war and was amplified after the period of stagflation in the 1970’s is a major contributor to the scale of the crisis we’re in and why I don’t believe policy makers have any idea of how to get us out of it. In fact what I think we’re going to have to wait on is basically the current set of policy makers abandoning all hope and certainly the political leaders abandoning hope in them before we’re going to see any sort of change around out of this crisis.

Now as to how bad it’s going to get – you have to know what caused it in the first place to have any idea there. And this is again why you tend to get, “I don’t know” type answers from most economists—and that goes right up to and including people like Joseph Stiglitz and Paul Krugman.

The reason they don’t know is that their economic theory is the wrong one. They’ve got a model of how the economy operates and it’s got no relevance to the real world, you’re not going to understand what’s happening in the real world when somebody asks you a question about it. So I, for some years, have been arguing that economic theory as it’s being taught in universities and as is commonly believed, is an utterly fallacious view of how the world operates. I published a book called Debunking Economics to make that case back in 2001. And the reason that economists can’t understand what’s happening in the economy is, and I know this is going to sound ludicrous to anybody who hasn’t actually studied economics, is that economists convinced themselves when they were about 18 years old that neither money nor debt matter.

Now, if you start from that mental position, how are you going to understand the real world in which we have manifestly clear now money and debt are crucial.

Now the reason they have their particular mythology inculcated into them is that early in their first year courses, back when I did economics, and now in second year because the courses have been dumbed down so much in the last 30 years, they learned what’s called the money illusion. And they get shown a model which has a proposition made that you can separate a consumer’s taste from their income. And then consumers are all supposed to know exactly what they desire in any particular combination of relative prices. And if you say, well let’s say we double all relative prices and double your income what combination are you going to choose? And the student does the mental exercise or the mathematical or graphical one and says, “Well, duh, the same combination.”

Being naive enough not to have credit cards at that stage, certainly when I was going through University, most of the students accept this and go on to believe that it isn’t absolute prices and money that matter but it’s relative prices. And they end up building mathematical models of how the economy operates that leave out of the equations, out of their variables, both debt and money.

Then along comes the real world, after 40 years of that and I’m sorry suddenly you realize your models don’t make any sense whatsoever. So a model that does make sense is Minsky’s. And it comes out of the work of Irving Fischer originally.

And the argument that Minsky made was that we live in an uncertain world and the mathematical world that economists swallow when they are at University—which is largely known as neoclassical economics—teaches them that you don’t need to know absolute prices, you only need to know relative ones. That all transactions are relative, that absolute magnitudes don’t matter and that credit can be forgotten about.

Well, it can’t in the real world. And that’s the lesson Irving Fisher learned the very hard way in the 1920’s and early 1930’s.

Minsky put it together quite effectively to say, “In the uncertain world with financial obligations, absolute prices are the links between the debts you accumulated in the past and your capacity to service them now.” And if you have a world where you borrow money to finance activity, and that’s the world we live in, then those absolute prices are crucial and so to is the level of debt.

As the level of debt rises, you have an increasing need to devote part of your current monetary income to servicing those monetary charges. And if you have debt and you’re trying to repay it, then the little mathematical model the student use that got shoved down their throats in first year before they are mature enough to bite the hand of the lecturer that’s feeding it to them, don’t work.

Because if you do double all prices and double incomes you do not get back to the same situation because it’s a non-linear process of repaying your debt.

You might get 1.73 times as much consumption. You might get 2.03, 2.07. You can’t say. So the argument that says you don’t need to worry about absolute prices is false as soon as you allow the existence of a world which debt exists and in which people have some need to pay their debt off over time.

So that mental construct that academic and then ultimately reserve bank economists use is on entirely the wrong track and it’s why they missed this whole process happening.

Now Minsky argues that the world you’ve got to look at is the one which is modeled from the point of view, not of the barter economy, which is the mental model that economists adopt in first year and don’t realize they’ve done it, but a Wall Street model. He said that in the Wall Street world it’s a world of credit driven systems with financial obligations being absolutely paramount, an uncertain future and people trying to speculate and invest to make money.

In that world they will borrow money, in a particular stage of the trade cycle. And here come two more terms that don’t turn up in conventional economic thinking: history and time.

Now I don’t need to ask the economics students here, “Have you studied economic history?” because I know the answer to the question—they haven’t. Economic history is abolished from most university courses around the world. So students don’t actually learn history when they are doing economics.

And I have often see people who haven’t had the misfortune of having an education in economics, saying, “Haven’t central bankers learned about this stuff? Don’t they apply the lessons of history of the 1930s and the 1890s? The 1870s?” For those who actually know their history, the answer is no they don’t. They don’t study economic history. Well, that’s one thing they’d better change.

They also don’t study the history of their own discipline. So they have no idea where the ideas come from. I’m proud to say that the University of Western Sydney, where I teach, is the only university in the country with a compulsory course in the history of economic thought.

And history itself is not part of economic theory, nor is time. Again, most economic models work on what’s called comparative statics. Or what they laughingly call general equilibrium. And all these ideas leave out of existence the very function of time.

