Source: Advisor Perspectives

A foundational principle of modern economics is that the creation of credit leads to economic growth. That precept underlies need for quantitative easing, and it is central to the question of what role monetary policy can and should play in stimulating a faster recovery from the Great Recession. It is also the subject of a debate between one of the world’s most prominent economic scholars, Paul Krugman, and a feisty Australian economist, Steve Keen.

Krugman is an unusually public figure for an academic. The Nobel Prize-winner and Princeton professor is also a widely-read New York Times columnist and prolific blogger, with the gift – unusual for someone in so wonky a profession – of clear and persuasive prose. He has earned a large and passionate audience, among them both ardent acolytes and rabid detractors. Krugman represents the mainstream of neoclassical economics, which believes that a combination of central bank monetary policy and government fiscal policy can moderate the business cycle.

Among the dissidents is Keen, the author of a provocative book, Debunking Economics. By his own admission, Keen is proudly out of the mainstream, but also able (“because of impediments like academic tenure,” he says in his book) to challenge it without fatal retribution. Keen thinks central bank controls are not as effective as Krugman believes, because private banks can create money in the form of debt through a process that is beyond the central bank’s control. Because of that, the economy will regularly experience “financial instability,” as advocated by Keynes’s disciple Hyman Minsky.

The debate in the blogosphere between those in the Krugman camp and those in the Keen camp has generated more heat than light; but the core of the debate is whether or not private banks can create money “out of thin air” to their heart’s content, by extending credit – leaving the central bank with no choice but to sanction this money creation.

Keen has taken aim at Krugman, and about a month ago Krugman, welcoming the challenge(at least initially), responded to Keen several times on his blog, setting off a furor in the economics blogosphere that has reverberated well beyond it.

I reviewed the exchange between Keen and Krugman, as well as much of the voluminous blog traffic of commenters weighing in, often to support one side or the other. I also conducted a personal phone interview with Keen. (I contacted Krugman through The New York Times to ask for an interview but did not receive a response.) These efforts shed new light for me on this debate, which I share below.

The crisis in economics

Economics is in a state of ferment; I would like to be able to say it is like physics before Einstein, but economics is not remotely comparable to Newtonian physics, and no Einstein-esque economist is going to perfect it.

The critical state of economic theory has been exacerbated by the financial crisis, and numerous heterodoxies today bedevil the neoclassical mainstream – Post-Keynesianism, followers of Hyman Minsky, Modern Monetary Theory, Austrian economics, even Marxist economics. These alternative ideasets have been chronicled in The Economist, and a partial cast of characters has been mapped in The Washington Post. Most of the debate goes on in the blogosphere, which is particularly prolix on this subject. I have noticed that virtually all of the bloggers are economists – they may or may not be academics, but they generally have economics degrees.

The volume of internet chatter among professional economists is staggering. A friend of mine was once chairman of the Federal Reserve Bank of Kansas City. He is not an economist but a businessman. (No, my friend is not Herman Cain.) He told me that when he arrived in the position, he found that there were 170 economists who reported to him – and he didn’t have the foggiest idea what they were all doing with their time. Now that I’ve read so much of the blogging on this subject, I think I could tell him. They are all kibitzing about Fed policy, reading charts and data and constructing models.

The bloggers are trying to determine what central bank policy should be. Some of the new schools of economics believe central banks like the Federal Reserve can create all the money they want without negative consequences. Others believe central banks shouldn’t exist at all. Some schools believe that, instead of trying to fine-tune a balance between inflation and GDP growth, the Fed should just target a constant rate of nominal GDP growth, to effect a balance of inflation and GDP growth all in one bang. And others still, believe the central bank has little to say about it because booms and busts will occur whatever it does (this is closest to the locus of the Keen-Krugman debate.)

The core of the dispute

The central question in the Keen-Krugman interchange is whether banks can create money with complete freedom, or whether they are effectively constrained by the actions of the central bank. The question at issue is whether banks can “create credit out of thin air,” a notion that seems to have been first advocated by the economist Joseph Schumpeter. Keen and others of his faction say they can; Krugman says they can’t.

But there are really two aspects to the debate. The first is the general charge that all of neoclassical economic theory is bankrupt because it is enthralled with equilibrium, and therefore it cannot model or understand the dynamic evolutionary economic process. That is to say, the essential nature of the economy is to be in disequilibrium, so theories obsessed with equilibrium cannot model it.

