Debt reduction is now the real story of the American economy, just as real story behind the apparent free lunch of the last two decades was rising debt. The secret that has completely eluded Bernanke is that aggregate demand is the sum of GDP plus the change in debt. So when debt is rising demand exceeds what it could be on the basis of earned incomes alone, and when debt is falling the opposite happens.

I’ve been banging the drum on this for years now, but it’s a hard idea to communicate because it’s so alien to the way most economists (and many people) think. For a start, it involves a redefinition of aggregate demand. Most economists are conditioned to think of commodity markets and asset markets as two separate spheres, but my definition lumps them together: aggregate demand is the sum of expenditure on goods and services, PLUS the net amount of money spent buying assets (shares and property) on the secondary markets. This expenditure is financed by the sum of what we earn from productive activities (largely wages and profits) PLUS the change in our debt levels. So total demand in the economy is the sum of GDP plus the change in debt.

I’ve recently developed a simple numerical example that makes this case easier to understand: imagine an economy with a nominal GDP of $1,000 billion which is growing at 10 percent a year, due to an inflation rate of 5 percent and a real growth rate of 5 percent, and in which private debt is $1,250 billion and is growing at 20% a year.

Aggregate private sector demand in this economy—expenditure on all markets, including asset markets—is therefore $1,250 billion: $1,000 billion from expenditure from income (GDP) and $250 billion from the change in debt. At the end of the year, private debt will be $1,500 billion. Expenditure is thus 20 percent above the level that could be financed by income alone.

Now imagine that the following year, the rate of growth of GDP continues at 10 percent, but the rate of growth of debt slows from 20 to 10 percent. GDP will have grown to $1,100 billion, while the increase in private debt this year will be $150 billion—10 percent of the initial $1,500 billion total and therefore $100 billion less than the $250 billion increase the year before.

Aggregate private sector demand in this economy will therefore be $1,250 billion, consisting of $1,100 billion from GDP and $150 billion from rising debt—exactly the same as the year before. But since inflation has been running at 5 percent, aggregate demand will be 5 percent lower than the year before in real terms. So simply stabilising the debt to GDP ratio results in a fall in demand in real terms, and some markets—commodities and/or assets—must take a hit.

Putting this example in a table, we get the following illustration:

Notice that nominal GDP remains constant across the two years–but this means that real output has to fall, since half of the recorded growth in nominal GDP is inflation. So even stabilising the debt to GDP ratio causes a fall in real aggregate demand. Some markets–whether they’re for goods and services or assets like shares and property–have to take a hit.

Now let’s apply this to the US economy for the last few years, in somewhat more detail. There are some rough edges to the following table—the year to year changes put some figures out of whack, and some change in debt is simply compounding of unpaid interest that doesn’t add to aggregate demand—but in the spirit of “I’d rather be roughly right than precisely wrong”, at your leisure please work your way through the table below.

Its key point can be grasped just by considering the GDP and the change in debt for the two years 2008 and 2010: in 2007-2008, GDP was $14.3 trillion while the change in private sector debt was $4 trillion, so aggregate private sector demand was $18.3 trillion. In calendar year 2009-10, GDP was $14.5 trillion, but the change in debt was minus $1.9 trillion, so that aggregate private sector demand was $12.6 trillion. The turnaround in two years in the change of debt has literally sucked almost $6 trillion out of the US economy.

That sucking sound will continue for many years, because the level of debt that was racked up under Bernanke’s watch, and that of his predecessor Alan Greenspan, was truly enormous. In the years from 1987, when Greenspan first rescued the financial system from its own follies, till 2009 when the US hit Peak Debt, the US private sector added $34 trillion in debt. Over the same period, the USA’s nominal GDP grew by a mere $9 trillion.

Ignoring this growth in debt—championing it even in the belief that the financial sector was being clever when in fact it was running a disguised Ponzi Scheme—was the greatest failing of the Federal Reserve and its many counterparts around the world.

Though this might beggar belief, there is nothing sinister in Bernanke’s failure to realize this: it’s a failing that he shares in common with the vast majority of economists. His problem is the theory he learnt in high school and university that he thought was simply “economics”—as if it was the only way one could think about how the economy operated. In reality, it was “Neoclassical economics”, which is just one of the many schools of thought within economics. In the same way that Christianity is not the only religion in the world, there are other schools of thought in economics. And just as different religions have different beliefs, so too do schools of thought within economics—only economists tend to call their beliefs “assumptions” because this sounds more scientific than “beliefs”.

Let’s call a spade a spade: two of the key beliefs of the Neoclassical school of thought are now coming to haunt Bernanke—because they are false. These are that the economy is (almost) always in equilibrium, and that private debt doesn’t matter.

