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.

King Arthur: [after Arthur's cut off both of the Black Knight's arms] Look, you stupid Bastard. You’ve got no arms left. 

Black Knight: Yes I have. 

King Arthur: *Look*! 

Black Knight: It’s just a flesh wound…

Most of Rory’s commentary in his newsletter has been reproduced by Christopher Joye in an amusing “ringside report” (Keen vs. Robertson: Round V) on the Business Spectator (incidentally, Chris’s post includes an excellent dig at the RBA’s performance in recent years; this is well worth a read in its own right).

Taking Chris’s extract as a guide, it seems that Rory’s entire consideration of my post boils down to this:

“**Needless to say, Dr Keen does not accept the assessment that a “schoolboy error” lies at the heart of his pessimistic forecast of a 40 per cent drop in Australian home prices. But instead of addressing the key point that debt servicing just got much easier for most home-buyers, Dr Keen responded by inventing a silly story about cars and fuel consumption – to make a point that completely missed the point…

“Does not accept the assessment”? Do we have a Dead Parrot talking here, as well as an armless Knight? The point of my post was that Rory’s argument that comparing Debt to GDP is a “schoolboy error” (“like comparing apples with oranges”) was itself a schoolboy error that betrayed the depressing lack of understanding that most neoclassical economists have of dynamics. In engineering and many other properly dynamic disciplines, stock to flow comparisons–like comparing Debt to GDP–abound. Far from being a “schoolboy error” to make them, it’s a “haven’t been properly educated at university” error to deride them.

They can be done in error, sure–when the resulting measure has nonsense dimensions, or is irrelevant to the issue at hand. Comparing Debt to GDP isn’t an instance of either error, since as I showed in that post, the resulting dimension is “Years”. The ratio matters because it tells you how long it would take to reduce debt to a given target, if a given percentage of income was devoted to repaying it.

The current answer is 1.59 Years, if all GDP was devoted to debt repayment (which can’t happen of course–5% of GDP p.a. is a more likely deleveraging rate) and if the target was a zero % debt ratio (which it wouldn’t be–the 1950-70 range of 25-50% is more likely), and if reducing debt didn’t affect GDP (which unfortunately ain’t the case–there will be many damaging positive feedbacks from reductions in debt to reductions in GDP).

And for Pete’s sake, a “stock to flow” comparison was the linchpin of Friedman’s Monetarism, as a blog member here pointed out:

cheapbastud said, on March 16th, 2009 at 1:22 am:

uhhhh, isn’t VELOCITY from the equation of exchange a stock/flow ratio (in this case it’s a flow/stock ratio)?

V = GDP/M

Maybe I’m making a horrible schoolboy error or maybe Mr. Robertson doesn’t know wtf he’s talking about.

Spot on. The “velocity of money” is the number you get from dividing nominal GDP ($/year) by the money stock ($). Its dimension is 1/years, so that the inverse of the ratio tells you how many times the money stock turns over in a year. The forlorn attempt to prove this was a constant was Friedman’s key research objective, since if V wasn’t a constant then much of the Quantity Theory of Money was invalidated.

Now I doubt that Rory is going to accuse Friedman of committing a “schoolboy error” here (though in truth Friedman is guilty of so many that there should be a Friedman Prize in Schoolboy Errors–and  virtually every year it could be awarded jointly with the Nobel Prize in Economics). So why accuse me?

In my long experience with attempting to debate economics with neoclassical economists, I have become accustomed to an often irrelevant and frequently false point being raised, after which discussion is terminated. The point of raising the point is not to engage in debate, but to shut it off. So too with this patently false argument that, because I use a “stock to flow” ratio, the remainder of my arguments can be ignored.

In itself, there’s nothing wrong with arguing this way–in a religious debate. If you have two perspectives, one of which sees a God as crucial to understanding the universe, and another which doesn’t, then they’re always going to argue past each other. But economics isn’t supposed to be a religion–it had, at least until this crisis hit, the pretension of being a science.

I hasten to add that I don’t see this as deliberate evasion by Rory, nor even necessarily conscious evasion–and ditto for the many neoclassical correspondents and referees I’ve dealt with over the years. They can, and do, cope with debates within the confines of their own belief systems; so if I was arguing that the NAIRU (don’t bother asking what it is if you don’t already know–it’s not worth the effort of discussion!) was 4% rather than 6%, or maybe even that prices were sticky downwards rather than perfectly flexible, I might get an argument.

But when you effectively challenge core beliefs–by arguing, for example, that equating marginal cost to marginal revenue doesn’t maximise profits (again, don’t bother, but if you must, check here)–you get a nonsense reply to shut the debate down.

In a true science, a substantive point is either contested or conceded. Rory did neither–though to cut him some slack here, he might not have realised why I wrote my piece either. I didn’t give him any forewarning, so he was free to make a mistaken interpretation of why I wrote something about him. Instead, whether he meant to or not, he ignored my main point, and changed the topic back to the house price issue .

From his point of view, I changed the topic, which in his post was house prices–his “stocks and flows” statement was just an aside. But in fact, if house prices had been all Rory had talked about in the newsletter to which I responded, I wouldn’t have bothered writing anything.

It was the “comparing stocks to flows is a schoolboy error” nonsense that inspired me to write something (and I was also responding to a reader’s request that I assist him in contesting that specific proposition). But Rory’s take is that I made my comment to distract attention from his argument about house prices:

“**Regardless, there remains a large hole in Dr Keen’s analysis (big enough to fit a bus?). Barely six months ago, he was highlighting the uptrend in the household sector’s interest-to-income ratio as the key force that would bring house prices crashing down.”

