“Gentleman, you have come sixty days too late. The depression is over.” - Herbert Hoover, responding to a delegation requesting a public works program to help speed the recovery, June 1930

“The past may not repeat itself, but it sure does rhyme.”  Mark Twain

In the last six months, the phrase “Green Shoots of Recovery” has entered the economic lexicon. It appeared to some observers that the global recession was coming to an end, while Australia itself was likely to barely feel its impact.

I would be as pleased as anyone if these “green shoots” were true harbingers of a genuine end to the economic downturn–not because I would enjoy being wrong for the sake of it, but because my expectations for the future are so bad that I’d prefer to see them not come to pass.

Unfortunately, on current data I expect that “green” is a better description of the knowledge level of those making the optimistic predictions, than of the colour of any budding economic recovery.

Of course, it could be argued to the contrary that many of those making such optimistic forecasts are highly trained professional economists, and not merely market commentators who migh have a vested interest in putting a positive spin on the news.

This is true–but far from being a reason to trust these forecasts, it is yet another reason to be sceptical of them.

Almost every holder of a PhD in economics who works for a formal economic body like the Treasury, the RBA or the OECD has been deeply schooled in “neoclassical” economics, often without knowing that there is any other way of thinking about how the economy functions. They think they are simply “economists”, and anyone who objects to their analysis or models must be uneducated about economic theory.

In contrast, virtually all University Departments of Economics contain at least one economist who rejects neoclassical economics, and instead subscribes to a rival school–like Austrian, Marxian, Post Keynesian, or Evolutionary Economics.

These contrarian academic economists often disagree amongst themselves, sometimes vehemently–you couldn’t get two more opposed points of view than Austrian and Marxian economics, for example–but they tend to be united in regarding neoclassical economic theory as pompous drivel.

There are probably many reasons for this dichotomy between University economics departments which almost always have a handful of dissidents, and official economics bodies like the OECD and Treasury that are almost exclusively staffed by neoclassical economists. But I suspect the main reason is tenure: universities offer it, while formal economic advisory bodies don’t.

As a result, academic economists who “turn feral” and reject neoclassical economics can still teach and publish and hang on to their jobs, even if their neoclassical Department Heads wish they would go away. OECD and Treasury economists who do the same thing probably find their employment coming to an end–because they don’t have tenure.

So anything published by a formal economic body like the OECD will be the product of a neoclassical economic model–and therefore, in my opinion and that of a sizable minority of academic economists, drivel (there was one exception–the Bank of International Settlements while Bill White, a supporter of Hyman Minsky’s “Financial Instability Hypothesis“, was its its Economic Adviser).

Of course, disputes between academic economists don’t matter in the real world, and most newspapers report the announcements of bodies like the OECD as statements of wisdom about the future–until, that is, a crisis like the Global Financial Crisis makes a mockery of the OECD’s neoclassical fantasies.

And what a mockery. This was the OECD’s forecast for the world economy in June 2007:

EDITORIAL: ACHIEVING FURTHER REBALANCING

“In its Economic Outlook last Autumn, the OECD took the view that the US slowdown was not heralding a period of worldwide economic weakness, unlike, for instance, in 2001. Rather, a “ smooth”  rebalancing was to be expected, with Europe taking over the baton from the United States in driving OECD growth.”

“Recent developments have broadly confirmed this prognosis. Indeed, the current economic situation is in many ways better than what we have experienced in years. Against that background, we have stuck to the rebalancing scenario. Our central forecast remains indeed quite benign: a soft landing in the United States, a strong and sustained recovery in Europe, a solid trajectory in Japan and buoyant activity in China and India. In line with recent trends, sustained growth in OECD economies would be underpinned by strong job creation and falling unemployment.” (OECD Economic Outlook, Volume 2007/1, No. 81, June 2007, p. 7)

Yeah, right. Instead the global economy was already well into the greatest economic crisis of the last 60 years. The next two years tore the OECD’s 2007 forecasts to shreds.

One might hope for some soul searching as a result of this–and hopefully some is occurring behind closed doors. But in a clear sign that the OECD hopes to see “Business as usual” restored in its modelling approach as well as the actual economy, its current Economic Outlook discusses the process of recovery from an economic crisis that it completely failed to foresee:

EDITORIAL: NEARING THE BOTTOM?

“OECD activity now looks to be approaching its nadir, following the deepest decline in post-war history. The ensuing recovery is likely to be both weak and fragile for some time. And the negative economic and social consequences of the crisis will be long-lasting. Yet, it could have been worse. Thanks to a strong economic policy effort an even darker scenario seems to have been avoided. But this is no reason for complacency; the need for determined policy action remains across a wide field of policies…”

“In summary, it looks as if the worst scenario has been avoided and that OECD economies are now nearing the bottom. Even if the subsequent recovery may be slow such an outcome is a major achievement of economic policy. But this is no time to relax — ensuring that the recovery stays on track and leads towards a long-term sustainable growth path will call for major policy efforts going forward.” (OECD Economic Outlook, Volume 2007/1, No. 81, June 2009, pp. 5 & 7)

With its utter failure to see this crisis coming, why does anyone still take the OECD seriously? Probably for the same reason that people still generally obeyed the Captain of the Titanic after it had struck the iceberg: authority counts for a lot in a crisis, even if the person in authority actually caused it.

But it’s also because it takes repeated failures before someone who asserts authority is rejected–one failure alone won’t do. So rather like Napoleon in exile in Elba, the OECD is still taken seriously by economic commentators–as with Peter Martin’s report (“Australia’s downturn to be shorter than expected“, The Age June 25th 2009):

“AUSTRALIA is set to soar out of its economic downturn sooner and more sharply than forecast in the budget, according to forecasts from the Organisation for Economic Co-operation and Development understood to have the backing of the Australian Treasury.

The OECD says the local economy should shrink 0.3 per cent this year, less than any other OECD economy and far less than the contraction of 1 per cent that underlies the forecasts in the May budget.

Next year the economy should roar back 2.4 per cent, also above budget forecasts and more than any other OECD economy apart from those recovering from collapse in 2009.

The Treasurer, Wayne Swan, greeted the forecasts released overnight in Paris as evidence Australia was “outperforming every other advanced economy in the face of the recession”.

The forecasts show Australia’s unemployment rate reaching 7.9 per cent late next year rather than the 8.25 to 8.5 per cent range assumed in the budget.”

A little scepticism in this report would have been appreciated, given the OECD’s track record–and if a political journalist had written the report, that might well have occurred. But it was written by an economics correspondent, and most of them have–like the OECD’s economists–been schooled only in neoclassical economics, and don’t know how flimsy the theory itself is (there are exceptions here, like Brian Tookey whose book Tumbling Dice is an excellent critique of neoclassical economics). So we get a report like this trumpeting good times and green shoots, with no irony (Peter Martin was far from the only one to present the OECD’s views without any scepticism–see also “Earth-destroying bomb defused – just” by Michael Pascoe or Glenn Dyer at Crikey “That’ s no green shoot, that’ s Australia in full bloom: OECD“).

Clearly it will take a few more predictive and policy failures before economic journalists realise that with the global financial crisis, neoclassical economics–and hence the OECD–is facing its intellectual Waterloo.

To be fair, official economic bodies and their uncritical fans were not the only source of “green shoot” euphoria. A large part of this feeling that the worst was over also came from the global experience of a recovery in stock markets from their recent lows.

The Dow has indeed had an impressive rally, from the low of 6547 on March 9 to the peak of 8799 on June 12–a rise of 34% in under a quarter of a year. This has led to many of the usual suspects proclaiming that the bear market is over, and a new rally is underway. Comparisons with 1929 are, of course, unjustified…

On closer inspection, reports of the death of the bear market are somewhat exaggerated.

Firstly, though the index has rallied by 34% from its low, it is still down 40% from the all time peak of October 2007.

Secondly, rallies like this came and went ad nauseam in the early 1930s, until the market hit rock bottom at 41.22 points on July 8th 1932–89% below the September 3rd 1929 peak of 381.17.

The biggest such rally occurred very soon after The Crash in 1929, starting on November 13th 1929 when the market was down 48% from its September peak. It then rose almost 50% from its low in under 6 months–and it was this recovery that inspired Hoover’s Oval Office gaffe.

But the market had only recovered half of what it had lost when the rally ran out of steam–a 50% fall followed by a 50% recovery still leaves you 25% below where you started from–and the inexorable slide of the Great Depression dragged the market down with it.

This current rally took a lot longer to start than its 1929 cousin, though it began from a comparable bottom (55% below the peak versus 48% below it in 1929), and it still has to go on for much longer and drive the market much higher to match its antecedent–let alone to proclaim the 2007 Bear Market is over (note also that Eichengreen and O’Rourke, using global data, argue that the current decline is far worse than in the Great Depression, with global markets down 50% on average 12 months after the crisis versus just 10% down after 1929–see Figure 2 here).

Meanwhile, in the Real World…

Though the stock market was providing some good cheer in the USA (at least until last week), the real economy continued to disappoint. To get an idea of just how bad the downturn has been, and how little inkling of it that conventional economists had, consider the Economic Report of the President, prepared by the US President’s Council of Economic Advisers, in 2008 and 2009.