One of Bernanke’s predecessors who also once believed these two things was Irving Fisher, and just like Bernanke, he was originally utterly flummoxed when the US economy collapsed from prosperity to Depression back in 1930. But ultimately he came around to a different way of thinking that he christened “The Debt Deflation Theory of Great Depressions” (Fisher 1933).

You would think Bernanke, as the alleged expert on the Great Depression—after all, that’s one of the main reasons he got the job as Chairman of the Federal Reserve—had read Fisher’s papers. And you’d be right. But the problem is that he didn’t understand them—and here we come back to the belief problem. The Great Depression forced Fisher—who was also a Neoclassical economist—to realize that the belief that the economy was always in equilibrium was false. When Bernanke read Fisher, he completely failed to grasp this point. Just as a religious scholar from, for example, the Hindu tradition might completely miss the key points in the Christian Bible, Bernanke didn’t even register how important abandoning the belief in equilibrium was to Fisher.

To know this, all you have to do is read Bernanke’s summary of Fisher in his Essays on the Great Depression:

The idea of debt-deflation goes back to Irving Fisher (1933). 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.

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 2000, p. 24)

There’s no mention of disequilibrium there, and though Bernanke went on to try to develop the concept of debt-deflation, he did so while maintaining the belief in equilibrium. Compare this to Fisher himself on how important disequilibrium really is in the real world:

We may tentatively assume that, ordinarily and within wide limits, all, or almost all, economic variables tend, in a general way, toward a stable equilibrium… But the exact equilibrium thus sought is seldom reached and never long maintained. New disturbances are, humanly speaking, sure to occur, so that, in actual fact, any variable is almost always above or below the ideal equilibrium…

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)

We might not be in such a pickle now if economics had started to become more of a science and less of a religion by following Fisher’s lead, and abandoning key beliefs when reality made a mockery of them. But instead neoclassical economics completely rebuilt its belief system after the Great Depression, and here we are again, once more experiencing the disconnect between neoclassical beliefs and economic reality.

For the record, here’s my “GDP plus change in debt” table for the 1930s, to give us some idea of what the next decade or so might hold if, once again, we repeat the mistakes of our predecessors.

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

Fisher, I. (1933). “The Debt-Deflation Theory of Great Depressions.” Econometrica
1(4): 337-357.

Click here to download this post as a PDF file.

]]> http://www.debtdeflation.com/blogs/2010/08/29/what-bernanke-doesn%e2%80%99t-understand-about-deflation/feed/ 155 http://www.debtdeflation.com/blogs/2010/08/19/webinar-on-the-australian-economy/ http://www.debtdeflation.com/blogs/2010/08/19/webinar-on-the-australian-economy/#comments Wed, 18 Aug 2010 23:42:48 +0000 Steve Keen http://www.debtdeflation.com/blogs/?p=4254 Broadcaster and podcaster Phil Dobbie, who amongst other roles conducts the podcasts for BNET.com, is launching a Webinar seminar series with a talk by me on the Australian economy.

A webinar is an online version of a seminar at which the speaker can give a lecture (complete with slides, simulations, etc.) that up to 1,000 people can attend, and attendees can ask questions during the talk.

This first webinar is entitled “The Aussie Economy – Good Times or Stormy Waters? “, and it will take place at 11am (Australian Eastern Standard Time) on Friday September 3rd 2010.

If you’d like to take part, please click this link and sign up: GoToWebinar

”The position we find ourselves in today is more due to our strong economic position going into the crisis and the massive stimulus packages undertaken by our trading partners,” Professor Bird says. ”The government can take little or no credit for either of these, a point it (and our learned academics) conveniently forget.” (Peter Martin, “Reserve Bank backing for stimulus“, The Age August 18 2010)

Ron is in effect making an appeal to the facts over simple assertion, but a careful look at the data shows that the facts support the letter signatories, and not Bird’s rejoinder.

His first point, that Australia had a “strong economy going into the crisis”, is just waffle: everyone appeared to have a strong economy going into the crisis—that’s why most economists were completely blindsided when the crisis actually occurred.

Remember that the OECD concluded that things were rosy across the globe in June 2007, just before the crisis hit?:

“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…” (OECD Economic Outlook June 2007).

His second point is simply wrong on the data. If it were true that the rest of the world had saved us rather than ourselves, then Western Australia and Queensland would have dragged us out of the slump, and our tradeable product industries would have risen most while non-tradeables would have lagged.

That is the exact opposite of what you find when you look at the data—something Ron clearly didn’t do before he wrote his rejoinder. The State that dragged Australia out of the slump was Victoria, and the industries that did it were the non-tradeables that were the most direct beneficiaries of the Rudd Stimulus.

Australia began to lose jobs in January 2009, and the crisis was at its most severe in March, when employment was falling at a rate of 80,000 jobs a year. We got back to zero job losses in August—a stunningly fast turnaround—and at that point the only State with rising employment was Victoria. WA and Queensland were still shedding jobs at a rate of 9,000 jobs a year at that point.