“Quoting Keen: In 1990, servicing mortgages cost three cents of the household dollar — now its 15 cents, even with lower interest rates. …This is because of the sheer size of the debt — that’s the pressure that’s going to be pushing house prices down and it’s actually the same kind of pressure that is in the US (see here; (The Age back in October also reported: “…Mr Keen said the lower end of the [housing] market was already collapsing”. Really?)”

“**Now that his debt-servicing ratio has crashed towards 10 per cent from 15 per cent, Dr Keen has nothing to say on the matter. Furthermore, with the ratio now trending lower, Dr Keen has stopped publishing the debt-service chart that once was at the centre of his analysis. (Between November 2006 and May 2008 the debt-service chart was regularly published in DebtWatch; for example, see Figure 21 in the February, April and May 2008 reports, and Figure 12 in the November 2006 report, see here).

“**Someone unkind might wonder if Dr Keen is steering clear of key facts that directly contradict the scary story he likes to tell. Pauline Hanson might be inclined to issue a “Please Explain”? In any case, contrary to Dr Keen’s ill-informed claim in the quote above, the situations in Australian and US housing and mortgage markets are very different, like chalk and cheese (see charts 4-15 in the attached PDF file).”

Well, actually, no Rory. Firstly, I mentioned two forces: the interest rate burden, and de-leveraging. True, the former has fallen somewhat; the latter is as potent as ever, and only just beginning to click in here, while it’s driving the collapse in the USA and Europe. I published two charts on that in the Dr StrangeLove post (they’re reproduced at the bottom of this post too), but I wasn’t ignoring the interest rate issue either.

The interest payment burden, while it has dropped substantially courtesy of the RBA’s belated and panicked cuts to rates, is still at higher levels than at any time outside the period 1989-1991–when rates were three times what they are now.

The reason I haven’t been publishing these charts in Debtwatch is not that they no longer make the case I want, but because the reports were growing too long and–given the software I was using to produce them–the layout was becoming too messy. I’m working with a few blog members to produce a web-accessible interface to all the data that will get around this problem ultimately, but it takes time to do this.

In the meantime, here are some of those charts. Firstly, interest rates and the interest rate payment burden as a percentage of GDP: rates and the burden have fallen, and sharply, but still only taken us back to levels that applied when average rates were 16% or higher between mid-1988 and early 1991. That’s hardly heaven.

How much further rates have to fall to return the interest rate burden to anything close to the average since 1960 is indicated by this next chart. We’re still way above the average burden for the last half century.

The average interest rate used above is a weighted average of business, mortgage and personal rates (and it probably understates the burden on business slightly, since I had to guess the latest figure–the RBA only updates business rates on a quarterly basis, and I extrapolated from the September figure using the most recent gap between the 3 year fixed rate for small business and the variable rate for large business; this gap was the smallest it’s been in years, so the business rate is probably higher than I guesstimated here). Breaking this down, and comparing the business payment burden as a percentage of Gross Operating Surplus and the household rates as percentages of Household Disposable Income yields the following chart:

Thus while the burden on business is substantially below what it was in 1990 (when the RBA’s rate hike to attempt to tame the asset bubble back then had a crippling impact on business) the burden on households now is still more than 4% higher (as a proportion of disposable income) than it was in 1990.

The reason for this, of course, is the dramatic increase in mortgage debt over the last twenty years. Analysts who believe that house prices will always rise focus just on that datum itself. I’ve argued from a Hyman Minsky, “Financial Instability Hypothesis” point of view, that this trend of rising house prices only occurs because the debt borrowed to buy houses has risen faster still.  The next chart, which indexes both mortgage debt and household prices to 100 in 1996, illustrates that point:

Finally, there are of course two forces that determine the interest repayment burden–the rate of interest and the level of debt (three actually if one looks at the real burden, but I couldn’t find that chart in a hurry so I’ll  leave it for another day). If you plot the level of debt as a proportion of GDP on a horizontal axis, and the interest rate on the vertical, then you can show combinations of Debt to GDP ratios and interest rates that have an equivalent outcome in terms of the interest rate burden: thus a combination of a Debt to GDP ratio of 40% and a nominal interest rate of 20% has the same impact as a burden of 400% and an average rate of 2%.

Checking the actual time path of the interest rate burden on this chart, I surmised that a speculative boom seems to occur whenever the burden falls to about the 8% level, whereas the maximum burden we’d ever experienced was 16.7% in 1990, with a debt ratio of 83% and an average interest rate of 19.7%.

Also, interpolating from the mean gap between the cash rate and average interest rates of 3.3%, it appeared that the debt ratio at which the minimum debt burden would be that “good times” level of 8%, was 240%: if the debt to GDP ratio ever hit that level, then there was no way the “good times” could ever come back. That analysis is shown in the next chart. Though we’ve retreated from the “maximum pain” line of 16.7%, we’re still well above the “good times” level of 8%–it would in fact take a further 3% fall in interest rates to take us back there, if there was no change in the debt ratio.

So there isn’t much room for rate cuts to reflate the economy–a 3% fall in average rates would require the cash rate to fall to 0.25%, and all of the rate cut to be passed on. That headroom would fall even further if that “schoolboy error” Debt to GDP ratio rose any further.

Thus the interest rate cuts have reduced the pain of debt servicing, but they haven’t reduced them to anything near the comfortable levels of the pre-1980s. And the main problem of debt-deleveraging remains, and will be the main factor driving the economy down, as the contribution that change in debt makes to aggregate demand plunges. That effect is already patently obvious in the US data:

And the first signs of the same process are now turning up in the Australian data, with the most recent “unexpected” increase in the unemployment rate:

The impact of de-leveraging is the main force that I see driving us into Depression, and taking house prices down in the process. There may well be a fillip to the bottom end of the housing market out of the Government’s ludicrous boost to the First Home Buyer’s Grant, but the weight of deleveraging will, I expect, soon tell against that.