The 2008 Report made the following forecasts–note in particular the “forecast” that unemployment would be below 5 percent between 2008 and 2013.

The 2009 Report, submitted to Congress and the incoming President in January of this year, made a mockery of the 2008 Report but still drastically underestimated the severity of the downturn: it forecast that unemployment would peak at 7.7% in 2009, growth would remain positive for the next five years.

Despite the frequency with which numerous economists who failed to anticipate the Global Financial Crisis continue to report sightings of “green shoots of recovery”, the actual economic data continued to be grimmer than even their most pessimistic revised forecasts.

The clearest evidence here is that the Federal Reserve’s “stress tests” for its Supervisory Capital Assessment Program assumed that even under an adverse scenario, unemployment would be below 9 percent by mid-2009. It is currently 9.4 percent. The tapering process that is built into neoclassical economic forecasts  is not evident in the data to date.

Deleveraging and Economic Breakdown

The reason that most economists continue to underestimate this downturn is because (a) the downturn is being driven by deleveraging from literally unprecedented levels of private debt, and (b) the neoclassical theory of economics, which dominates academic and market economics alike, ignores the role of private debt in the economy.

The reason that I anticipated this crisis four years ago is that I reject the mainstream “neoclassical” approach to economics, and instead analyse the economy from the perspective of Hyman Minsky’s “Financial Instability Hypothesis”, in which private debt plays a crucial role. In our credit-driven economy, demand is the sum of GDP plus the change in debt. If debt is low relative to GDP, then its contribution to demand is relatively unimportant; but if debt becomes large relative to demand, then changes in debt can become THE determinant of aggregate demand, and hence of unemployment.

That is manifestly the case in America today. Under the stewardship of neoclassical economics in the personas of Alan Greenspan and Ben Bernanke, the growth in private debt has not merely been ignored but has actively been encouraged, in the dangerously naive belief that the private sector is being “rational” when it borrows.

This apparent indictment of the private sector as therefore “irrational” is in fact really an indictment of neoclassical economics for abuse of language. What neoclassical theory means by the word “rational” is “able to correctly anticipate the future”–which is the definition, not of rationality, but of prophecy.

There is nothing “irrational” about being unable to predict the future–it is fundamentally uncertain, while modern economic theory hides from this reality just as Keynes’s contemporary economic rivals did in the 1930s when he wrote that:

“I accuse the classical economic theory of being itself one of these pretty, polite techniques which tries to deal with the present by abstracting from the fact that we know very little about the future.” (Keynes, “The General Theory of Employment”, Quarterly Journal of Economics 1937)

Instead, in the uncertain world in which we live, the private sector necessarily speculates about the future–and some of those speculations will be wrong. The role of regulation and government economic policy should be to confine those speculations, as much as is possible, to productive pursuits rather than gambles about the future path of asset prices–a pasttime that has always in the past led to Ponzi asset bubbles.

This time, with government policy driven by neoclassical economics and its deluded attitudes towards the future, policy has actually encouraged  the private sector to borrow to indulge in two giant Ponzi Schemes–the stock market and (belatedly) the housing market. It has gambled with borrowed money that share and house prices would always rise faster than consumer prices.

That gamble worked for some decades, but it then failed–in 1987-89. Had the Greenspan Fed not intervened then to “rescue” Wall Street, there is every possibility that the US would have experienced a mild Depression then–mild because the level of debt was lower then that at the time of the Great Depression (165% in 1989 versus 175% in 1929), and crucially because the rate of inflation then was high (5% in 1989 versus 0.5% in 1929).

The lower level of debt would have meant that less deleveraging would have been required to return to a predominantly income-financed economy in 1989 than was required in the 1930s, while high inflation would have meant a lower likelihood of deflation during the Depression itself, and possibly that inflation alone could have eroded the debt burden. It still would not have been pretty–certainly it would have been worse than the 1983 recession, when unemployment as it is currently defined peaked at 10.8 percent.

But what we face now will be far worse, because deleveraging from the now unprecedented debt level of almost 300% of GDP will drive America into a Depression that could easily be deeper than that of the 1930s.

This is already becoming apparent in the data, as economic historians Barry Eichengreen and Kevin O’ Rourke point out in “A Tale of Two Depressions“:

“To sum up, globally we are tracking or doing even worse than the Great Depression, whether the metric is industrial production, exports or equity valuations. Focusing on the US causes one to minimise this alarming fact. The “ Great Recession”  label may turn out to be too optimistic. This is a Depression-sized event.”

The comparison of unemployment rates (which Eichengreen and O’ Rourke didn’t make) bear this out: using the current OECD definition of unemployment, this downturn is well ahead of the 1979 recession even though unemployment started from a lower level; and using the much broader U-6 definition, which is more strictly comparable to the NBER definition used during the Great Depression, unemployment now is as bad as at the same stage of the Great Depression, and increasing as rapidly.

Deleveraging is already extreme: the most recent flow of funds data shows that private debt is falling rapidly and therefore subtracting from aggregate demand rather than adding to it. As noted in earlier Debtwatch Reports, in the modern debt-dependent economy, changes in the demand financed by changes in private debt are strongly negatively correlated with the unemployment: when debt’s contribution to demand falls, unemployment rises.

The turnaround in debt growth in the USA is unprecedented in the post-WWII period. Even during the 1980s and 1990s recessions, debt continued to grow both in nominal terms and as a percentage of GDP. Now debt is falling at arate of almost US$2 Trillion a year (which equates to 14 percent of GDP).

This is why the crisis exists, is so much worse than the official economic forecasters expected, and will continue and be much deeper than they currently believe: the crisis is being driven by deleveraging, and neoclassical economists do not even include private debt in their models.

As noted in earlier Debtwatch Reports, there is a very strong link between the rate of growth of debt and unemployment: when debt grows more quickly, unemployment falls; when debt grows slowly or falls, unemployment rises.

This is not because debt is a good thing, but because our economies have become so debt-dependent that changes in debt now have a far stronger influence on economic activity than do changes in GDP.

The US Government is attempting to “pump-prime” its way out of trouble by public-debt-financed deficit spending, which raises 4 further issues:

1. this so-called Keynesian remedy can work when private debt levels are relatively low, and government policy to attenuate private speculation is strictly adhered to (see my 1995 paper Finance and Economic Breakdown);
2. however, in our rampantly speculative economies, this policy has only worked when it has re-started the private debt binge, resulting in rising debt levels over time;
3. this can’t happen this time around, because all sectors of the private economy–businesses both real and financial, and households–are already debt-saturated. There is no “greenfields” group to lend to, as was possible in 1990 when household debt was a “mere” 60% of GDP, and the derivatives market in finance had yet to explode; and finally
4. the scale of the private debt bubble is just too big to be countered by substituting public debt for private debt.

This last point is evident in the data. Even though the US government has thrown the proverbial kitchen sink at government spending, the increase in public debt (which adds to aggregate demand) is more than counteracted by private sector deleveraging (which subtracts from aggregate demand):

Total US Debt is therefore falling. Though in the long run this is a good thing–we must return to a non-debt-dependent economy and once we have gotten there, stay there–the transition will be as pleasant as Cold Turkey is for a heroin addict.

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.

Madoff’s firm was famous for returning constant positive results, even on a month by month basis, for decades. As Henry Blodget on Yahoo’s Tech Ticker reports below, many Wall Street professionals were incredulous of these results, but invested in his firm anyway–because they thought his returns must be coming from him exploiting his “market maker” role on the Nasdaq to do insider trading.

This in itself is a delicious commentary on the oxymoron of self-regulating financial markets. Insider trading is illegal, but many bigwigs on the Street were quite willing to risk their money with someone whom they thought could only be making that much money if he were breaking the law.

In fact, he was breaking the law, but not that way: rather than making profits from insider trading and then funnelling part of the proceeds to those who gave him the funds with which to do it, he was simply taking in principal from “investors” and paying it back to them as interest.

This is what qualifies his (alleged) activities as Ponzi Scheme, named after Charles Ponzi,* whose dream of a means to get rich quick by arbitrage on International Reply Coupons (IRC) turned into a giant financial fraud.

* Incidentally, while I link to the Wikipedia entry on Ponzi and his scheme, it’s somewhat inaccurate on Ponzi’s early history, and also leaves out important attenuating facts about him. By far the best reference is the brilliantly researched and beautifully written Ponzi’s Scheme: The True Story of a Financial Legend by Mitchell Zuckoff. Read it and you will learn that, in addition to turning into a somewhat inadvertent but large scale swindler, Ponzi also literally gave the skin off his own back–and on two separate occasions–to save the life of a nurse who had suffered horrific burns. I can’t see many of those accused of running a Ponzi Scheme these days giving anyone the shirt off their backs, let alone their own skin.

Ponzi believed he had stumbled on a path to riches when he received an IRC in the mail and then found that it was mispriced around the world. IRCs were designed to facilitate communication. Person A in country X could write to person B in country Y, and enclose an IRC that person B could then exchange for a postage stamp for the reply.

Great idea, except that the prices were set before the First World War, and not adjusted after it. For argument’s sake, let’s say the price for an IRC was 1 dollar in the USA and 1 lira in Italy, and the exchange rate in 1910 was 1 dollar for 1 lira.