So, Minsky starts from history and time. And he says, let’s imagine a time in history where there was a previous financial crisis. And you’re all thinking that must be 1990, maybe the younger ones are thinking 2000. So, 1990-1991 we had a financial crisis in the past. Bernie was part of that experience and remembers it well. And as a result of that crisis, everybody is conservative about the amount of debt they are going to consider taking on. That applies both to lenders and borrowers.

Because everybody is conservative, the only projects that are put forward for funding are projects that actually are likely to have a cash flow that’s going to exceed their financial commitments. And because the economy has recovered from that crisis, however that might have happened, most of those projects succeed. Because they succeed, everybody thinks, “Ah, we were too conservative last time around. If we’d actually borrowed more money, been more leveraged, we would have made a larger profit.” So, as a result of that, people start to relax their risk premiums so they become more adventurous.

As Minsky put it, quite classically, “Stability, in a world with an uncertain future, and complex financial instruments, is destabilizing.” So the experience of a period of stable growth, leads to rising expectations, and sets off the next bubble. When the next bubble begins, you suddenly have a period of self-fufilling expectations for awhile –where that high level of investment and a larger growth in the money supply, which is not under the control of the reserve bank, but caused by the willingness of borrowers to take on debt. That expansion of the money supply drives the big economic activity and makes it profitable once more to speculate on asset prices. You then get caught in another bubble for awhile where partly positive feed back systems are good which boosts investment and spending and improve confidence, that illusive word, rise and cause a boom in the real economy to take place. But you also have a boom in the artificial economy –the speculative world. And that often comes to dominate the real world. I remember one, Robert Holmes a Court I think, one of the classic speculators from the end of the last bubble, saying he didn’t like to invest in real projects because he could only expect a rate of return of only 5 or 10 percent and he was much happier with 20.

A twenty percent rate of return is a recipe for catastrophe in the future. It can’t be sustained.

So, you get this bubble going on and then out of that bubble come people like those speculators: the Bonds, the Skases and so on of the 1990s, the “Fast Eddies” of the most recent period, who only make money because asset prices are rising. They buy assets on a rising market, they pay amounts of money for those assets which are beyond debt servicing of the debt exceeds cash flow from the businesses.

The only way they can get out of trouble is by re-leveraging later for a larger level of debt or selling the asset on a rising market which is what they do. Now, of course, ultimately that momentum has to break down because even though asset prices are rising, debt is rising faster. And that is the thing which as been left out of reserve bank visions around the world, including Australia. Debt rises faster than the asset prices rise, the servicing costs rise faster. Ultimately, you may have a boom coming out of that as we did back in the 1970s and the 1990s, that changes income relativities as well, and that can shock the system internally and turn it around. So that wage demands get to be higher than people anticipated, raw material prices go through the roof and undercut profitability, and so on. You then reach a crisis. The asset bubble bursts, and you are back where you started again in a debt induced recession.

Now that’s the process we’ve been going through in the Western economies since the mid ’60s. The first major financial was 1966. If you go back and take a look at the Dow Jones then and see the collapse that happened then, it was at that stage that the biggest stock market crash since 1929. I recommend going and look at Robert Schiller’s home page where Robert has done an excellent job of assembling long term data series on asset prices, particularly share markets and houses in America. And you will see that bubble in price to earnings ratio where the earnings are over a ten year period. And that price to earnings ration points out two major bubbles in the past, the 1929 bubble and the 1966. We are now well above that level and so is the driving factor which is the level of debt.

Now to give you an idea of how much debt has grown during this whole process, again what Minsky talked about was the tendency for the ratio of debt to income ratio to ratchet up over time. The reason for that is that you borrow money during a boom and you have to repay it during a slump. You don’t quite have the cash flows you thought you would to service the debt, so when you’ve got it down to a reasonable level, it’s not quite back to as low a level as before the last bubble began.

So, you get a series of ratcheting up of the level of debt. And the more you overlay speculative lending, where you borrow money not to invest in real projects, but to gamble on asset prices, the more you drive that level up. That’s certainly been the case in the Australian situation, and the American. If we go back to 1945, the ratio of debt to GDP was roughly 45%. So, it owed less than half a year’s income to pay all it’s debts off if it ever wanted to do that. It now owes 290% of it’s GDP. That’s not factoring in the obvious nettable outcome of all the monstrous derivatives that have been pumped around the system. The most irresponsible of them in this most recent crisis is something we’ve never seen in history before. For those who want to see how bad that is and go to the Bank of International Settlements page and look for the data there on over-the-counter transactions derivatives. You’ll see that as of July 2008, there was $683 trillion worth of outstanding derivative contracts out there. Now, when that gets netted out we’re going to see a fairly substantial increase in even that astronomical level of debt.

Putting 290% of GDP in context, in terms of debt levels, that is 60% higher than the peak debt reached during the Great Depression in America and about 120% higher than it reached when the Depression began. The reason the ratio was that high during the Great Depression was because the level of debt caused a period of deflation. And that deflation and collapsing output meant that even though Americans reduced their nominal debt levels from 1929 to 1932, their indebtedness relative to their income rose from about 175% of GDP to 235% of GDP. Now, we’re starting this crisis at 290% of GDP.