This charge seems wholly valid to me. In answer to the mainstream’s deficiencies, Keen said in my interview with him, “I want to eliminate the neoclassical mainstream and replace it with a Schumpeterian dynamic growth evolutionary mainstream.”

Schumpeter, you’ll recall, was the economist who coined the term “creative destruction” to characterize the capitalist economic process – a term beloved by nearly all economists, but of which it is difficult to find any trace in mainstream economic models. Says Keen, “Creative destruction doesn’t involve equilibrium, so they leave it out completely. It’s about how investment comes in pulses and waves … so you get an inherent explanation for the cyclicality of capitalism out of Schumpeter.”

The second aspect is a chicken-and-egg problem: Do banks take in deposits and then lend, or do they loan first, then use the proceeds of the loan to create deposits? It is not merely a chicken-and-egg question – those, like Keen, who say banks can create money out of thin air also say that the central bank must condone, willy-nilly, this so-called “endogenous” money creation. Krugman, on the other hand, says the central bank can control the process. That is, he believes money is created only “exogenously” by the central bank. Keen is a disciple of Hyman Minsky, who was a disciple of John Maynard Keynes but also of Schumpeter. Minsky believed that this process of banks creating money, in the form of debt, would inevitably lead to frequent financial bubbles and crises.

Judging from how much feverish blogging there has been surrounding the Keen-Krugman battle alone, this is a thorny question to resolve one way or the other. The amazing thing is that, in this debate, one side or the other will present what appears to be a very simple proof that they are right – and yet the other side is not persuaded in the least.

What really bothers me about the debate

It is difficult for a non-economist to decipher the debates, which revolve around esoteric terminology known only to the disputants – like “aggregate demand” and even “money.” Most people certainly don’t know what economists mean by “money.” A friend of mine told me he was at a meeting recently with a number of people, most of whom thought that when the central bank increased the money supply it actually physically printed currency – and all the people at the meeting were financial advisors.

As I said, almost all of the debates are among economists, bandying about terms that are, in principle, quantified aggregates of manifestly intangible, imprecisely defined theoretical objects like “aggregate demand,” “economic growth,” and “money” (not just currency), none of which can be measured very accurately, even if they are defined. Then they make stepwise arguments involving causality from one aggregate to another, like “an increase in money increases aggregate demand.” These feel to me like either verbally constructed tautologies, or oversimplifications of a more complex process.

For example in one of the most enlightening blog entries that I found discussing the Krugman-Keen debate, written by a University of Massachusetts graduate student named Josh Mason, Mason actually tries – I say “tries;” I do not think he succeeded – to clarify what “aggregate demand” really means. Is the orthodox view that aggregate demand is the same thing as aggregate income? Not quite, Mason says: “The question, as always, is which way causality runs. The term ‘aggregate demand’ is shorthand for the argument that causality runs from aggregate expenditure to aggregate income, whereas pre-Keynesian orthodoxy held that causality ran strictly from income to expenditure.”

But surely causality doesn’t only run one way. This was George Soros’s insight in the concept he calls “reflexivity;” in Soros’s application, this means that the price implied byprojected future earnings for an investment can also be a cause of those earnings. Causality runs both ways, complicating the relationship.

I am particularly baffled by these debates, because my background is in pure mathematics. Economics pretends to be mathematics, but it is not mathematics. There is a major difference. No mathematician uses a term in a formula, or a statement of a theorem, unless that term has first been defined with excruciating precision. Hence, there is no question of what the term means, let alone any debate that is carried on only because two disputants have different concepts of the meaning of their terms. As a result, a very simple proof of something will invariably persuade the other side. The cost of this, however, is that mathematics is strictly limited in what it can define and prove.

In economics, it is completely different. Terms are used in formulas without ever having been precisely defined. Economists may think they’ve defined them, but they should try reading some real mathematics to see what a precise definition truly is. The economists, I think, leave the work of definition to be inferred from the way the terms are used in the formulas. This, to me, is weird – but I suppose it could work, and it does work sometimes, but more often it leads to ridiculous debates that leave matters of real importance unexamined.

That seems to be the case in the Keen-Krugman faceoff. The most central terms – inflation and GDP – are so riddled with measurement problems that they are almost arbitrary fictions, a reality with which no one ever grapples. There is never so much as a nod to the fact that a large body of intelligent people believe that economic growth, by mathematical necessity, cannot continue forever, or even for long – yet efforts to define clearly enough what “economic growth” means in order to close the gap with this external (and sometimes internal) body of thought are rarely seen in debates among economists.