Then along comes WWI and currencies go haywire–say now that a lira is only worth ten cents. But it still buys one IRC in Italy, which if shipped to the USA will then be exchangeable for a $1 stamp.

Ponzi thought that he could:

1. Raise dollars in the USA
2. Ship them to Italy
3. Exchange them for Italian Lira–$1 buying 10 lira (let’s say)
4. Buy 10 IRCs with the 10 Lira
5. Ship the IRCs back to America
6. Sell them to people who were going to buy them at the Post Office for (say) half price
7. Make a fortune…

Great idea, except that the great financial journalist Clarence Barron calculated that, to support the scale of investments in Ponzi’s Scheme towards its end, there would need to be 160 million IRCs in circulation; but there were in reality only 27 thousand to be had.

An awareness that this might be the case was probably why Ponzi couldn’t convince the big end of town to invest–remember the old adage “If it sounds too good to be true, it probably is”? (something the “investors” in Madoff’s firm obviously forgot). So he set up a shop front, promising retail investors a 50 percent return on their money in 45 days.

Some people who didn’t know the adage took a punt, and within days Ponzi had his first funds–well before he worked out the mechanics of his arbitrage scheme. When 45 days elapsed and the first “investor” turned up expecting his $50 return on a $100 investment, Ponzi gave him money the only way he could–by handing over some of the money initially deposited by those early investors.

“Wow! Ponzi makes good on his promise: invest $100, and seven weeks later earn $50. Why if I left that $100 with him–or better still, left that AND added the $50 he’s just given me (minus say $25 for a good night out in celebration), then in another seven weeks I’ll have $187.50. And if I re-invest that…”

So went the word, as successful investors in Ponzi’s Scheme bragged to their friends about how much money the nice Mr Ponzi had made them.  Ponzi never got the mechanics of the IRC arbitrage scheme worked out–and he continued to dream up schemes that, if they succeeded, would mean his apparent dividends were actually legitimately earned–and stuck with the practice of paying out principal deposited by later investors as interest to earlier ones.

Ultimately, he took in something close to US$15 million from about 40,000 people. Some of them who got out early walked away a lot wealthier, but at the end of the scheme, those still in it could only recoup $5 million–the other $10 million had gone to the early escapees, and to fund Ponzi’s temporarily luxurious lifestyle and minimal operating costs.

On some scales, Madoff’s is a more modest scheme than Ponzi’s–rather than promising 50% every 45 days (which works out at an annual rate of return of 2,680%), Madoff returned investors roughly 1% a month. As a result, the Big End of Town could persuade itself that the returns were initially the result of a successful investment strategy–and then later as the sheer volume grew, that they were the result of insider trading.

So Madoff attracted really wealthy investors: it appears that his firm “managed” over US$17 billion for less than 100 investors–though Madoff himself allegedly estimated his total losses at US$50 billion. And the scheme ran for almost half a century–far longer than Ponzi’s brief time in the financial sun (less than a year).

So is this the World’s Biggest Ponzi Scheme, as some headlines are trumpeting?

It’s certainly the biggest of what I call Type I Ponzi Schemes: direct, undisguised schemes in which principal is paid out as interest. But the biggest Ponzi Schemes by far are what I call Type II: here, instead of a direct “principal in, interest out” pump, we have “borrow money, buy assets with it, drive up the asset price, sell the assets, pay off the debt plus interest, and keep part of the asset price appreciation as profit”.

That, of course, describes margin lending on the stock market, and above all, leveraged speculation on house prices. It works a treat while asset prices continue to rise, but a fundamental precondition for this is that the level of debt has to rise even faster–since interest on the debt compounds it, and no real money is being made (by doing boring stuff like producing widgets and flogging them for a profit–the legitimate equivalent to Ponzi’s never-practised arbitrage scheme).

It falls over when the next entrant into the scheme looks at the level of debt required to enter, compares it to his/her income, says to self “there’s no way I could ever repay this out of my income” and decides not to play.

In reality, the world’s financial system has become one giant Type II Ponzi Scheme, and we are now reaping the whirlwind of that fiasco. While some made a fortune by getting out early, others are locked into the downward spiral as asset prices  plummet for lack of buyers, excessive debt, and distressed selling to meet interest payments, and margin calls.

Madoff’s (alleged) Ponzi Scheme may be the most dramatic Ponzi Scheme, but in reality we’ve all been for a ride in Ponzi’s Magical Mystery Machine.

Part of the appeal of it all is the sheer fun of the boom. As Ponzi himself put it when interviewed on his deathbed in a Brazilian hospital for the destitute:

“Even if they never got anything for it, it was cheap at that price. Without malice aforethought I had given them the best show that was ever staged in their territory since the landing of the Pilgrims! It was easily worth fifteen million bucks to watch me put the thing over.”

Below are some early reports on Madoff’s Scheme. I’ll continue adding to them as they come in–though at some stage there will doubtless be a flood that I can’t keep pace with.

December 12: Yahoo Finance Tech Ticker: “I Knew Bernie Madoff Was Cheating; That’s Why I Invested with Him“. “So why did these smart and skeptical investors keep investing? They, like many Madoff investors, assumed Madoff was somehow illegally trading on information from his market-making business for their benefit. They didn’t consider the possibility that he was clean on that score but running a good old-fashioned Ponzi scheme.”

December 12: More on Madoff and the world’s biggest explicit Ponzi Scheme (in reality both the stock market and housing market bubbles were also Ponzi Schemes) The World’s Biggest Ever Heist. “Right now, there are a handful people whose world has suddenly been turned upside-down: who have, overnight, suddenly lost billions of dollars of dynastic wealth to a Wall Street con man. I’m sure that their names will appear sooner or later. But there really is no precedent that I can think of: when has one man ever managed to steal $50 billion dollars? If the $100 million Harry Winston heist in Paris was the “steal of the century”, what’s this?.”

December 11: Henry Blodget on Clusterstock: Bernie Madoff: The Indictment. “The criminal indictment of Bernie Madoff is embedded below. The good stuff starts at the bottom of page 2, when the FBI agent begins talking about his interview with two of Bernie’s senior employees. According to the WSJ, these two employees are Bernie’s sons. Also don’t miss the last paragraph, where the agent interviews Bernie himself.”

December 11th: Prominent Trader Accused of Defrauding Clients, NY Times. “On Wall Street, his name is legendary. With money he had made as a lifeguard on the beaches of Long Island, he built a trading powerhouse that had prospered for more than four decades. At age 70, he had become an influential spokesman for the traders who are the hidden gears of the marketplace. But on Thursday morning, this consummate trader, Bernard L. Madoff, was arrested at his Manhattan home by federal agents who accused him of running a multibillion-dollar fraud scheme — perhaps the largest in Wall Street’s history…”

“Mr. Madoff invited the two executives to his Manhattan apartment that evening. When they joined him there, he told them that his money-management business was “all just one big lie” and “basically, a giant Ponzi scheme.”

“The senior employees understood him to be saying that he had for years been paying returns to certain investors out of the cash received from other investors.”

Check the Madoff Client Database to see Madoff’s identified victims, complete with a map of there locations. Amazing!

What’s Really Going On? or…

Why Did I See it Coming and “They” Didn’t?

Part 2: The Models

“But this long run is a misleading guide to current affairs. In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean is flat again.” (Keynes, A Tract on Monetary Reform, 1924)

In last month’s Debtwatch, I explained why the data side of why the “Financial Instability Hypothesis” enabled me to predict this crisis, long before conventional “neoclassical” economists had any idea it was approaching.

This month I explain why the models neoclassical economists build are hopelessly inadequate–as models of the economy in general, as guides to what is likely to happen in the future, and as sources of policy recommendations to end this crisis.

In particular, the Australian Treasury’s prediction that Australia will avoid recession simply cannot be trusted.

Neoclassical Models: Crisis? What Crisis?

The focus of neoclassical economists on misleading indicators is compounded by the models they build, which–as well as omitting crucial data like the debt to GDP ratio–are congenitally incapable of identifying serious turning points in the economy.

This are several reasons for this, but first and foremost is their belief that the economy is fundamentally stable, and will always return to a long-run equilibrium growth path after any shock. The models they construct have this expectation of a return to long-term growth paths after any short term divergence from trend “hard wired” into their results.

An instance of this for the Australian Treasury’s macroeconomic model (TRYM) is shown in Figure One, which shows the impact on business investment in the model of a simulated monetary shock in 2010. The shock initially pushes business investment above the long term trend, to which it then returns after eight years.

This is not a prediction by the model as such, but a product of its structure, which assumes that the economy will always return to a supply-side driven equilibrium in a relatively short time frame.

Figure One

TRYM’s supply-side behaviour is determined simply by the assumption that, in the long run, the economy will return to an equilibrium rate of growth, given by the sum of assumed trends in population growth and labour productivity, at an assumed equilibrium rate of unemployment called “NAIRU” (“Non-Accelerating Inflation Rate of Unemployment”). As the Treasury’s documentation of TRYM puts it (see http://www.treasury.gov.au/contentitem.asp?NavId=016&ContentID=235):

“The model could be described as broadly new Keynesian in its dynamic structure but with an equilibrating long run.  Activity is demand determined in the short run but supply determined in the long run… The model will eventually return to a supply determined equilibrium growth path in the absence of demand or other shocks.” (THE MACROECONOMICS OF THE TRYM MODEL OF THE AUSTRALIAN ECONOMY, p. 6; emphasis added)

and

“the aggregate supply curve is vertical in the long term at a level of employment and production consistent with the NAIRU. (Or more precisely the economy grows along a steady state growth path consistent with the NAIRU.)” [AN INTRODUCTION TO THE TRYM MODEL APPLICATIONS AND LIMITATIONS p. 6]

Neoclassical models like TRYM are thus variable in the present–and have some capacity to predict the very short term, if their guesses about the size of any shock are reasonably accurate. But they are anchored to some point in the (not too distant) future when it is assumed that “equilibrium” will once again apply, and they are therefore useless as guides in the medium term.