And Rory, let’s lighten up here please. My Dr StrangeLove post was meant to make in a comic fashion a point that obviously hadn’t gotten through via serious discussion: that stock to flow comparisons are, if done correctly, legitimate aspects of analysing a dynamic system. Concede that point, and I’ll tickle you with my next sword thrust, rather than slicing your legs off.

Over to you, Mr Joye, for the ringside commentary.

A link to this blog from a US legal advisory website the Practising Law Institute’s In Brief ( “DEFLATION IN THE REAL WORLD“) reminded me of  Bernanke’s book Essays on the Great Depression, which I’ve been aware of for some time but have yet to read. I’ll make amends on that front early this year; fortunately, an extract from Chapter One is available as a preview on the Princeton site (I couldn’t locate the promised eBook anywhere!; in what follows, when I quote Bernanke it is from the original journal paper published in 1995, rather than this chapter).

To put it mildly, Bernanke’s analysis is not promising.

The most glaring problem on first glance is that, despite Bernanke’s claim in Chapter One “THE MACROECONOMICS OF THE GREAT DEPRESSION: A Comparative Approach” that he will survey “our current understanding of the Great Depression”, there is only a brief, twisted reference to Irving Fisher’s Debt Deflation Theory of Great Depressions, and no discussion at all of Hyman Minsky’s contemporary Financial Instability Hypothesis (and a blogger informed me that his entire reference to Minsky in the book amounted to one discussion and one footnote, which I’ll get to later on).

While he does discuss Fisher’s theory, he provides only a parody of it–in which he nonetheless notes that Fisher’s policy advice was influential:

“Fisher envisioned a dynamic process in which falling asset and commodity prices created pressure on nominal debtors, forcing them into distress sales of assets, which in turn led to further price declines and financial difficulties. His diagnosis led him to urge President Roosevelt to subordinate exchange-rate considerations to the need for reflation, advice that (ultimately) FDR followed.

He then explains that neoclassical economists in general readily dismissed Fisher’s theory, for reasons that are very instructive:

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 macroeconomic effects. ” (Bernanke 1995, p. 17)

Bernanke himself does try to make sense of Fisher within a neoclassical framework, which I’ll get to below; but the general neoclassical reaction to Fisher that he describes is a perfect example of the old (and very apt!) joke that an economist is someone who, having heard that something works in practice, then ripostes “Ah! But does it work in theory?”.

It is also–I’m sorry, there’s just no other word for it–mind-numbingly stupid. A debt-deflation transfers income from debtors to creditors? From, um, people who default on their mortgages to the people who own the mortgage-backed securities, or the banks?

Well then, put your hands up, all those creditors who now feel substantially better off courtesy of our contemporary debt-deflation…

What??? No-one? But surely you can see that in theory…

The only way that I can make sense of this nonsense is that neoclassical economists assume that an increase in debt means a transfer of income from debtors to creditors (equal to the servicing cost of the debt), and that this has no effect on the economy apart from redistributing income from debtors to creditors. So rising debt is not a problem.

Similarly, a debt-deflation then means that current nominal incomes fall, relative to accumulated debt that remains constant. This increases the real value of interest payments on the debt, so that a debt-deflation also causes a transfer from debtors to creditors–though this time in real (inflation-adjusted) terms.

Do I have to spell out the problem here? Only to neoclassical economists, I expect: during a debt-deflation, debtors don’t pay the interest on the debt–they go bankrupt. So debtors lose their assets to the creditors, and the creditors get less–losing both their interest payments and large slabs of their principal, and getting no or drastically devalued assets in return. Nobody feels better off during a debt-deflation (apart from those who have accumulated lots of cash beforehand). Both debtors and creditors feel and are poorer, and the problem of non-payment of interest and non-repayment of principal often makes creditors comparatively worse off than debtors (just ask any of Bernie Madoff’s ex-clients).

Back to Bernanke’s take on Fisher, rather than the generic neoclassical idiocy on debt-deflation. Firstly, Bernanke’s “summary” of Fisher’s argument starts with asset price deflation: ”Fisher envisioned a dynamic process in which falling asset and commodity prices created pressure on nominal debtors…”.

Sorry Ben, but (to use a bit of crude Australian vernacular), this is an “arse about tit” reading of Fisher.  Fisher’s dynamic process began with excessive debt, not with falling asset prices. You have confused cause and effect in Fisher’s theory: excessive debt and the deleveraging process that engendered lead to falling asset and commodity prices as symptoms (which then amplify the initial problem of excessive debt in a positive feedback process). To make this concrete, Fisher referred to:

“two dominant factors, namely over-indebtedness to start with and deflation following soon after” (Fisher 1933, p. 341)

I hope that’s clear enough that, in Fisher’s argument, overindebtedness is the first factor and deflation the second–and in fact, Fisher argues that overindebtedness causes deflation, if the initial rate of inflation is low enough (he also countenances the situation in which inflation is higher and deflation doesn’t eventuate, which he argues won’t lead to a Depression). Before I discuss Bernanke’s own attempt to express what his misinterpretation of Fisher in neoclassical form, it’s worth setting Fisher’s own causal sequence out in full. In his Econometrica paper, Fisher argued that the process that leads to a Depression is the following:

“(1) Debt liquidation leads to distress selling and to

(2) Contraction of deposit currency, as bank loans are paid off, and to a slowing down of velocity of circulation. This contraction of deposits and of their velocity, precipitated by distress selling, causes

(3) A fall in the level of prices, in other words, a swelling of the dollar. Assuming, as above stated, that this fall of prices is not interfered with by reflation or otherwise, there must be

(4) A still greater fall in the net worths of business, precipitating bankruptcies and

(5) A like fall in profits, which in a “capitalistic,” that is, a private-profit society, leads the concerns which are running at a loss to make

(6) A reduction in output, in trade and in employment of labor. These losses, bankruptcies, and unemployment, lead to

(7) Pessimism and loss of confidence, which in turn lead to

(8) Hoarding and slowing down still more the velocity of circulation. The above eight changes cause

(9) Complicated disturbances in the rates of interest, in particular, a fall in the nominal, or money, rates and a rise in the real, or commodity, rates of interest.” (Econometrica, 1933, Volume 1, p. 342)

(Check this previous blog entry for more on this topic)

In its own way, this is a very simple process to both understand and to model. To understand it, all we have to do is look at the current economic situation in the USA–all nine stages of Fisher’s process are already well under way there. I’ve also modelled the debt component of this process in my papers on financial instability (and the deflation aspect too in other research I’ve yet to publish, but which will be in my forthcoming book for Edward Elgar, Finance and Economic Breakdown [expected publication date is 2011]).

So why didn’t Bernanke–and other neoclassical economists–understand Fisher’s explanation and develop it?

Because an essential aspect of Fisher’s reasoning was the need to abandon the fiction that a market economy is always in equilibrium.

The notion that a market economy is in equilibrium at all times is of course absurd: if it were true, prices, incomes–even the state of the weather–would always have to be “just right” at all times, and there would be no economic news at all, because the news would always be that “everything is still perfect”. Even neoclassical economists implicitly acknowledge this by the way they analyse the impact of tariffs for example, by showing to their students how, by increasing prices, tariffs drive the supply above the equilibrium level and drive the demand below it.

The reason neoclassical economists cling to the concept of equilibrium is that, for historical reasons, it has become a dominant belief within that school that one can only model the economy if it is assumed to be in equilibrium.

From the perspective of real sciences–and of course engineering–that is simply absurd. The economy is a dynamic system, and like all dynamic systems in the real world, it will be normally out of equilibrium. That is not a barrier to mathematically modelling such systems however–one simply has to use “differential equations” to do so. There are also many very sophisticated tools that have been developed to make this much easier today–largely systems engineering and control theory technology (such as Simulink, Vissim, etc.)–than it was centuries ago when differential equations were first developed.

Some neoclassicals are aware of this technology, but in my experience, it’s a tiny minority–and the majority of bog standard neoclassical economists aren’t even aware of differential equations (they understand differentiation, which is a more limited but foundational mathematical technique). They believe that if a process is in equilibrium over time, it can be modelled, but if it isn’t, it can’t. And even the “high priests” of economics, who should know better, stick with equilibrium modelling at almost all times.

Equilibrium has thus moved from being a technique used when economists knew no better and had no technology to handle out of equilibrium phenomena–back when Jevons, Walras and Marshall were developing what became neoclassical economics in the 19th century, and thought that comparative statics would be a transitional methodology prior to the development of truly dynamic analysis –into an “article of faith”. It is as if it is a denial of all that is good and fair about capitalism to argue that at any time, a market economy could be in disequilibrium without that being the fault of bungling governments or nasty trade unions and the like.

And so to this day, the pinnacle of neoclassical economic reasoning always involves “equilibrium”. Leading neoclassicals develop DSGE (“Dynamic Stochastic General Equilibrium”) models of the economy. I have no problem–far from it!–with models that are “Dynamic”, “Stochastic”, and “General”. Where I draw the line is “Equilibrium”. If their models were to be truly Dynamic, they should be “Disequilibrium” models–or models in which whether the system is in or out of equilibrium at any point in time is no hindrance to the modelling process.

Instead, with this fixation on equilibrium, they attempt to analyse all economic processes in a hypothetical free market economy as if it is always in equilibrium–and they do likewise to the Great Depression.

Before the Great Depression, Fisher made the same mistake. His most notable contribution (for want of a better word!) to economic theory was a model of financial markets as if they were always in equilibrium.

Fisher was in some senses a predecessor of Bernanke: though he was never on the Federal Reserve, he was America’s most renowned academic economist during the early 20th century. He ruined his reputation for aeons to come by also being a newspaper pundit and cheerleader for the Roaring Twenties stock market boom (and he ruined his fortune by putting his money where his mouth was and taking out huge margin loan positions on the back of the considerable wealth he earned from inventing the Rolodex).

Chastened and effectively bankrupted, he turned his mind to working out what on earth had gone wrong, and after about three years he came up with the best explanation of how Depressions occur (prior to Minsky’s brilliant blending of Marx, Keynes, Fisher and Schumpeter in hisFinancial Instability Hypothesis [here's another link to this paper]). 

Prior to this life-altering experience however, as a faithful neoclassical economist, Fisher portrayed the market for loans as essentially no different from any other market in neoclassical thought: it consisted of independent supply of and demand functions, and a price mechanism that set the rate of interest by equating these two functions–thus putting the market into a state of equilibrium.

However even with this abstraction, he had to admit that there were two differences between the “market for loanable funds” and a standard commodity market: firstly that the loanable fund market involves commitments over time, whereas in standard neoclassical mythology, commodity markets are barter markets where payment and delivery take place instantaneously; and secondly, it is undeniable that sometimes people don’t live up to those commitments over time–they go bankrupt.