Understanding Minsky in common-sense terms

I think economics often becomes clearer if you disdain the abstractions and think in more ordinary terms.

The economist Randall Wray, a disciple of Minsky, makes things a little clearer by pointing out that Minsky said that anybody can create money out of thin air, by loaning to someone else. That at least gets us to stop thinking that we can only discuss aggregates of ill-defined monetary units mediated by institutions.

As an experiment, I tried thinking about it this way. Suppose there is a community in which some particularly well-respected person – let’s call her Ms. X – is not only held to have high credibility, but is also assumed to have a significant wealth, or access thereto.

Ms. X lends her credibility – not to say, sometimes, explicitly her credit – to numerous people in the community in whom she believes. Her honor and sense of responsibility are of such a high order that she tends to command these same qualities in others. Hence, her credibility and/or credit tend to rub off on, and to be extended to, anyone for whom she vouches – and she vouches for many people.

Hence, for example, an innovative writer of children’s books wishes to try creating a line of books using specialized expertise that can be provided by an arts and crafts supplier in the community. Ms. X recommends the book writer to the arts and crafts supplier, vouching that the book writer is someone whom Ms. X esteems and stands behind. The book writer asks the supplier to provide certain materials and expertise to facilitate her innovation.

These agreements or collaborations can be cemented through loan agreements, with Ms. X as countersigner or extender of credit, or merely through a tacit underlying presumption of Ms. X as guarantor, in cash or in kind. After all, aren’t all exchanges and collaborations some combination of extensions both of credit in strict monetary terms, as well as in the broader sense – the sense meaning trust or expectations of eventual compensatory treatment?

The point is that, with the general level of credit extended by Ms. X to many people, economic activity will no doubt increase. “Aggregate demand” will increase. “Money” will increase. These statements are true not because they are true in some quantitative sense, but because they are true qualitatively – the degree to which the economic activity, the aggregate demand, and even the “money” all increase could probably be measured, after a fashion, but it would be very approximate.

The source of all the confusion, in my view, is the idea that if you can’t measure something and model it mathematically, it has no meaning. There is too much mathematics used and expected in economics, and too much of it is of poor quality and distorts the ideas it is meant to undergird. Keen agrees. “If you’re actually aware of the limitations of mathematics, you say, ‘Well, this is a guide, but I could have missed something,’” he told me. “So there’s more modesty in a proper non-equilibrium dynamic modeling approach than you’ll ever get out of neoclassical equilibrium modeling.”

To go on with the Ms. X analogy, the economic growth that her spreading trust engenders is delicate. If she overextends – if she stands behind more people than she can actually back up, or if she has miscalculated the trustworthiness or credibility of some of her mentees – her own credibility – and through her, theirs – may suffer erosion. You can see how things could collapse quickly. This is, I believe, a simple version of the Minsky financial instability hypothesis.

This simple narrative confirms that creating “credit” in the broad sense – trust and confidence in your trading partners and collaborators – can help spawn economic activity, though it can also create a credit bubble that can break. But if the sole and entire purpose of this exercise were to get it put into formulas, you can see how you might lose a lot of the texture. Perhaps it’s possible, but if you do it too soon, and too imprecisely, you’ll create a Babel in which people fight over the formulas, instead of over what’s actually going on.

Michael Edesess is an accomplished mathematician and economist with experience in the investment, energy, environment and sustainable development fields. He is a Visiting Fellow at the Hong Kong Advanced Institute for Cross-Disciplinary Studies, as well as a partner and chief investment officer of Denver-based Fair Advisors. In 2007, he authored a book about the investment services industry titled The Big Investment Lie, published by Berrett-Koehler.

These are the themes of his new book, End This Depression Now. In old-fashioned Keynesian style he believes that the solution to insufficient market demand is for the government to run larger budget deficits. It should start by giving revenue-sharing grants of $300 billion annually to states and localities whose budgets are being squeezed by the decline in property taxes and the general economic slowdown.

All this is a good idea as far as it goes. But Mr. Krugman stops there – as if that is all that is needed today. So what he has done is basically get into a fight with intellectual pygmies. Thus dumbs down his argument, and actually distracts attention from what is needed to avoid the financial and fiscal depression he is warning about.