They are also useless for long term prediction because the model’s long run equilibrium is unaffected by the short term disturbance: if the figure assumed for the NAIRU in the model remains unchanged, along with the estimates for population and productivity growth, then the model will average the rate of growth those assumptions imply, regardless of how severe a shock the short-term disturbance causes.

In the case of the RBA’s main model, this is a real growth rate of 3.25 percent per annum (see Tables 7 & 8 of RDP2005-11)–so the economy is assumed to converge to a tranquil future path after any disturbance, with no residue from the shock itself (apart from a change in the price level for permanent increases in the money supply).

Ironically, this means that models like TRYM produce medium term predictions of an acceleration in growth after the impact of a shock like this financial crisis–otherwise the model could not get back to its “long run equilibrium growth path”.

There was thus no prospect that Neoclassical models could predict the crisis, and their guidance on what will happen–with or without policy intervention–are irrelevant.  Unlike these models, the actual economy does not have a point of balance in the future to which it is tethered. It is therefore no wonder that these models gave no warning of the impending crisis–indeed the wonder would be if they had done so!

This is why supposedly authoritative bodies like the OECD could claim “our central forecast remains indeed quite benign” just two months before all hell broke loose (as noted in my last Debtwatch). If economic data have been apparently tranquil, these models will predict tranquility ahead; if the data have been depressed, they will predict a bit of a downturn, followed by a return to equilibrium some years hence.

Neither prediction is worth a pinch of salt.

To have any hope of predicting the future using an economic model, it has to be one with genuine dynamics–not a model that simply assumes that “when the storm is long past the ocean is flat again”, as Keynes satirically remarked. Such a model has to specify what it sees as the main causal factors in the economy, and then let those factors interact. The medium and long term outcomes are thus a product of the interaction of the causal variables in the model, just as the short term is.

Models of this nature are commonplace outside economics, and scientists, mathematicians and engineers have designed an impressive range and variety of computer simulation programs to support this genuinely dynamic approach to modelling.

I developed such a model of Minsky’s Financial Instability Hypothesis in the early 1990s.

A Minsky Model: Finance and Economic Breakdown

The basic principles in Minsky’s financial instability hypothesis are extremely simple. A capitalist economy is necessarly cyclical. During a boom, investors will take on debt to finance investment, but because the economy is cyclical, they will later find themselves in a recession when they have to repay that debt.

Therefore their repayments don’t quite cancel all the extra debt, and debt levels tend to ratchet up over time. These debt cycles with an overall secular trend towards increasing debt can lead to an ultimate crisis where the debt overwhelms the economy–a Depression.

This is not an inevitable outcome of Minsky’s theory, but he emphasises that since market economies have experienced Depressions in the past, to be valid a model of the economy must…

“ make great depressions one of the possible states in which our type of capitalisteconomy can find itself”  (Minsky, 1982, Inflation, Recession and Economic Policy, p. xi)

In the model I developed in 1993, under some circumstances, the economy could taper to equilibrium; but under others, a series of debt-driven financial cycles would lead to an eventual crisis where debt overwhelmed the economy. The following graphics set out the model in flowchart format. It can also be summarised in three very simple propositions:

1. Firms borrow to invest during booms;
2. Workers’ capacity to secure wages rises is affected by the rate of employment; and
3. Banks lend money to finance investment;

and four very simple “stylised facts”:

1. Wages share of output will rise if wage rises exceed productivity;
2. The employment rate will rise if the rate of growth exceeds the sum of population  and productivity growth;
3. The debt to GDP ratio will rise if investment exceeds profits; and
4. an increased rate of economic growth will reduce the debt to GDP ratio.

As a flowchart, the model is as shown in Figure Two (the blue boxes contain mathematical sub-systems).

The simulation below and in Figure Three are with no debt in the model–in which case the model generates simple cyclical growth.

Figure Two

Figure Three explodes the “Graph” subsystem of the model. The same set of graphs is used in subsequent Figures to display the behaviour of the more complete models, where debt and Ponzi investing are added.

Figure Three

When the debt switch” is flicked to include borrowing to finance productive investment only–so all borrowed money leads to an increase in the capacity to produce output–then one of two situations will apply.

Figure Four shows the first such situation: when the model begins close to its equilibrium values, it continues to converge towards it. Employment and income distribution (proxied here by the wages share of output) taper to equilibrium values, as does the debt to output ratio (which is negative, implying positive net financial assets for firms).

Figure Four

However, if the system starts further away from equilibrium, then the system’s behaviour is rather like that described by Fisher in his Debt Deflation Theory of Great Depressions:

“There may be equilibrium which, though stable, is so delicately poised that, after departure from it beyond certain limits, instability ensues, just as, at first, a stick may bend under strain, ready all the time to bend back, until a certain point is reached, when it breaks.

This simile probably applies when a debtor gets “ broke,” or when the breaking of many debtors constitutes a “ crash,”  after which there is no coming back to the original equilibrium.

To take another simile, such a disaster is somewhat like the “ capsizing”  of a ship which, under ordinary conditions, is always near stable equilibrium but which, after being tipped beyond a certain angle, has no longer this tendency to return to equilibrium, but, instead, a tendency to depart further from it.” (Fisher, 1933)

With this far from equilibrium starting point, the system goes through a series of cycles in which the debt to output ratio ratchets up, as Minsky surmised, until such time that the next boom leads to such an accumulation of debt that it cannot be repaid–debt service consumes all available revenues–and the economy falls into a permanent slump.

Figure Five

I have commented frequently that economists are prisoners of their models–rather than seeing the economy, they see their model of it. Though I differ from the neoclassical mainstream in the type of model I see, on this front I was not very different. I therefore expected to find a pattern like that shown for the debt to output ratio in Figure Five in the Australian data, when I prepared an expert witness case for the NSW Legal Aid in December 2005: a gradual hump-like increase in debt to output ratios.

Instead what I saw was the pattern shown in Figure Six.

Figure Six

That was an almost purely exponential increase in the debt to GDP ratio over time–disturbed only by the growth and bursting of two obvious super-bubbles (one in the early 1970s that was associated with the demise of the Whitlam government, and the other that drove Keating’s “recession we had to have” in the early 1990s).

It was obvious that a key aspect of Minsky’s theory that my model omitted had to be introduced: Ponzi investing, in which individuals take out debt to speculate on asset prices, but don’t actually build any assets in the process. I introduced this into the model by adding a speculative debt component, where borrowing for speculation rose whenever the rate of growth exceeded a minimum level. With that modification, the pattern shown in Figure Seven resulted.

Figure Seven

This model generates a generally exponential increase in debt levels, with super-bubbles in speculative borrowing occurring regularly, and borrowing to finance speculation gradually accelerates to ultimately dwarf borrowing for productive investment.

At some point the debt burden becomes too great for the economy to finance, and debt accumulates faster than it is repaid, leading to a secular crisis and not merely a financial cycle. Guided both by Minsky’s hypothesis and my mathematical models, I felt that we were at such a secular turning point in the real world when I saw the data in Figure Six (three years ago, in December 2005).

I feared that Australia–and probably the rest of the world–was in for a serious debt-induced downturn. Knowing that there was little if any likelihood that this danger would be perceived by the neoclassically-trained economists who dominate Treasuries and Central Banks (and University Economics Departments) around the world. I decided to go public with my analysis

This was more than confirmed when RBA Deputy Governor Ric Battellino published a graph showing Australia’s long term debt to GDP ratio during a speech in September 2007 (see Figure 8, which is augmented to include estimates of non-bank credit prior to 1953). 

Figure Eight

The model I’ve outlined above is extremely simple, and would need to be substantially embellished to capture the main dynamics of a market economy. But it is already streets ahead of neoclassical models by not making an artificial distinction between the short and long term. To paraphrase Keynes, “in the long run we are still in the short run”.

Avoiding Recession?

The Australian Government is almost unique amongst OECD nations in predicting positive growth during 2009. Indeed, only ten countries are holding out for positive real growth next year in the OECD’s recent Economic Outlook are Australia (1.7%), the Czech Republic (2.7%), Greece (1.9%), Korea (2.7%), Mexico (0.4%), Norway (1.3%), Poland (3%), the Slovak Republic (4%), Sweden (0%), and Turkey (1.6%) (see Figure Nine, taken from the OECD Economic Outlook No. 84 for November 2008, p. 82). The other nineteen countries all expect to record negative growth.

These “predictions” should be seen for what they are–not so much predictions as assumptions of a class of economic models that has little connection with the real world. The scale of the downturn “predicted” for 2009 largely reflects the judgments of national Treasuries–including Australia’s–as to how severe a shock the financial crisis represents.