Fisher dealt with these differences in the time-honoured neoclassical manner: he assumed them away. He imposed two conditions on his models:

“(A) The market must be cleared—and cleared with respect to every interval of time. (B) The debts must be paid.” ( Irving Fisher, 1930, The Theory of Interest. New York: Kelley & Millman p. 495)

Fisher did discuss some problems with these assumptions, but in keeping with the neoclassical delusion that one couldn’t model processes out of equilibrium, these problems didn’t lead to a revision of his model.

Of course, if Fisher had been a realist, he would have admitted to himself that a model that presumes the economy is always in equilibrium will be a misleading guide to the behaviour of the actual economy. But instead, as seems to happen to all devotees of neoclassical economics, he began to see his model as the real world–and used it to explain the Stock Market bubble of the 1920s as not due to “irrational exuberance”, but due to the wonderful workings of a market economy in equilibrium.

Since Wall Street was also assumed to be in equilibrium, stock prices were justified. And he defended the bubble as representing a real improvement in the living standards of Americans, because: 

“We are now applying science and invention to industry as we never applied it before. We are living in a new era, and it is of the utmost importance for every businessman and every banker to understand this new era and its implications… All the resources of modern scientific chemistry, metallurgy, electricity, are being utilized–for what? To make big incomes for the people of the United States in the future, to add to the dividends of corporations which are handling these new inventions, and necessarily, therefore, to raise the prices of stocks which represent shares in these new inventions.” (Fisher, October 23rd 1929, in a speech to a bankers’ association)

Have you heard that one before: a “new era”? If I had a dollar for every time I saw that twaddle used to justify companies with negative earnings having skyhigh valuations during the Internet Bubble…

Fisher even dismissed the 6% fall in the stock market that had occurred in the day before his speech as due to “a certain lunatic fringe in the stock market, and there always will be whenever there is any successful bear movement going on… they will put the stocks up above what they should be and, when frightened, … will immediately want to sell out.” 

The future, he told the assembled bankers, was rosy indeed:

Great prosperity at present and greater prosperity in view in the future … rather than speculation … explain the high stock markets, and when it is finally rid of the lunatic fringe, the stock market will never go back to 50 per cent of its present level… We shall not see very much further, if any, recession in the stock market, but rather … a resumption of the bull market, not as rapidly as it has been in the past, but still a bull rather than a bear movement.” (Fisher 1929)

Prior to this speech, he had made his fatefully wrong prediction on the future course of the Dow Jones in the New York Times. For the record, his statement was:

“Stock prices have reached what looks like a permanently high plateau. I do not feel that there will soon, if ever, be a fifty or sixty point break below present levels, such as Mr. Babson has predicted. I expect to see the stock market a good deal higher than it is today within a few months.”

Well, so much for all that. The stock market crash continued for three years, unemployment blew out from literally zero (as recorded by the National Bureau of Economic Research) to 25 percent, America’s GDP collapsed, prices fell… the Great Depression occurred.

At first, Fisher was completely flummoxed: he had no idea why it was happening, and blamed “speculators” for the fall (though not of course for the rise!) of the market, lack of confidence for its continuance, and so on… But experience ultimately proved a good if painful teacher, when he developed “the Debt-Deflation Theory of Great Depressions”.

An essential aspect of this new theory was the abandonment of the concept of equilibrium.

In his paper, he began by saying that:

We may tentatively assume that, ordinarily and within wide limits, all, or almost all, economic variables tend, in a general way, to ward a stable equilibrium. In our classroom expositions of supply and demand curves, we very properly assume that if the price, say, of sugar is above the point at which supply and demand are equal, it tends to fall; and if below, to rise.

However, in the real world:

New disturbances are, humanly speaking, sure to occur, so that, in actual fact, any variable is almost always above or below the ideal equilibrium.

Therefore in theory as well as in reality, disequilibrium must be the rule:

“Theoretically there may be—in fact, at most times there must be— over- or under-production, over- or under-consumption, over- or under spending, over- or under-saving, over- or under-investment, and over or under everything else. It is as absurd to assume that, for any long period of time, the variables in the economic organization, or any part of them, will “stay put,” in perfect equilibrium, as to assume that the Atlantic Ocean can ever be without a wave.” (Fisher 1933, p. 339; emphasis added)

He then considered a range of “usual suspects” for crises–the ones often put forward by so-called Marxists such as “over-production”, “under-consumption”, and the like, and that favourite for neoclassicals even today, of blaming “under-confidence” for the slump. Then he delivered his intellectual (and personal) coup de grâce:

I venture the opinion, subject to correction on submission of future evidence, that, in the great booms and depressions, each of the above-named factors has played a subordinate role as compared with two dominant factors, namely over-indebtedness to start with and deflation following soon after; also that where any of the other factors do become conspicuous, they are often merely effects or symptoms of these two. In short, the big bad actors are debt disturbances and price- level disturbances.

While quite ready to change my opinion, I have, at present, a strong conviction that these two economic maladies, the debt disease and the price-level disease (or dollar disease), are, in the great booms and depressions, more important causes than all others put together…

Thus over-investment and over-speculation are often important; but they would have far less serious results were they not conducted with borrowed money. That is, over-indebtedness may lend importance to over-investment or to over-speculation.

The same is true as to over-confidence. I fancy that over-confidence seldom does any great harm except when, as, and if, it beguiles its victims into debt. (Fisher 1933, pp. 340-341. Emphases added.)

From this point on, he elaborated his theory of the Great Depression which had as its essential starting points the propositions that debt was above its equilibrium level and that the rate of inflation was low. Starting from this position of disequilibrium, he described the 9 step chain reaction shown above.