Drilling down into Victoria’s number shows that most of the industries that led the charge out of recession had very little to do with trade, and a lot to do with the stimulus: the biggest boomer was Professional employment (24 thousand jobs), where either trade or the stimulus could be the cause, but the next four biggest movers are all clearly non-tradeables: Retail (23000), Finance (21000), Education (15000), and Health (14000).

Only once employment was rising again did the resource states and export industries really kick in—but even then, the main drivers of employment growth across the country were the non-tradeable industries that benefited most from the stimulus. The largest single numerical increase was still in Professional employment (79000), but the next five (Accommodation and Food Services 49,000; Health 47,000; Construction 30,000; Education 29,000; Real Estate 23,000) are clearly driven by the government stimulus package–including part of the package that I am critical of, which I prefer to call the First Home Vendors Boost. The export-oriented Mining and Agriculture sectors share effective seventh place in the expansion at 20,500 each.

So the facts support the letter signatories and not Professor Bird. It isn’t the case that we conveniently forgot some important facts—since they were clearly on our side—but that those making the case against the stimulus have simply failed to check the facts.

Finally, let’s get real here: this whole debate is being driven by the pseudo-conflict between Labor and Liberal over the economy. Frankly, if the Liberals had been in power, they would have reacted in much the same way that the Labor Party did, and followed the same advice from Ken Henry: “Go early, go hard, and go households”.

Because of that debt level, bank profits have gone through the roof as a share of GDP. Back before we had a financial crisis—when debt levels were far lower than today—so too were bank profits as a share of GDP. A sustainable level of bank profits appears to be about 1% of GDP. The blowout from this level to virtually six times as much began when bank deregulation began under Hawke and Keating, and then took off as Howard and Costello encouraged everyone to become “Mum and Dad Investors”, which meant borrowing money from the bank and gambling on share and house prices.

As readers of this blog know, I build models of financial instability, and in my models, one symptom of an economy that is headed for a Depression is a rise in bankers share of income at the expense of workers and capitalists. The model below has yet to be calibrated to the data, but the similarities with the actual data are still ominous.

One empirical reality illustrated by the model as well is that even if firms are the ones taking on the debt (as they are in this model—it does not include household borrowing), workers are the ones that pay for this in terms of a declining share of national income: rising debt is associated with a constant profit share of GDP but a falling workers share.

When the crisis really hits,  both workers and capitalists suffer as bank income goes through the roof—leading to a Depression. The only way out of this is to abolish large slabs of the debt, and coincidentally to drive bankers share of income back down to levels that reflect is supportive role as a provider of working capital for firms—rather than a parasitic role as the financier of Ponzi schemes.

This is the real debt story of our economy right now. As the first chart above indicates, private debt is far higher than Government debt, even after the increase last year due to Rudd’s stimulus package. Government debt is currently 5.5% of GDP, whereas private debt—even though it has fallen slightly due to business deleveraging—is over 150% of GDP: 27 times the size of Government debt. The so-called debate that the major parties are having over the size of Government debt is an embarrassment.

“That only capitalism can save the planet”

I’m on the Opposition side, along with the poet and novelist Kate Jennings, and former Executive Director of Greenpeace International Paul Gilding. The Government side is Economics Editor of The Sydney Morning Herald Ross Gittins,  businesswoman and company director Lucy Turnbull, and businessman, activist and writer Geoffrey Cousins.

The full description of the debate can be found here on the IQ Squared website.

We’ll be ranging across quite a few topics within that “That only capitalism can save the planet” rubric. To quote the IQ Squared header:

Critics of capitalism have been crowing ever since the onset of the global financial crisis.
Capitalism has been blamed for nearly every one of the earth’s ills – poverty, pestilence, exploitation, environmental degradation, the lot!
Capitalism has been celebrated as the only cure for the earth’s ills – poverty, pestilence, exploitation, environmental degradation, the lot!
So, who is right?

If you’d like to be part of the audience for this debate, which is held in the City Recital Hall Angel Place (2 Angel Place, Sydney), click on this link, or call 02 8256 2222 to reserve a seat. Tickets are A$32.

If you can’t be there in person, you can watch excerpts from the debate on the ABC’s Big Ideas on Tuesday August 17 (on ABC1 at 11am)– and it may also be played in full at 11am on Wednesday August 11. You should also be able to listen to it on ABC Radio National just after the 6pm news on Thursday  August 12. Check the IQ2 website for full details–and please note that it warns that “broadcast times are subject to change and that debates are no longer broadcast live”.

It’s sobering to remember here that we have had 17 consecutive monthly increases in Australian capital city home values. If the sharemarket rose for 17 months straight and then tapered, people would not think twice about. It might be wise to apply the same logic to our housing market.