On that scale, the only country giving this financial crisis serious weight is Iceland, which is estimating its damage as equivalent to about 14% of GDP–represented by the change between the growth rate recorded for 2007 and that expected for 2009. Australia’s Treasury has apparently persuaded the OECD that this crisis will knock only a couple of percent off growth.

Figure Nine

Notice also that the OECD expects growth to dramatically improve in 2010–even Iceland is expected to almost return to positive growth for the calendar year as a whole, while in the 4th quarter it is expected to record positive growth at an annual rate of 2.6% (see Figure Ten). Australia is expected to rebound to 3.1% annualised growth by the last quarter of calendar year 2010.

Why? Because by that stage into the future, the “long run” in the OECD’s neoclassical model of the economy starts to reassert itself, and every economy is predicted to boom away, to erase the impact of the “temporary” shock of the 2008 financial crisis.

I’d love to see the OECD’s predictions for Iceland for 2011 and 2012–they should show massive growth to overcome the impact of the -9.3% figure for next year, and return to the long run equilibrium assumption the model makes for Iceland–which is probably above 5% p.a. Australia is also likely to be shown to enjoy a rosy 4% or above rate of growth.

These predictions, and those of any other neoclassical model–including the Treasury’s TRYM model, and the RBA’s small model–are no more than a statement of faith in the long run stability of a market economy.

I expect that faith will be sorely tested in the coming years.

Figure Ten

END OF COMMENTARY

Comments on the Data

It appears that Australia’s debt to GDP ratio has peaked at 165% of GDP, and it is now starting to fall. It could still turn up once again if deflation takes hold, but for the meantime, this seems to be the top of the bubble.

Now as debt levels start to fall–firstly relatively to GDP and then, ultimately, in absolute terms as well–the macroeconomic effect of the bubble’s bursting will be felt. This trend appears in the next two graphs, which show the annual rate of change of debt and GDP, and the contribution that change in debt makes to aggregate demand (which I define as the sum of GDP and the change in debt).

One intriguing aspect of the next two charts is the fact that the rate of growth of debt has fallen over time–from a peak of over 34% year on year for the 1973 bubble, to 25% for the 1989 bubble, and 17% for the bubble that has now peaked in 2008–but the contribution that rising debt makes to demand has risen–from just over 10% in 1973, to 14% in 1989 and 19.5% in 2008.

This apparent paradox is the result of the increasing scale of debt compared to GDP. Back in 1972, when the first debt super-bubble began, debt was equivalent to only 33% of GDP–and therefore a 1/3rd increase in debt, while dramatic, only increased the ultimate debt to GDP ratio by 11%. In mid-1984, when the second superbubble took off, debt was already 54% of GDP, and therefore the slower rate of growth of debt resulted in the debt to GDP ratio rising vt 57% by the time the bubble burst.

This time round, though debt grew by a maximum of only 17% in one year, the debt superbubble which began in mid 1993 increased the debt to GDP ratio by a staggering 109%, from 79% at its commencement to 165.43% by its peak.

Why Did I See it Coming and “They” Didn’t?

The financial crisis is widely accepted as having started in August 9 2007, with the BNP’s announcement that it was suspending redemptions from three of its funds that were heavily exposed to the US securitisation market (click here for the BNP August 9 2007 press release).

Just three months beforehand, the OECD released its 2007 World Economic Outlook, in which it commented that:

“In its Economic Outlook last Autumn, the OECD took the view that the US slowdown was not heralding a period of worldwide economic weakness, unlike, for instance, in 2001. Rather, a “ smooth”  rebalancing was to be expected, with Europe taking over the baton from the United States in driving OECD growth.

Recent developments have broadly confirmed this prognosis. Indeed, the current economic situation is in many ways better than what we have experienced in years. Against that background, we have stuck to the rebalancing scenario. Our central forecast remains indeed quite benign: a soft landing in the United States, a strong and sustained recovery in Europe, a solid trajectory in Japan and buoyant activity in China and India. In line with recent trends, sustained growth in OECD economies would be underpinned by strong job creation and falling unemployment.” (OECD World Economic Outlook Vol 81 p. 7; emphases added)

Similarly, Reserve Banks around the world had set interest rates to relatively high levels to restrain rising inflation, which was then seen as the main threat to continued economic prosperity. Our own RBA increased rates when the crisis began, and three more times since. And it was not alone: the European Central Bank also raised rates after the crisis (see Figure One) .

Figure One

Reserve Interest Rates

In December 2005, almost two years before the crisis hit, I realised that a serious financial crisis was approaching. I was so worried about its probable severity–and the lack of awareness about it amongst policy makers–that I took the risk (for an academic) of going very public about my views. I began commenting on economic policy in the media, started the DebtWatch Report (the first was published two years ago in November 2006), registered a webpage with the apt name of www.debtdeflation.com, and established the blog Steve Keen’s Oz Debtwatch.

How come I got it right, and “they”–the official economic managers–got it so wrong?

It’s not because I’m any brighter than they are–there are plenty of highly intelligent people in those organisations. Instead, it’s because they follow mainstream views in economics, and I follow a minority perspective. The economic history we are currently living through is proof that the mainstream is fundamentally wrong about the nature of the economy, while my minority perspective is at least partially right.

This is not something one should be able to say about a science, and there lies the rub: economics is not even close to qualifying as a science. A better model for economics is a group of warring religions–or science, such as it was, before Galileo’s empirical revolution, when what mattered to scientists was not empirical relevance, but conformity to with the Bible.

Forty years ago, Keynes was The Messiah, and his General Theory was the Bible. But the “stagflation” episode of the 1970s allowed a new Messiah to arise: Milton Friedman, with his doctrine of Monetarism. Though Monetarism itself is no longer espoused, the economic religion that Friedman represented–known as “Neoclassical Economics”–supplanted the previous Keynesian orthodoxy. Today, the majority of economists know of no other way to think about the economy–and they run Central Banks and Treasuries throughout the world, and dominate tuition in universities.

They also develop mathematical models of the economy, which are in turn used to guage its health, and to advise politicians about policy challenges in the near future. According to these models, just over a year ago the economy was in fine shape, and the main policy challenge was to avoid overheating that would lead to rising inflation.

Well inflation did rise. But simultaneously the global economy was falling into a serious recession driven by a global financial meltdown that these economists and their models completely failed to anticipate. Rarely in human history have policy makers been so badly misled by the so-called experts.

The three key aspects of Neoclassical economics that led to its wildly inaccurate forecasts are the beliefs that:

1. A market economy always tends towards equilibrium;
2. Money impacts “nominal” variables like the rate of inflation, but has no long term impact on “real” variables like employment and GDP growth; and
3. Finance markets are rational; in particular, the level of private debt reflects rational calculations about future income, and can therefore be ignored by policy-makers.

The key aspects of the approach that I take (the “Financial Instability Hypothesis” developed by Hyman Minsky) that alerted me to the approaching danger are the propositions that:

1. A market economy is inherently cyclical;
2. Money is fundamentally credit-driven, and has impacts on real variables as well as nominal ones in the short and long term; and
3. Finance markets destabilise the real economy, because they are prone to bouts of euphoric expectations that lead to debt-financed speculative bubbles.

These very different perspectives have two key effects on the economists who hold them:

• they focus attention on very different sets of economic data; and
• they inspire mathematical models of the economy that are very, very different.

What is “a beautiful set of numbers” lies in the eyes of the beholder

Neoclassical economists focus upon three numbers:

1. The rate of economic growth (preferably above 3% per year);
2. Unemployment (which they prefer to be low, but not “too low”–the moving target for which in Australia was 4.5% until recently); and
3. The rate of inflation (which they prefer to be as low as possible, and certainly below 3%).

On all three fronts, from the vantage point of 2006, 2007 looked like being a vintage year–except that the first number was so high that the second was tending too low, which could mean that the third could start to rise. Hence the economic focus was on reducing growth via higher interest rates, to increase unemployment slightly and thus reduce the rate of inflation (see Figure Two).

Figure Two

Australian Growth, Unemployment and Inflation

The RBA’s policy response to this was immediate and decisive. Having already raised rates in 0.25% increments five times since 2002, it accelerated its inflation-control program with three more increases in 2006, two in 2007 –the first of these coming just before the crisis broke, and the other famously during the 2007 election campaign–and two more during early 2008.

Figure Three

Movements in Australian Reserve Interest Rates

Unfortunately, the RBA’s response was also the wrong one. While inflation did rise, it was not the main problem facing the economy. Trying to control the inflation rate by raising interest rates at that time was a bit like trying to control a patient’s blood pressure when he was dying of cancer. That cancer, as is now widely acknowledged, was private debt. The economic variable that their Neoclassical training led them to ignore, the ratio of private debt to GDP, was now indisputably the most important number of all.

Economists who are influenced by Hyman Minsky–broadly known as “Post Keynesians”, since Minsky was a follower of Keynes–focus precisely on that datum. This ratio of a stock (outstanding debt at a point in time) to a flow (the annual output of goods and services) tells you how many years of income it would take to reduce debt to zero. It therefore measures the degree of pressure that finance is imposing on the real economy.