Of course, if the economy had been in equilibrium to begin with, the chain reaction could never have started. By previously fooling himself into  believing that the economy was always in equilibrium, he, the most famous American economist of his day, completely failed to see the Great Depression coming.

How about Bernanke today? Well, as Mark Twain once said, history doesn’t repeat, but it sure does rhyme. Just four years ago, as a Governor of the Federal Reserve, Bernanke was an enthusiastic contributor to the “debate” within neoclassical economics that the global economy was experiening “The Great Moderation”, in which the trade cycle was a thing of the past–and he congratulated the Federal Reserve and academic economists in general for this success, which he attributed to better monetary policy:

“In the remainder of my remarks, I will provide some support for the “improved-monetary-policy” explanation for the Great Moderation.”

Good call Ben. We have now moved from “The Great Moderation!” to “The Great Depression?” as the debating topic du jour.

On that front, his analysis of what caused the Great Depression certainly doesn’t imbue confidence. This chapter (first published in 1995 in the neoclassical Journal of Money Credit and Banking [ February 1995, v. 27, iss. 1, pp. 1-28]–the same year my Minskian model of Great Depressions was published in the non-neoclassical Journal of Post Keynesian Economics [Vol. 17, No. 4, pp. 607-635]) considers several possible causes:

• A neoclassical, laboured re-working of Fisher’s debt-deflation hypothesis, to interpret it as a problem of “agency”–”Intuitively, if a borrower can contribute relatively little to his or her own project and hence must rely primarily on external finance, then the borrower’s incentives to take actions that are not in the lender’s interest may be relatively high; the result  is both deadweight losses (for example, inefficiently high risk-taking or low effort) and the necessity of costly information provision and monitoring)” (p. 17);
• Aggregate demand shocks from the return to the Gold Standard and its effect on world money supplies; and
• Aggregate supply shocks from the failure of nominal wages to fall–”The link between nominal wage adjustment and aggregate supply is straightforward: If nominal wages adjust imperfectly, then falling price levels raise real wages; employers respond by cutting their workforces” (p. 21).

None of these “causes” includes excessive private debt–the phenomenon that I hope now even Ben Bernanke can see was the cause of the Great Depression–and the reason why he and neoclassical economists like him are no longer discussing “The Great Moderation”.

Whle they were doing that, a minority of economists–myself included–were avidly developing both Fisher and Minsky’s theories of Great Depressions. We are known generally as “Post Keynesian” economists, and there Minsky is an intellectual hero.  And how did Ben handle Minsky? I have yet to read all of the Essays, but a blogger who has made the following comment:

In the entire volume (Bernanke, ‘Essays on Great Depression’, 2000, Princeton) there is a single refence to Minsky in Part Two, page 43 – “Hyman Minsky (1977) and Carles Kindleberger (1978) have … argued for the inherent instability of the financial system but in doing so have had to depart from the assumption of rational economic behaviour.” A footnote adds – “I do not deny the possible importance of irrationality in economic life; however it seems that the best research strategy is to push the rationality postulate as far as it will go.”

No need for any comment!!!!!!!

Indeed! Having not properly comprehended the best contemporary explanation of the Great Depression, and dismissed the best modern explanation because it didn’t make an assumption that neoclassical economists insist upon,  Bernanke is now trapped repeating history (incidentally, this comment by Bernanke also gives the lie to the “assumptions don’t matter, it’s only the results that count” nonsense that Friedman dished up as neoclassical economic methodology–neoclassical economists in fact care desperately about their assumptions and are willing to dismiss rival theories simply because they don’t make the same assumptions, regardless of how accurate they are). It is painfully obvious that the real cause of this current financial crisis was the excessive build-up of debt during preceding speculative manias dating back to the mid-1980s. The real danger now is that, on top of this debt mountain, we are starting to experience the slippery slope of falling prices.

In other words, the cause of our current financial crisis is debt combined with deflation–precisely the forces that Irving Fisher described as the causes of the Great Depression back in 1933.

The next stage of the model allows for repayment of loans, and re-circulation of these repayments. For this, another account is needed: a capital account that records the inactive reserves of the banking system–those reserves the banking system has available for lending. The two additional steps that are considered now are:

1. The firm pays money to the bank that is to be taken off its outstanding debt. This is a transfer of H from the firm’s deposit account to the bank’s capital account, and in recognition of receiving it, the bank is olbiged to reduce the recorded amount of outstanding debt by the same amount; and
2. The bank can now re-lend existing inactive reserves to firms. This is a transfer of money I from the bank’s capital account to the firm’s deposit account, and in recognition of having given it to the firm, the bank records that the firm’s debt has risen by the same amount.

Adding these new flows to the table generates the following system:

This is still an equilibrium system–though it operates at a lower level than the previous one where a single injection of credit money circulated indefinitely, because there is less money in active circulation. The next step–and the one that explains how money can expand endogenously–is to introduce the creation of new credit money. The mechanism is extremely simple. As Basil Moore, the pioneer of “endogenous money” theory, argued decades ago, major firms have “lines of credit” that enable them to increase their spending at will, in return for accepting a matching increase in their debt levels. In a growing economy, these “lines of credit” (and their domestic equivalent, the gap between aggregate credit card balances and aggregate limits) are growing all the time.

In this simple model, this simultaneous expansion of both debt and money is captured by the sum J being added to the firm’s deposit account, in return for the bank adding the same sum to the outstanding debt of the firm.