That comment evinced the following comment on Chris Zdatappone’s report in the Fairfax Press from the reader “Dave”:

If the share market had risen for 17 consecutive months, people would be screaming BUBBLE. Somehow this logic seems to defy Chris Joye … Oh dear.

Oh dear indeed. In a speculative market like the stock market, much of the buying is driven by the belief that prices will continue to rise; as soon as that belief evaporates, buyers become sellers and the price doesn’t “taper”, but plunge. A certain Irving Fisher once commented that “stock prices have reached a permanently high plateau”, only to see them (and his reputation and wealth) evaporate in the ensuing 3 years.

So the hope for Chris Joye is not that house prices will behave like stock market prices, but precisely the opposite. Bears like myself argue that the housing market has indeed become just like the stock market—a place where leveraged speculation in the belief that house prices always rise does far more to explain house price movements than any appeals to “fundamentals”—and this is the main reason that house prices have risen so much in the last two decades.

There is however one important way in which house prices do differ from shares: the first sign of trouble is not a sudden drop in prices, but a fall in the number of sales and an increase in the length of time it takes for properties to sell. That sign was evident in the data from the last year or so, which is why I argued that a fall in house prices was imminent in a previous article on Business Spectator. Now that the data are unequivocal, the following processes are likely.

Firstly, with an increased stock of unsold houses on the market, buyers are likely to take yet more time to make a decision—which will add further to the backlog. If prices are falling, why hurry? The urgency will leave the buy side.

Secondly, so-called investors—whom I prefer to call speculators, since 90% of them have bought existing properties rather than built new ones—will start to consider whether they should swap from the buy side to the sell side. After all, no-one in their right mind buys an investment property in Australia for the rental returns: it’s capital gains or nothing DownUnder. Do you capitalize on gains to date, or hang on hoping that the upward trend will re-assert itself once more?

Given the skewing of our market away from owner-occupiers and towards speculators in the last two decades, this second effect could cause a sudden increase in the number of properties on the market—at just the same time that buyers have become more relaxed about closing a sale. It’s this sort of process in an asset market that is why asset prices don’t “taper”—or “plateau”, to use a word from an earlier time.

I expect these two processes to lead to an accelerating rate of decline in house prices now, as they did in the USA when “Flip That House” ceased being a winning trade.

I’ll have more to say on this shortly, but for now I can do no better than to direct you to the Business Spectator news report of the fall:

House prices fall 0.7% in June, flat in quarter

and Christopher Joye’s press release on this topic:

House prices on ice – for now

I also recommend Rob Burgess’s election blog perspective here:

POLL POSITION: Will Labor fall with house prices?

And I thank Rob for referring in his article to my last post in Business Spectator in June:

Housing nears the precipice

I’ll give a presentation covering the statistics on the debt-driven process that led to the economic crisis, an explanation of how money is created in a pure credit economy (based on my “Roving Cavaliers of Credit” post on this blog), and a model of debt-deflation as covered in my recent talk in New York.

If you’d like to attend the conference, the organisers have agreed to give a $45 discount on the $395 registration fee to anyone who is referred from my blog. If you’d like to attend, click here to send an email to reserve a place at the conference. They don’t have an online fee payment system for the conference, though you can use their PayPal link to pay your fee. Alternately, you can send a check to:

American Monetary Institute
P.O. Box 601
Valatie, NY 12184
Ph: 224-805-2200

I hope to see some of you there.

The presentation slides are linked here, and the paper here. The presentation is new and much more detailed than the one I gave at the Levy; the paper is the same as that linked to the Levy presentation.

I am still doing some development work on this model, including expanding it to include fiat as well as credit money (and I hope ultimately to fit it to the US data as well), but for now it’s the most complete single sectoral model of debt-deflation I’ve put together.

I’ve also linked an MP4 format file here, since the Flash Video compression seems to result in rather hard to read text on the slides.

PS I’ve just checked part of the video above, and after a while there’s a very large gap between the visuals and my commentary. This is probably due to my stuff-up when I got back from New York: I used an automatic backup program to transfer files from the camera to my computer, and then deleted the files from the camera–only to find that the New York material hadn’t been transferred!

An undelete program saved my bacon (thank you File Restore Plus), but in such operations there’s always some problem, and this is one of them. Nonetheless it’s better than losing the whole thing. So please put up with the disconnect.

If you’ve already read the paper I gave at the Minsky conference, then you’ve read what’s published there; the main reasons for putting it here in blog form were to make it more accessible, and to post a video of the talk I gave at the Levy. I’ve also reproduced this below.

Shortly I’ll be publishing the video of the talk I gave in New York to members of the Debtwatch blog there–over 30 people turned up and a very lively discussion ensued. I also went into considerably more detail on the modelling, and my approach to modelling in general.