A certain amount of debt is vital to the proper functioning of a market economy, since most companies need flexible working capital to be able to operate, and overdraft facilities and lines of credit provide that flexibility. But too high a debt to GDP ratio means that the financial burden of debt repayment on the economy is excessive, and Minsky’s theory implies that there is a tendency for the debt to GDP ratio to ratchet up over a series of booms and busts, resulting eventually to a Depression.

I did not see the data in Figure Three until December 2005, since my “day job” is as an academic rather than an economic policy maker. I had signed a contract to produce a book on financial instability as long ago as 1998, but the unexpected success of Debunking Economics, and the follow-on debate that engendered amongst academic economists, forced me to delay commencing that task.

As soon as I did see the data–in December 2005, when preparing an Expert Witness report for a court case (the “Cooks Case”)–my Minskian eyes told me that a serious crisis was on its way. Given that the debt to GDP ratio was far higher than during either major post-WWII crisis (1973 and 1989), it appeared obvious that Australia was about to experience its most severe economic crisis since the Great Depression.

Because I knew that neoclassical economists would not realise this was about to happen, were likely to make things worse by increasing interest rates as the crisis approached, and would probably mis-diagnose the cause once it occurred–as they had during the Great Depression–I decided to go public with my analysis via the media, a regular commentary timed to coincide with the RBA meeting (DebtWatch), and eventually a blog (www.debtdeflation.com/blogs).

Figure Four

Australia's Debt to GDP Ratio 1955-Now

Minsky’s hypothesis warns that a crisis begins with the faltering of an asset price bubble. That not one but two bubbles were in progress was obvious in both Australian and American stock market and housing data.

Minsky argues that there are two price levels in a market economy–one for commodities set largely by the costs of production and financed largely from income, and the other for assets, set largely by people’s expectations of future gain, and financed mainly by debt. The ratio of one price level to another thus gives an indication of whether the economy is in a bubble, or a bust.

There are curly issues in the ratio of share prices to the CPI–the reinvestment of retained earnings give shares an upward trend over time compared to the CPI, while the index itself overstates share returns due to survivor bias. But the relatively rapid movement in share prices, versus the slower changes in consumer prices, means that a blowout in the ratio is a good indicator of a bubble. On that basis, Australia’s market had clearly entered a bubble in early 2003, while the USA’s began in 1995 (and had already burst in 2000, only to restart in 2003).

Figure Five

No such curly issues apply with the house price to CPI ratio. Especially when dealing with established houses, there is no long term trend, as the Herengracht Canal index establishes. In a real price series going back over 300 years, house prices have risen and fallen compared to consumer prices, but there is clearly no rising trend (see Figure Five).

Figure Six

CPI-Deflated Price Index for Amsterdam's Herengracht Canal

On this basis, both Australian and US house markets were clearly in bubbles, and the US bubble was unprecedented in its history.

Figure Seven

USA and Australian House Price Indices

The final piece of evidence that pushed me from expecting a serious recession to quite possibly a Depression was provided by the RBA in September 2007–a month after the crisis began–with a chart showing Australia’s private debt to GDP ratio going back till 1860.

Even after I augmented it to include an estimate for non-bank debt prior to 1953 (which made current data look less extreme compared to historical data), it implied that our debt crisis was more than twice as severe as the one that caused the Great Depression. When the Great Depression began at the end of 1929, Australia’s debt to GDP ratio was 65 percent. It has now reached a peak of 165 percent.

Figure Eight

Australia's Debt to GDP Ratio from 1860-Now

That impression was confirmed when I later saw the US data–courtesy of Gerard Minack and the availability online of US Census reports. Its debt to GDP ratio was 150 percent at the end of 1929 (and subsequently blew out to 215 percent as prices and GDP collapsed in the first 3 years of the Depression).

With financial sector debt included, the USA reached that peak again in 1987–the year Greenspan, despite his “Austrian” approach to economics that decried government intervention of any sort, performed his first “successful” rescue during the Stock Market Crash in October.

That rescue worked, not by overcoming the problem of excessive debt-financed speculation, but by re-igniting so that it reached even higher levels. Though borrowing slumped after the Savings and Loans collapse in 1989/90–falling from 170 to 165 percent of GDP–the bubble began once more in 1994. It then rocketed on through the Dotcom Bubble, and didn’t even draw breath then since there were now two asset market bubbles feeding off each other–the Subprime Bubble’s expansion more than counteracted the Dotcom Bubble’s collpase, until finally there were two debt-financed asset bubbles running at once–an unprecedented event in America’s financial history.

By 2004, even non-financial private debt had exceeded the level that triggered the Great Depression, while total private sector debt reached a staggering 290 percent of GDP (without including the impact of financial derivatives, another form of debt that did not exist in the 1920s).

Figure Nine

USA's Long Term Debt to GDP Ratio 1920-Now

The RBA data in Figure Eight was first published in a speech by Deputy RBA Governor Ric Battellino (“Some Observations on Financial Trends“). I found his interpretation of the chart both stunning, and predictable:

“The factors that have facilitated the rise in debt over the past couple of decades –  the stability in economic conditions and the continued flow of innovations coming from a competitive and dynamic financial system –  remain in place. While ever this is the case, households are likely to continue to take advantage of unused capacity to increase debt. This is not to say that there won’ t be cycles when credit grows slowly for a time, or even falls, but these cycles are likely to take place around a rising trend. Eventually, household debt will reach a point where it is in some form of equilibrium relative to GDP or income, but the evidence suggests that this point is higher than current levels.” (emphasis added)

This was stunning, because the previous two peaks in the debt to GDP ratio were followed by Depressions, and yet they were far lower than the current level. Even the most anecdotal approach to history would imply that all might not be well at present.

It was predictable, because it was consistent with the mindset that has dominated economics for three decades now, ever since Friedman’s counter-revolution against Keynesian economics in the 1970s. Whereas the once-dominant Keynesian approach saw the economy as potentially unstable, Friedman’s revived “Neoclassical” approach presumed that the economy was self-equilibrating. Thus data which an engineer would see as indicating an approaching breakdown was interpreted by an economist as indicating an approaching equilibrium. 

This belief in a tendency to equilibrium is built into the models of the economy that neoclassical economists construct–which is why these models gave no warning of the approaching crisis, and why economists were the last ones to realise that a crisis was actually happening. I’ll discuss their models–and the Minskian alternative–in next month’s Debtwatch.

Australian Private Aggregate Debt Table

Australia's Private Debt Table Disaggregated

Then along came the Subprime Crisis, and we received a rude reminder of why Central Banks were created in the first place: to ensure that the world would never again experience a Great Depression.

We are not in a Great Depression–not yet anyway–but a key pre-condition for one has developed right under the noses of Central Banks: excessive private debt. In fact, debt levels today are twice as high as in 1929, which is why this financial crisis is causing far more carnage than 1929 did.

At the time of the Stock Market Crash of October 1929, the US’s debt ratio was 150%; today it is 290%. Australia’s ratio was 64%; today, it is 165%. The regulators who were supposed to keep us from the jaws of The Beast have instead led us closer towards its belly.

Figure One

USA and Australian Debt to Output Ratios 1920-2008

This was not, of course, a conscious decision. It has happened because Central Banks are run by economists, and the dominant “Neoclassical” faction within economics ignored the real lessons of the Great Depression.

The false lesson that Neoclassical economics preaches is that the market economy is fundamentally stable, and the Great Depression was caused by the monetary authorities tightening credit in the aftermath to the Stock Market Crash, rather than loosening it.

The real lesson of the 1930s is that a credit-driven market economy is fundamentally unstable, and a Great Depression occurs when debt-financed speculation results in excessive private debt at the same time as inflation is low.

Central Banks, under the misguidance of conventional economic theory, ignored the role of private debt in the economic system. They instead reinterpreted their charters–which emphasised full employment–as a mandate to keep inflation low.

As the RBA put it in its most recent Annual Report, its:

“duty … to ensure … the stability of the currency… the maintenance of full employment … and the economic prosperity and welfare of the people of Australia… has found concrete expression in the form of a medium-term inflation target. Monetary policy aims to keep the rate of consumer price inflation at 2– 3 per cent, on average, over the cycle.” (Annual Report 2008, page 5).

With its Neoclassical eyes fixated on the rate of inflation, it ignored the expansion of private debt–as did its equivalents at Central Banks around the world, as did government Treasuries, and as did international economic agencies. This is why the sudden collapse of the world economic order took economists by surprise. They were looking at their mathematical models, which ignore private debt (and indeed money!), rather than at the real world, where debt is king.

Nowhere was this more obvious than with the OECD–the organisation whose imprimatur the Australian Treasury seeks. The following are the unabridged opening two paragraphs from the Editorial to the OECD Economic Outlook from May of 2007 (with the really funny bits in bold):

“In its Economic Outlook last Autumn, the OECD took the view that the US slowdown was not heralding a period of worldwide economic weakness, unlike, for instance, in 2001. Rather, a “ smooth”  rebalancing was to be expected, with Europe taking over the baton from the United States in driving OECD growth.

“Recent developments have broadly confirmed this prognosis. Indeed, the current economic situation is in many ways better than what we have experienced in years. Against that background, we have stuck to the rebalancing scenario. Our central forecast remains indeed quite benign: a soft landing in the United States, a strong and sustained recovery in Europe, a solid trajectory in Japan and buoyant activity in China and India. In line with recent trends, sustained growth in OECD economies would be underpinned by strong job creation and falling unemployment.”