In that sense I’m saying that debt is the actual cause of the disease and and the cause in the American case is pretty close to 1.5 to 2 times as bad as the Great Depression. So, I think it’s going to be… we’ll be lucky to come out of things as well as the Great Depression. We’ll certainly come out worse than 1990. People who believe we’re going to stop at less than double digit rates of unemployment are, I think, deluding themselves. And that’s unfortunately what economists normally do.

We also have deflation hitting us. In 1930-1931 the rate of falling prices in American was roughly 10% per annum. The maximum rate of fall of prices in any particular month occurred in 1932 or 1933 and it was about 2%. The second largest rate of fall in consumer prices in recorded history was in November of last year. Already. So there’s all sorts of signals that this could be a worse crisis than the Great Depression.

Now, how much confidence do I have in policy makers today to get us out of it? None. There are several reasons for that. First of all, the people in charge at the moment did not see this coming. Again, Bernie was talking about how economists were thinking about how they’d abolished the trade cycle.

They actually had a whole debate going in American, particularly American journals, but also English ones, called the Great Moderation. And their description, up to and including the beginning of 2007 of what was happening in the macro economy was a reduction in the volatility in the trade cycle: more consistent growth, less bouts of inflation, more stability. And one of those many foolish economic commentators in the newspapers, for the London Times, had a piece published in the beginning of 2007 called the “Great Moderation” which began with the line, “History will marvel at the stability of our era.” I don’t think he was being ironic. He actually believed it.

Even though I support the stimulus the Rudd government has given, why I don’t think it’s going to work is because of the nature of this particular turn around. We had a cycle in ‘73, we had a cycle in ‘89, each time the recovery from that cycle involved, not restoration of true stability, but a restarting of the engine of private borrowing. If you go back to 1973 in Australia, I think the debt to GDP ratio then was about 45%. It slumped slightly, and then it took off again. We got to 1983 or ‘84, another bubble, a super bubble in debt occurred at that stage, took out debt ratio to about 90%. It slumped to about 85% by ‘92-’93, then took off again. It’s now, in Australia’s case, peaked at about 165% of GDP. If you factor in corporate bond issues, it’s about 177% of GDP. That is 7 times the ratio of debt to GDP we had back in the 1960s.

Now, we don’t have to have a period of ever accelerating debt. A lot of fringe thinkers in economics believe that’s the case. Probably the best period of economic performance in Australia’s history was the post war period from 1945 to 1965 even though it includes the credit crunch Bernie talked about a moment ago. Across that whole period, that 20 to 25 year period, the ratio of debt to GDP was stable at about 25% of GDP. Now, at that stage, debt was doing what debt should, and that’s providing working capital to corporations, investment funds for those who don’t have enough retained earnings to do it and a small amount of money for people to buy houses who wanted to own their own houses rather than renting. That’s the legitimate function of the financial system.

In Australia’s case, in mid-1964, the ratio of debt to GDP started to accelerate, and from that stage on, debt was grown 4.2% faster than GDP on average for the next 45 years. Now, that’s unsustainable. I know that, again having some conversations with Reserve Bank staff, their attitude was, and this in print from the current Governor in a hearing before the House of Representatives committee about 3 or 4 years ago, that there’s an inverse relationship between debt servicing and interest rates. So, when interest rates fall, debt will rise. And when interest rate rise, debt will fall.

That’s not at all what happened, unfortunately. A good look at the data shows simply an exponential take off of debt to GDP, independent of what interest rates were doing. If you simply look at the ratio of debt to GDP, and do a regression on that, using an exponential function, you’ll find a correlation between a simple exponential growth of that ratio and the actual data of .9912.

Now, I know most people don’t know what I’m talking about, but I’m saying 99% of the increase in the debt ratio can be explained by simply saying debt grows 4.2% faster than GDP. Now, that is an impossible situation to maintain indefinitely because ultimately your debt is going to be a hundred times your GDP and of course you can’t service that amount no matter what interest rates are. It’s going to have to change direction.

It’s changing direction now. In Australia’s case the level of debt to GDP, is almost 3 times what we had prior to the Great Depression. And there I come to a strong criticism of how our Reserve Banks have behaved. Because they have ignored the actual dynamics of the capitalist economy, because they haven’t understood them, they followed the wrong theories. I might actually add, without knowing that there are alternative theories. Because they’ve done that, they’ve ignored the actual problem as it’s run away from us.

And therefore their decisions have actually encouraged the financial system to get back on the speculative band wagon when they should have been kicking them off it in the first place. If you look at the data, I think it’s fairly convincing if we hadn’t had central banks then in 1987 we would have had a crisis about the same size or smaller than the Great Depression. It would have been attenuated by the scale of government. That would have turned us around. We’ve gone another 20 years and we therefore, I think, face a crisis which is bigger than the Great Depression and of which our managers of the economy have less of an idea of how the economy functions, than we had back in 1929.

It’s going to be a long one. Thank you.