Here’s the problem: To focus the argument against “Austerian” advocates of fiscal balance, Mr. Krugman hopes that economists will stop distracting attention by talking about what he deems not necessary. It seems not necessary to write down debts, for example. All that is needed is to reduce interest rates on existing debts, enabling them to be carried.

Mr. Krugman also does not advocate shifting taxes off labor onto property. The implication is that California can afford its Proposition #13 – the tax freeze on commercial property and homes at long-ago levels, which has fiscally strangled the state and led to an explosion of debt-leveraged housing prices by leaving the site value untaxed and hence free to be pledged to banks for larger and larger mortgage loans instead of being paid to the public authorities. There is no hint in Mr. Krugman’s journalism of a need to reverse the tax shift off real estate and finance (onto income and sales taxes), except to restore a bit more progressive taxation.

The effect of Mr. Krugman’s suggestions is for the government to subsidize the existing financial and tax structures, leaving the debts intact and ignoring the largely regressive, unfair and inefficient system of taxation. It is unfair because the profits of the rich – and even worse, their asset-price (“capital”) gains are taxed at lower rates and riddled with tax loopholes and giveaways. The wealthy benefit from the windfall gains delivered by the public infrastructure investment advocated by Mr. Krugman, but there is not a word about the public recouping this investment. Governments are indeed able to create their own money as an alternative to taxing, but some taxes – above all, on windfall gains, like locational value resulting from public investment in roads or other public transportation – are justified simply on grounds of economic fairness.

So it is important to note what Mr. Krugman does not address these issues that once played so important a role in Democratic Party politics, before the Wall Street faction gained control via the campaign financing process – even before the Citizens United case. For over a century, economists have recognized the need for financial and fiscal reform to go together. Failure to proceed with a joint reform has led the banking and financial sector – along with its major client base, the real estate sector – to scale back property taxes and “free” the economy with taxes so that the revenue can be pledged to the banks as interest to carry larger loans. The effect is to load the economy at large down with private and public debt.

In Mr. Krugman’s reading, private debts need not be written down or the tax system made more efficient. It is to be better subsidized – mainly with easier bank credit and more government spending. So I am afraid that his book might as well have been subtitled “How the Economy can Borrow its Way Out of Debt.” That is what budget deficits do: they add to the debt overhead. In Europe, which has no central bank permitted to monetize the deficit spending, this pays interest to transfers to the bondholders (and their descendants). In the United States, the Federal Reserve can monetize this indebtedness – but the effect is to subsidize domestic debt service.

Mr. Krugman has become censorial regarding the debt issue over the last month or so. In last Friday’s New York Times column he wrote: “Every time some self-important politician or pundit starts going on about how deficits are a burden on the next generation, remember that the biggest problem facing young Americans today isn’t the future burden of debt.”[1]

Unfortunately, Mr. Krugman’s failure to see today’s economic problem as one of debt deflation reflects his failure (suffered by most economists, to be sure) to recognize the need for debt writedowns, for restructuring the banking and financial system, and for shifting taxes off labor back onto property, economic rent and asset-price (“capital”) gains. The effect of his narrow set of recommendations is to defend the status quo – and for my money, despite his reputation as a liberal, that makes Mr. Krugman a conservative. I see little in his logic that would oppose Rubinomics, which has remained the Democratic Party’s program under the Obama administration.

Many of Mr. Krugman’s readers find him the leading hope of opposing even worse Republican politics. But what can be worse than the Rubinomics that Larry Summers, Tim Geithner, Rahm Emanuel and other Wall Street holdovers from the Democratic Leadership Committee have embraced?

Perhaps I can prod Mr. Krugman into taking a stronger position on this issue. But what worries me is that he has moved sharply to the “Rubinomics” wing of his party. He insists that debt doesn’t matter. Bank fraud, junk mortgages and casino capitalism are not the problem, or at least not so serious that more deficit spending cannot cure it. Criticizing Republicans for emphasizing structural unemployment, he writes: “authoritative-sounding figures insist that our problems are ‘structural,’ that they can’t be fixed quickly. … What does it mean to say that we have a structural unemployment problem? The usual version involves the claim that American workers are stuck in the wrong industries or with the wrong skills.” [2]

Using neoclassical sleight-of-hand to bait and switch, he narrows the meaning of “structural reform” to refer to Chicago School economists who blame today’s unemployment as being “structural,” in the sense of workers trained for the wrong jobs. This diverts the reader’s attention away from the pressing problems that are genuinely structural.