With this extension, we move out of the realm of equilibrium–so long as J is positive, the money supply and the economy will be expanding (we also comprehensively invalidate “Walras’ ‘Law’”, a cornerstone of neoclassical economics–but that’s a topic for a later post). Starting from the equilibrium values of the previous system, the bank balances and incomes in the system grow as indicated by the next two graphs.

All the models so far describe “well behaved” financial systems: the banks make their money out of the spread between loan and deposit rates of interest (other extensions cover non-bank lending, which is part of the explanation of why debt exceeds money; but that’s another topic in itself). Next we introduce a badly behaved financial intermediary: one that pretends to make more money than the others, but in reality makes none at all–a Ponzi Scheme.

This is enough for one post; to be continued in Ponzi Maths–Part 3.

I will also have to finish this in a later post–probably in the first couple of days of the New Year–because Sydney’s fireworks beckon, and we have to be on board the cruiser we’re watching them from at 7pm.  But what is here is part of a long-promised explanation of my model of money creation. In a couple of days I’ll publish the punch line, which is a newly developed model of a Ponzi Scheme.

To begin at the beginning: in the last year, I have developed a method of building dynamic models of financial processes using a table layout that is closely related to the accounting methodology of “double-entry book-keeping”. The table represents the flows in and out of bank accounts:

As I illustrate below, a dynamic model of a financial system can easily be derived from this basic schema, since each row represents a specific relationship between accounts, and the entries in a column represent all the action for that account. Simply add up the entries in each column, and you have a system (of differential equations) that represents the relevant model of the financial system.

I originally developed this as a means to communicate my dynamic modelling to other economists, since the vast majority of them have never studied differential equations–let alone systems dynamics. When I presented a model as a system of ODEs (“Ordinary Differential Equations”), they frequently failed to grasp the logic–and colleagues who are systems engineers, such as Trond Andresen or Mike Radzicki, found a similar response to their sophisticated flowchart models. Economists, even non-orthodox ones, simply aren’t accustomed to thinking dynamically, and normally lack any exposure to the sophisticated tools that engineers in particular use routinely today.

This applied in spades when I first presented my model of the endogenous creation of money to the bi-annual Post Keynesian Economics Conference in Kansas City in 2006. A room packed with about 100 conference participants broke out in a vigorous debate, with many criticising my analysis because “You must have made mistakes in your double-entry book-keeping.” 

I knew the model was accurate, so the thought occurred to me that, if so, it should be possible to present the model in double-entry book-keeping format. Sure enough, when I presented exactly the same model to the Society of Heterodox Economists conference later that year (with several people from the previous conference in attendance), the reaction was far better.

One person even commented that he was a bit disappointed because my presentation was less mathematical than usual! I then informed him that he’d actually seen a presentation involving a six-dimensional dynamic system.

Since then, I have found that this method was not merely a presentation tool, but also a very useful development tool for building dynamic systems. I’ve built models of non-bank lending, a credit crunch, etc., all of which will turn up in (non-neoclassical!) economics journals at some stage, and in my forthcoming books.

Since Bernie Madoff’s spectacular collapse, I’ve wanted to add an extension to model Ponzi finance, and at 11.30am Sydney time on December 30th, I’ve cracked the basic mathematics of a Ponzi Scheme. I can’t resist posting (part of!) this before the New Year, as a “Happy New Year” present to my loyal band of bloggers.

But first things first: the mathematics of an absolutely minimalist pure credit economy. In February I’ll explain why I believe that the endogenous expansion of credit money–and not the “money multiplier”–is the key driver still today in the growth of the financial system (and also why I differ from Austrians like Peter Schiff in my analysis of the economy, and how it might be reformed to avoid asset bubbles in future). For now, just take this on board as a thought experiment: IF there was no Central Bank, and no Government, how would money be created in a pure credit economy?

The answer, in a nutshell, is “by the banking system creating matching deposits when it issues loans”. In this model, loans by the banks create deposits, which then finance economic activity. Economic activity consists of firms that own factories hiring workers to work in them to produce goods for sale, using borrowed money to finance their wage payments (and their own consumption and inter-firm purchases as well), and banks making profits on the spread between loan and deposit rates of interest.

The basic mechanics of this system, which can function indefinitely at a constant level of production with a single loan injection, are shown in the following table, which has 4 accounts: a Firm Sector Loan, Firm Sector Deposit, Bank Sector Deposit (strictly the Banksector’s  profit and loss account), and Workers Deposit.

For now I’ll use a simple capital letter to indicate each flow–in every case this will be replaced by some appropriate product (for example, “A” below will be replaced by the interest rate on loans times the current outstanding loan balance for the firm sector).

The six processes in this model are:

1. Interest accrues on the outstanding loan at the rate +A;
2. The bank pays the firm interest on the balance in its deposit account by a transfer B from its deposit account to the firm’s deposit account;
3. The firm sector transfers the sum C from its deposit account to the bank’s deposit account to pay the interest on the outstanding debt. The bank is then obliged to record that the outstanding debt has been reduced by that amount–hence the -C entry in the Firm Loan account;
4. The firm hire workers to produce output–a flow D goes from the Firm’s Account to the Workers’;
5. The bank is obliged to pay interest to the workers on the balance in their accounts; the flow E goes from the bank’s deposit account to the workers;
6. Finally, the bank and the workers consume some of the output of the firm sector and pay for this with transfers from their accounts of F and G.

This simple system describes a self-sustaining economy which could function indefinitely at a constant level.  Simulating this system with equilibrium values yields a model in which bank accounts remain at a constant level and finance a constant level of income for all classes over time. The first graph below indicates the equilibrium values of bank accounts, and the second shows the equilibrium annual incomes that result (I don’t want to scare off non-mathematical readers with mathematical symbols right now, so anyone who wants to see what A to G are, please scroll to the bottom of this blog entry). 