Yeah, right. Just three months later, the financial crisis began.

It should by now be painfully obvious that conventional economics cannot be relied upon to explain where we are, how we got here, where we might end up, and what might work to avoid the worst consequences. To understand it, we have to go back to the economist who got it right, but was ignored by the economics profession: Irving Fisher.

The Debt-Deflation Theory of Great Depressions

Fisher had been an academic cheerleader for the financial bubble of the Roaring Twenties–his main claim to fame one can find on the Internet is that he uttered the fateful prediction that “Stock prices have reached what looks like a permanently high plateau” the week before the Stock Market Crash of 1929.

Four years on, chastened and effectively bankrupted, he reflected that a Great Depression ensued when too much debt was accompanied by falling prices. He christened the phenomenon a “debt-deflation”.

A key aspect of Fisher’s reasoning was that, though economists of his time modelled the economy as if it were permanently in equilibrium, the real economy would always be in disequilibrium. As he put it, even if the economy did tend towards equilibrium:

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

He also argued that the forces that gave rise to a Depression were innately disequilibrium in nature. The two key factors that caused a Depression, he argued, were excessive debt and falling prices. Though other factors might lead to a crisis (such as overconfidence or excessive speculation), debt and deflation were the two key forces that turned a garden-variety downturn into a Depression. As he very poignantly put it (since he himself was a victim):

“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 then laid out the sequence of events that follows when a financial crisis ensues in the context of excessive debt and low inflation:

“(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.” 

After the Crash of 1929, when business debt was dominant, many firms found themselves with debt repayment commitments that they couldn’t meet out of cash flow. They undertook “ distress selling”  to try to raise the money they needed— and because everyone dropped their prices, prices fell across the board. Even firms that managed to pay their debts down in nominal terms found that their revenues fell even more than their debt, leading to “ Fisher’s Paradox”  that:

“the more debtors pay, the more they owe. The more the economic boat tips, the more it tends to tip. It is not tending to right itself, but is capsizing.”

That phenomenon is strikingly obvious in the historical data, which shows the rate of inflation falling from trivial levels (of between 0.5% and 1% p.a.) to minus 10% p.a. between 1931 and 1933.

Figure Two

Inflation Rates 1920-40 USA and Australia

Economic growth also came to a shuddering halt as the ensuing credit crunch cut spending levels, and as cash-strapped businesses sacked their workforce. That decline is also evident in the data, with the rate of real economic growth falling from 6% before the crash to minus 8% after it–and as low as minus 13% in 1932.

Figure Three

Rate of Economic Growth 1920-40, USA and Australia

The decline in both output and prices meant that the debt to GDP ratio continued to rise after the Stock Market Crash of 1929–even though credit was tight, and anyone who was in debt was trying to reduce it. Notice on Figure One that debt ratios continued to rise until 1932–from 150% to 215% of GDP in America, and from 64% to 77% of GDP in Australia.

The effect of this decline on employment was so severe that it has remained etched into humanity’s psyche. When the Stock Market began its collapse, the level of unemployment in America, as recorded by the National Bureau of Economic Research, was 0.04%–one 25th of one percent. Three years later, it reached 25%. Australia’s unemployment rate blew out too, from a higher initial level of 9% to a peak of 20% in 1932. The world had suddenly moved from The Great Gatsby to They Shoot Horses, Don’t They?

Figure Four

Unemployment Rates 1920-40, USA and Australia

This calamity, which economic theory said could not happen, both discredited conventional economic thought, and gave credence to the then unfashionable views of John Maynard Keynes (Fisher, with his reputation in tatters after his false assurances that nothing was amiss in 1929, was largely ignored–even though Fisher’s explanation of how Depressions occur was superior to Keynes’s). When the world emerged from the World War that followed the Great Depression, so-called Keynesian Economics dominated the profession, and the once supreme Neoclassicals were ignored.

However, one of the most prophetic observations that Keynes ever made concerned the likelihood that his new ideas would fail to be truly accepted by the economics profession. In the Preface to his General Theory of Employment, Money and Wages, Keynes observed that:

“The ideas which are here expressed so laboriously are extremely simple and should be obvious. The difficulty lies, not in the new ideas, but in escaping from the old ones, which ramify, for those brought up as most of us have been, into every corner of our minds.”

So it proved to be. Though calling themselves “Keynesian”, most academic economists continued to cling to the preceding “Neoclassical” ideas (especially in the area of microeconomics, which Keynes did not address).

As the experience and the memory of the Great Depression receded, academic economics produced a hybrid of Keynes’s macroeconomic ideas grafted on top of Neoclassical microeconomics that they called “the Keynesian-Neoclassical Synthesis”.

Unfortunately, the ideas were incompatible–and over time, wherever there was a conflict, academic economics rejected the Keynesian graft, rather than the underlying Neoclassical microeconomics. After fifty years of this, Keynes’s ideas were completely ejected from the economic mainstream, the Neoclassical belief that the economy is self-correcting became dominant once more, and economists trained in this belief came to dominate Treasuries and Central Banks around the world. They ignored levels of private debt, championed deregulation of finance,  and virtually encouraged asset price speculation.

Now we have twice as much debt as caused the Great Depression, and inflation so low that, were it not for unprecented factors (the rise of China, global warming and peak oil), deflation would almost be a certainty.

Having thus unlearnt the real lessons of the Great Depression, the economics profession may yet make us relive it.

END OF COMMENTARY

Comments on the Data

It appears that Australia’s debt to GDP ratio has peaked at 165% of GDP. It could still turn up once again if deflation takes hold, but for the meantime, this seems to be the top of the bubble.

Now as debt levels start to fall–firstly relatively to GDP and then, ultimately, in absolute terms as well–the macroeconomic effect of the bubble’s bursting be felt.

This is because aggregate demand is the sum of income plus change in debt. For the last decade, the latter factor has been adding to demand–and aggregate supply, asset prices, and our import bill have adjusted upwards to suit. But as the change in debt drops and ultimately turns negative, it will subtract from demand–and supply (read employment), asset prices and imports will follow it down.

If Australians decided to reduce their debt to income ratio by 10% each year–to get back to the 25% level that applied back in the 1960s (before this long-term speculative bubble took off)–it would take roughly 15 years to get there.

Chart One

Monthly change in Debt, Australia

Chart Two

Contribution to Demand from Change in Debt, Australia

Table One

Agggregate Debt Summary Australia

Disaggregated Debt Summary, Australia

Australia's 1964-2008 Debt Bubble

Australia's long term addiction to debtTrends in Disaggregated Debt, Australia

Monthly changes in disaggregated debt, Australia

Dateline goes to air tonight (Wednesday) at 8.30pm. It is also accessible on the web, the day after the program goes to air.

In other news, the podcasts are currently not functional, but I hope to fix them up tomorrow.

My answer is: a lot worse. The empirical grounds for this assessment are:

• The ratio of asset prices to consumer prices–or the inflation-adjusted asset price index;
• The ratio of private debt to GDP; and
• Japan

In short, global asset markets have a lot further to fall, and a serious recession–the worst we have experienced since the Great Depression–is inevitable. Let’s first look at what the recent drop in retail sales implies for the economy.

An “unexpected” fall in retail sales

Retail sales fell sharply in June, taking most economic commentators by surprise. Even perennial optimists, such as Shane Oliver, were forced to consider that the odds of a recession were “at least 40 percent”.

In reality, the fall in retail sales was inevitable. Spending in Australia has been driven by the biggest debt bubble in our history, and when that bubble peaked, spending had to fall. Since households had taken on a far larger share of debt than business during this bubble, the impact was bound to be seen first in retail sales, rather than investment spending, as I pointed out in November 2006:

“If households reduce their debt levels smoothly, they will have less disposable income to spend and retail sales will slump. If bankruptcies become widespread, the sales downturn will be overlaid with a financial crisis.” (Debtwatch, November 2006, p. 18;

see http://www.debtdeflation.com/blogs/pre-blog-debtwatch-reports

The suddenness of the turnaround is also no surprise, when you look at the data from a financial point of view. Just as your personal spending each year is the sum of your net income plus the change in your debt, aggregate spending for the economy is the sum of GDP plus the change in debt. As debt rises, the contribution made to spending by any change in debt also rises. Private debt–and household debt in particular–has risen so much in Australia that, at its peak, the change in debt was responsible for almost 20 percent of aggregate demand.

FIGURE 1

As is obvious in Figure 1, debt’s contribution peaked at the end of 2007, and it has been falling ever since. The monthly figures make this even more obvious (Figure 1 records change in debt over a whole year). The monthly increase in total private debt peaked at $30 billion in mid-2007, and trended up to $27 billion by the end of 2007. It has since fallen to a mere $5 billion in the month of June (see Table 1 and Figure 2).

Table 1

Figure 2

At some point, it will turn negative, and change in debt will therefore substract from aggregate demand rather than adding to it. Given that at its peak, debt financed almost 20 percent of demand, even stabilising debt at its current level–$1.85 trillion, compared to a GDP of $1.1 trillion–would result in a 20 percent fall in aggregate demand.