The word “structural” refers to the systemic imbalances that neoclassical economists dismiss as “institutional”: the debt overhead, the legal system – especially unfair and dysfunctional bankruptcy and foreclosure laws, regulations against financial fraud, and wealth distribution in general. In 1979, for example, I juxtaposed economic structuralism to Chicago School monetarism in my monograph on Canada in the New Monetary Order. I have elaborated that discussion in my textbook on Trade, Development and Foreign Debt (new ed. 2010). The tradition is grounded in the Progressive Era’s reform program. Correcting such structural and institutional defects, parasitism and privilege seeking “free lunches” is what classical political economy was all about – and what the neoclassical reaction sought to exclude from the economic curriculum. But from the perspective of neoclassical writers through Rubinomics deregulators, the problem of massive, unpayably high debt expanding inexorably by compound interest (and penalty fees) simply disappears.

So the great problem today is whether to stop the siphoning off of income and wealth to financial institutions at the top of the economic pyramid, or reverse the polarization that has taken place over the past thirty years between creditors and debtors, financial institutions and the rest of the economy. I realize that it is more difficult to criticize someone for an error of omission than for an error of commission. But the distinction was erased a month ago when Mr. Krugman got lost in the black hole of banking, finance and international trade theory that has engulfed so many neoclassical and old-style Keynesian economists. Last month Mr. Krugman insisted that banks do not create credit, except by borrowing reserves that (in his view) merely shifts lending savings from wealthy people to those with a higher propensity to consume. Criticizing Steve Keen (who has just published a second edition of his excellent Debunking Economics to explain the dynamics of endogenous money creation), he wrote:

Keen then goes on to assert that lending is, by definition (at least as I understand it), an addition to aggregate demand. I guess I don’t get that at all. If I decide to cut back on my spending and stash the funds in a bank, which lends them out to someone else, this doesn’t have to represent a net increase in demand. Yes, in some (many) cases lending is associated with higher demand, because resources are being transferred to people with a higher propensity to spend; but Keen seems to be saying something else, and I’m not sure what. I think it has something to do with the notion that creating money = creating demand, but again that isn’t right in any model I understand.

Keen says that it’s because once you include banks, lending increases the money supply. OK, but why does that matter? He seems to assume that aggregate demand can’t increase unless the money supply rises, but that’s only true if the velocity of money is fixed;[3]

But “velocity” is just a dummy variable to “balance” any given equation – a tautology, not an analytic tool. As a neoclassical economist, Mr. Krugman is unwilling to acknowledge that banks not only create credit; in doing so, they create debt. That is the essence of balance sheet accounting. But writing like a tyro, Mr. Krugman offers the mythology of banks that can only lend out money taken in from depositors (as though these banks were good old-fashioned savings banks or S&Ls, not what Mr. Keen calls “endogenous money creators”). Banks create deposits electronically in the process of making loans.

Mr. Krugman then doubled down on his assertion that bank debt creation doesn’t matter. People decide how much income they want to save, or decide how much to borrow to buy goods that their stagnant wage levels no longer enable them to afford. Everything is a matter of choice, not a necessity (“price-inelastic” is the neoclassical euphemism) said Krugman:

First of all, any individual bank does, in fact, have to lend out the money it receives in deposits. Bank loan officers can’t just issue checks out of thin air; like employees of any financial intermediary, they must buy assets with funds they have on hand.

So how much currency does the public choose to hold, as opposed to stashing funds in bank deposits? Well, that’s an economic decision, which responds to things like income, prices, interest rates, etc.. In other words, we’re firmly back in the domain of ordinary economics, in which decisions get made at the margin and all that. Banks are important, but they don’t take us into an alternative economic universe.

As I read various stuff on banking — comments here, but also various writings here and there — I often see the view that banks can create credit out of thin air. There are vehement denials of the proposition that banks’ lending is limited by their deposits, or that the monetary base plays any important role; banks, we’re told, hold hardly any reserves (which is true), so the Fed’s creation or destruction of reserves has no effect.[4]

Not only do banks create new credit – debt, from the vantage point of their customers – but in the absence of government spending and regulation along more progressive lines, this new debt creation is the only way that the economy has avoided a sharp shrinking of consumption as real wages have remained stagnant since the late 1970s. The banks offer is one most people can’t refuse: “Take out a mortgage or go without a home,” or “Take out a student loan or go without an education and try to get a job at McDonald’s.” In other words, “Your money or your life.” It is what banks have been saying throughout the ages.