Notice that incomes are substantially greater than the size of the initial loan. A lot of people who have attempted to build a monetary model have made the mistake of believing that the spending the loan can finance is identical to the amount of the loan itself. This ignores the fact that the loan finances a turnover of economic activity–in effect, it ignores what economists call the velocity of circulation. The interest bill is also effectively paid out of the “small change” from the profits capitalists make–whereas a lot of analysts have presumed that the interest couldn’t be paid at all. I’ll go into what was wrong with that perspective in more detail in the February Debtwatch Report; for now take it from me–and from the simulations–that paying interest on debt is a breeze for capitalists in a productive economy in which there is no unproductive debt.

The impact of unproductive debt–money borrowed simply to speculate on rising asset prices–is the focus of this post, but unfortunately time has got away from me and I have to get off the blog and on to the boat.

Thanks to all readers, and especially to the blog participants. Most people will finish 2008 in a state of absolute bewilderment. Members of the debtdeflation blog will only feel that way tonight if they overdo the alcohol consumption!

So here’s a toast to you all. Happy New Year, and I look forward to corresponding with you all in 2009.

Steve Keen 

Symbols

Parameter Values

These are just for illustrative purposes–they are not derived from any fit with empirical data–but they are reasonable values nonetheless for this toy monetary economy model.

On the money issue, this is one where I beg to differ both with the response Josh put forward, and most of my fellow economists as well–non-orthodox and non-orthodox. I think it’s wrong to say that money is destroyed when debt is repaid–but to explain why, I need to both put forward a dynamic model, and find an appropriate analogy.

Most people (and economists) seem to believe that debt and money are like matter and anti-matter: debt (anti-matter) is destroyed by adding money (matter) to it. That makes a debt account a negative money account–and therefore to reduce it, you have to destroy money. Since interest if charged on debt, and repaying debt destroys money, an increasing amount of money has to be created to maintain a constant amount of debt.

Not so. For a start, a debt account is not a repository for money (or anti-money), and you can’t pay anything in to it. It is a record of what you owe to the bank, which a bank is obliged to update whenever you make a payment intended to reduce your debt. But the money that you pay to the bank actually goes somewhere else–which I’ll get to in a moment.

If a capitalist has a debt to a bank, that obligates him/her to pay the bank interest; equally, if you have a credit deposit with a bank, that obligates the bank to pay you (a lower rate of) interest on that deposit. The spread between the two–high interest rate times debt minus low interest rate times deposit–is the source of the bank’s income. So the bank is quite at liberty to spend for its own needs out of the balance in the account. When it does spend, that money comes back into circulation.

Ditto for wages: workers won’t work without receiving wages. When they receive a wage, it is paid into their bank accounts, and they will spend out of these–which amounts to a transfer back to the capitalists accounts. The capitalists make their profit from the gap between their sales and their production costs (and the whole system is fuelled by the capacity of the production system to produce a physical surplus over the inputs–that’s the real ecological issue in all this of course).

So long as no debt is actually repaid, the amount of money in existence can continue circulating between these three classes of accounts ad infinitum–it is not destroyed, nor does any new money need to be created. The system could keep on going at the same level of production indefinitely, with no change in the quantity of money in circulation.

Now consider repayment of debt. When a capitalist makes a payment intended to reduce debt, the bank is obliged to record that the debt has been reduced by that amount–but what does it do with the money? As I emphasised above, it doesn’t “mix it with anti-money”, thus destroying both money and debt in the process: instead it records that the money has been given to it in order to reduce the recorded level of debt, adjusts the debt account accordingly, but now has money that it must also do something with.

It can’t put that money into the same account as interest payments go to, and then spend it: that’s seigniorage. Many critics of credit money think that’s what banks do–and certainly they’ve been instances of banks effectively doing that–but as a sustained practice, it will bring both the financial system and the bank itself to ruin. So as a matter of sound practice, and also as a matter of historical practice most of the time, that debt-repayment money goes into a separate account. Call it a principal (as opposed to income) or reserve account.

Is the money that has been paid into there destroyed? No–it’s been taken out of circulation, in that it can’t be directly used to purchase anything; but it hasn’t been destroyed.

The analogy I can think of here is a basketball game, with a reserve bench. The rules of the game specify that there can be no more than five players on court at any one time, and seven reserves. When one of the players goes off, he/she isn’t “destroyed” when sitting with the reserves: s/he just becomes “inactive”.

Ditto debt that has been repaid. It can’t be allowed to participate in “the game”, but it is sitting there “in reserve” and can re-enter if it follows the rules. The rules in basketball are one player off, one on; the rules in the game of monetary credit are that this money “in reserve” can’t be spent to buy commodities, but it can be re-lent. Once re-lent it’s back in circulation again–and a corresponding debt is created with it, because another “rule of the game” is that if you get credit money, you get an equivalent debt recorded against you.

The repayment of the loan thus reduces the amount of money in circulation–which is limited to the sums in deposit accounts–but it doesn’t destroy the money equivalent of the reduced loan. Thus outstanding loans will be equivalent to the sum of deposit accounts, but the sum of money in and out of circulation will be greater than the amount of debt.

I know that argument goes against both conventional and unconventional wisdom, and it’s something I only came to by developing a mathematical model of endogenous money creation–a basic paper on which I’ve attached to this email. However, it happens to accord with Keynes’s interpretation, which I discuss in the attached paper as well.

Please post this to the discussion list Chuck–and keep in touch!
Cheers, Steve