This hit will be felt by both asset and commodity markets: asset prices will fall, as will output and employment. The government’s attempts to counter this–by running a deficit rather than a surplus–will initially be swamped by the sheer scale of the turnaround in debt-financed spending. Even if the government runs a deficit of A$20 billion–the same scale as this year’s intended surplus–it will make up for less than a tenth of the fall in debt-financed spending.

The current “credit crunch” is, therefore, only the first act in a long-drawn out process of reducing debt levels. The second act will be “the recession we can’t avoid”. That recession–which will affect most of the OECD, since all major OECD nations bar France have suffered a similar blowout in private debt levels–will only add to the current decline in asset prices.

The USA: Double Bubble

While the Dow has fallen substantially in the last year, its inflation-adjusted value is still three times its long-term average, and more than 4 times its average prior to the start of this bubble.  Even if the index falls merely to its long term average, it still has another 62% to go (in real terms)  from its current level. If it reverts to its pre-bubble average, it has another 73% to go.

Figure 3

If those figures seem ludicrously pessimistic and unrealistic to you, take a look below at the CPI-adjusted Nikkei–which fell 82% from its peak at the end of 1989 to its low in 2003. At the time, most commentators blamed Japan’s Bubble Economy and subsequent financial crisis on the opaque and anti-competitive nature of its financial system. We were assured that nothing so ridiculous could happen in the transparent, competitive and well-regulated US financial system.

Yeah, right.

Figure 4

The story for the US housing market is little better. The index has already fallen 23% from its peak in 2006. A reversion to the long term mean implies a further 38% fall in the average house price in America; while reversion to the pre-Bubble mean implies a further 41% fall.

Writedowns by US financial institutions certainly haven’t yet factored in that degree of possible fall in housing values, and as Wilson Sy pointed out recently in two brilliant research papers (1 2), the banks’ “stress test” modelling greatly underemphasises the impact of such asset price falls on their financial viability. House price falls in the USA are far from over, and likewise “unexpected” writedowns by US financial institutions.

Figure 5

Overall, if US markets fall back to their pre-Bubble levels, the stock market will plunge about 80% from its peak (much the same degree of fall as applied in Japan) and the housing market will fall 55% (rather more than happened in Japan, where average house prices fell 44%–but less than Tokyo, where they fell over 70%).

The unique feature of this US asset bubble is that it affects both stocks and houses. There have been three Stock Market Bubbles in the USA in the last century: the “usual suspects” of the 1920s and 1980′s, but also one that doesn’t normally rate a mention: a ’60s Bubble that peaked in 1966, and was followed by a slump that only ended in mid-1982 (see Figure 6).

As Figure 6 indicates, this dual bubble has no precedent. Not only is it a bubble in both asset markets, both bubbles dwarf anything previously experienced. Even the great Roaring Twenties stock market bubble barely pokes its head above the long term average, compared to the 2000s Stock Market bubble–and in the 1920s, as Figure 6 shows, the housing market was relatively undervalued. The overvaluation of today’s housing market far exceeds the now comparatively minor bubble when Keating (Charles, not Paul) was on the loose in the USA.

Figure 6

While the Australian Stock Market is not as severely overvalued as the American, it is still substantially over its long term trend. Even after the recent falls, the inflation-adjusted All Ordinaries Index exceeds its level before Black Tuesday in 1987. It has another 30% to go before it will have reverted to the mean of the last 25 years (see Figure 7).

Figure 7

The prognosis for the Australian housing market is substantially worse. Even on short term data–covering only the last 22 years–the market could fall 40% if it reverted to the mean, and 50% if it reverted to the pre-bubble mean. Nigel Stapledon’s research into long term house prices in Australia–which is not shown here–implies an even greater potential for a fall in house prices.

Figure 8

Of course, such talk can seem nonsensical and alarmist. Especially if you ignore what happened in Japan.

Japan: the world’s most recent debt-deflation

Japan clearly underwent a debt-deflation after its “Bubble Economy” spectacularly burst in 1990. In its aftermath, house prices across Japan fell on average by 42%, and by over 70% in Tokyo (though they have since recovered slightly).

Figure 9

Figure 10

What has happened there can happen in Australia, the USA, and the rest of the OECD–especially since our Bubbles, while smaller than the Tokyo bubble, are larger than that for Japan as a whole (see Figure 11).

Figure 11

The killer behind the Bubble: Debt

The level of overvaluation of asset markets reflects the unprecedented scale of private debt, both here and in America–since the vast bulk of that debt was undertaken to finance “Ponzi” speculation on shares and housing. This is the reason that this recession will be so severe–as will the asset market bust.

Every “recovery” from a debt-induced recession since 1970 has involved resumption in the tendency for debt to grow faster than GDP (see Figure 12, where the once seemingly major debt crisis of the late 80s is now just a pimple on the upward trend of the debt ratio to its current unprecedented level).

Yet today the debt to GDP ratio is more than twice that of the Great Depression. It is simply cannot go any higher. Who else, after all, can banks lend to, now that they have exhausted the “subprime” market?

The only way for the debt to GDP ratio now is down (unless we’re unlucky enough to experience deflation, in which case the ratio will rise further, as in the Great Depression), and as it heads down, so will output and employment. A serious recession is inevitable.

Welcome to “the recession we can’t avoid”.

Figure 12

I hope that this month’s discussion is more along the lines of “if you guys are the money experts, how come you didn’t see it coming?”–it, of course, being the unfolding collapse of the US housing market, and the resulting extreme turmoil on financial markets.

That turmoil had begun before last month’s meeting. No doubt, Board fears about its potential impact on Australia were assuaged:

• by reference to FRB Chairman Bernanke’s assurances that losses in the US subprime mortgage market would be in the relatively trivial range of “in the order of between $50 billion and $100 billion” (Reuters);
• by the assurance that the exposure of Australia’s financial institutions to US subprime loans was limited; and
• by the observation that lending practices in Australia were far superior to those in the USA–with subprime lending accounting for 13 percent of US loans versus 1 percent for the equivalent Australian classification of non-conforming loans.
  That is all so last month now.
• Bernanke observed last week that “global financial losses have far exceeded even the most pessimistic projections of credit losses on those loans”.
• Several Australian financial institutions and funds have folded, and quite a few more are facing the need to increase their rates above the 0.25% increase mandated by the rise in the cash rate; and
• If Australian lending practices are so much more prudent than those in the USA, how come household debt has risen more than three times faster in Australia than in the USA? (see Chart 1) And why can Australian households cope with an aggregate level of debt service that, clearly, American households can’t handle? (see Chart 2; but also see my closing note below)

Note: I’m having trouble uploading charts, but they are available in the PDF document that is accessible from the Debtwatch Reports page.

Chart 1: Household Debt vs GDP, USA and Australia

Chart 2: Interest Payments vs Household Income, USA and Australia

One explanation that I don’t expect the RBA’s economists will give the Board is possibly the most important: its economic models consider neither credit conditions, nor debt, nor even money itself. As a result, its technical advisors don’t even pay attention to the key variables that brought us the subprime crisis in the first place.

In this, they are no different to the vast majority of economists, who share, as Federal Reserve Governor Bernanke and Board member Mishkin once put it:

“the widespread acceptance of the view that there is no long-run tradeoff between output (or unemployment) and inflation, so that monetary policy affects only prices in the long run” (Bernanke and Mishkin, 1997, “Inflation Targeting: A New Framework for Monetary Policy?”, Journal of Economic Perspectives 11, pp. 97-116)

As a consequence, most economists omit money, credit, debt and the like from their economic models–because they don’t believe that they have any impact on the economy (apart from causing inflation).

As the subprime financial crisis spreads, I expect that Bernanke and Mishkin will look back on this statement as so much naive wishful thinking. Hopefully, the RBA’s economists will do likewise. In the meantime, they–and the RBA Board, having agreed to a rate rise at the last meeting–must now be wondering how long it will be before this “unanticipated monetary shock” forces them to consider lowering rates to avoid an even more serious economic downturn.

… And Deeper in Debt: Australia’s obsession with borrowed money

The Centre for Policy Development (www.cpd.org.au) will be launching mini-book by me with the above title on September 18, at the Sydney Mechanics School of Arts (280 Pitt Street) at 12pm. Please email the Centre (contact@cpd.org.au) if you would like to attend, and/or reserve a copy of the report. Go to www.cpd.opg.au/events/…and-deeper-debt for more details.

Abbreviated Report

This is an abbreviated Debtwatch, since I’m putting most of my energy into … And Deeper in Debt. My standard charts are appended below, but the majority of my analysis for this month will be reserved for that book.

Closing Note

While I play down the differences between Australia and the USA above, there are some aspects of the US market that do make it substantially worse than here–notably the practice of extending “teaser” loans to borrowers with initially low interest rates, where the gap between the initial and standard interest payments is added on to the principal. The “honeymoon” period on many of those loans expire in the next few months, and households who took them out will face the double whammy of increased debt and higher repayments.But Australian households are still under substantial debt-stress, and the recent blowout in personal debt may indicate that it is really starting to bite hard. Last month’s growth rate in personal debt was astronomical (see Chart 3), and it may be a sign that households are resorting to easily available credit-card debt to meet living expenses and still be able to pay the mortgage.
Chart 3: Monthly growth rates in types of debt