The difference is that they can now create credit freely – and as Alan Greenspan has pointed out to Senate committees, workers are so debt-burdened (“one check away from homelessness”) that they are afraid that if they complain about working conditions, ask for higher salaries (to say nothing of trying to unionize), they will be fired. If they miss a paycheck their credit-card rates will soar to about 29%. And if they miss a mortgage payment, they may face foreclosure and lose their home. So the banking system has cowed the population with its credit- and debt-creating power.

Mr. Krugman’s blind spot with regard to the debt overhead derails trade theory as well. If Greece leaves the Eurozone and devalues its currency (the drachma), for example, debts denominated in euros or other hard currency will rise proportionally. So Greece cannot leave without repudiating its debts in today’s litigious global economy. Yet Mr. Krugman believes in the old neoclassical nonsense that all that is needed is “devaluation” to lower the cost of domestic labor. It is as if he is indifferent to the suffering that such austerity imposes – as Latin American countries suffered at the hands of IMF austerity plans from the 1970s onward. Costs can “be brought in line by adjusting exchange rates.”[5] The problem thus is simply one of exchange rates (which translates into labor costs in short order). Currency depreciation will (in Mr. Krugman’s trade theory) reduce labor’s cost and other domestic costs to the point where governments can export enough not only to cover their imports, but to pay their foreign-currency debts (which will soar in depreciated local-currency terms).

If this were the case, Germany could have paid its reparations debt by depreciating the mark in 1921. But it did so by a billion-fold and even this did not suffice to pay. Neither neoclassical trade theorists nor Chicago School monetarists get the fact that when public or private debts are denominated in a foreign (hard) currency, devaluation devastates the economy. The past half-century has shown this again and again (most recently in Iceland). Domestic assets are transferred into foreign hands – including those of domestic oligarchies operating out of their offshore dollar or Swiss-franc accounts.

Blindness to the debt issue results in especial nonsense when applied to analysis of why the U.S. economy has lost its export competitiveness. How on earth can American industry be expected to compete when employees must pay about 40 percent of their wages on debt-leveraged housing, about 10 percent more on student loans, credit cards and other bank debt, 15 percent on FICA, and about 10 to 15 percent more in income and sales taxes? Between 75 and 80 percent of the wage payment is absorbed by the Finance, Insurance and Real Estate (FIRE) sector even before employees can start buying goods and services! No wonder the economy is shrinking, sales are falling off, and new investment and hiring have followed suit.

How will the government running a larger deficit cope with today’s dimension of the debt problem – except by taking Mr. Krugman’s suggestion to enable states and localities to spend marginally more revenue and avoid further layoffs, while the military industrial complex steps up its “Pentagon capitalism”? So far, the great increase in recent government debt has been to bail out the banking sector, not to help the “real” economy recover.

Increasing the debt burden of European nations has the same dire consequences. Germany balks at bailing out Greece unless Greece moves to streamline its bloated government and inefficient bureaucracy, stop tax evasion by the wealthy, clean up corruption and, in a word, be more Germanic. The U.S. “Austerian” budget cutters whom Mr. Krugman criticizes likewise can point to wasteful government spending, failing to distinguish positive infrastructure investment from pork-barrel “roads to nowhere” and tax loopholes promoted by Congressional politicians whose campaigns are sponsored by special financial interests, real estate and monopolies.

But I fear that Mr. Krugman is being drawn into the gravitational pull of Rubinomics, the Democratic Party’s black hole from which the light of clarity dealing with the debt issue and bad financial and legal structures simply cannot escape. The only variables he admits are structure-free: The federal government can indeed spend more and reduce interest rates (especially on mortgages) so that the higher mortgage debt, student debt, personal debt and corporate debt overhead can be afforded more easily. No need to write any of these debts down. That seemingly obvious and sensible structural solution lies outside the scope of Mr. Krugman’s neoclassical economics. He fails to recognize that debts that can’t be paid, won’t be. This is the immediate problem facing the U.S. and European economies today – and the way in which it is resolved will shape the coming generation.

The problem with Mr. Krugman’s analysis is that bank debt creation plays no analytic role in Mr. Krugman’s proposals to rescue the economy. It is as if the economy operates without wealth or debt, simply on the basis of spending power flowing into the economy from the government, and being spent on consumer goods, investment goods and taxes – not on debt service, pension fund set-asides or asset price inflation. If the government will spend enough – run up a large enough deficit to pump money into the spending stream, Keynesian-style – the economy can revive by enough to “earn its way out of debt.” The assumption is that the government will revive the economy on a broad enough scale to enable the individuals who owe the mortgages, student loans and other debts – and presumably even the states and localities that have fallen behind in their pension plan funding – to “catch up.”

Without recognizing the role of debt and taking into account the magnitude of negative equity and earnings shortfalls, one cannot see thatwhat is preventing American industry from exporting more is the heavy debt overhead that diverts income to pay the Finance, Insurance and Real Estate (FIRE) sector. How can U.S. labor compete with foreign labor when employees and their employers are obliged to pay such high mortgage debt for its housing, such high student debt for its education, such high medical insurance and Social Security (FICA withholding), such high credit-card debt – all this even before spending on goods and services?

In fact, how can wage earners even afford to buy what they produce? The problem interfering with the circular flow between producers and consumers (“Say’s Law”) is not “saving” as such. It is debt payment. And unless debts are written down, the U.S. economy will shrink just as will the economies of Greece, Spain, Portugal, Italy, Ireland, Iceland and other countries subjected to the Washington Consensus of neoliberal austerity.

Michael Hudson’s new book summarizing his economic theories, “The Bubble and Beyond,” will be available in a few weeks on Amazon.

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. experience supervising postgraduate research students

. ability to contribute to one or more of the interdisciplinary programs and/or initiatives with which the department is involved (e.g. Masters in Development Studies).

This role presents an excellent opportunity to grow and develop your academic career in a school that offers innovative degrees at undergraduate and postgraduate levels, that attract the very best students from Australia and overseas.

All applications must be submitted via the University of Sydney careers website. Visit sydney.edu.au/positions and search by the reference number for more information and to apply.

CLOSING DATE: 7 June 2012 (11.30pm, Sydney time)

The University reserves the right not to proceed with any appointment.

The University is an Equal Opportunity employer committed to equity, diversity and social inclusion. Applications from equity target groups and women are encouraged.

For more information please contact Lynne Chester via email: lynne.chester@sydney.edu.au

Personal credit and business credit have been the deadweight’s, averaging an annual growth of -1% and -0.5% respectively. Housing credit has offset this with an average annual growth rate of 6.9% since October 2008. However, this has since slowed to an average annual rate of 5.3% for the first 3 months of this year and is continuing on this slowing trend. With significantly less credit coming into the market, the Government have had no choice but to compensate deficit spending.

Though, as pointed out in last week’s blog post Inflation or Noflation, the ALP has recently embarked on a mission of austerity to please the big rating agencies.

*As at the 27^th April 2012

This leaves increasingly fewer options to maintain a path of economic growth here in Australia. The deterioration in credit growth has forced the RBA to revise their already revised economic outlooks. The following graphs review the RBA’s predications versus the actual outcomes for both growth and inflation.

While the accuracy of these outlooks is debatable, the precision of their recent 2012 prediction for inflation has positioned the Bank well in justifying a 50 basis point reduction of the target cash rate on Tuesday 1 May. However, given the two 25 basis point reductions for November and December last year had no noticeable effect on credit growth, particularly housing credit growth, I would suggest this measure will too provide little effectiveness. And then, of course, there is always the question of how much the big banks will actually pass on with their increasing funding costs. NAB have so far been the first, passing on 32bps.

With mining conditions deteriorating, house prices falling, Government austerity measures, a struggling retail sector and lack of effectiveness through monetary stimulus, unfortunately the Australian economy has nowhere to grow.

Click here for data in Excel: Debtwatch; CfESI
Click here for more data in Excel: Debtwatch; CfESI
Click here for this post in PDF: Debtwatch; CfESI

Chris Vedelago had a very nice piece about how confusing the various commercial house price statistics are:

The Real Estate Institute of Victoria said the city’s median house price rose 0.9 per cent in the March quarter. Except that, according to RP Data-Rismark, it fell 1 per cent. Australian Property Monitors, which is owned by Fairfax, believes prices rose 1.6 per cent in the three-month period. Residex, on the other hand, estimates values fell 1.9 per cent… (“Confused about the market? We all are“, The Age April 29)

I’m happy to ignore these numbers—and even more so the spin doctoring that goes with them. The ABS numbers are in, and they show a 1.1% national fall over the March quarter. Sydney house prices fell 1.8% according to the ABS, whereas Australian Property Monitor alleged they rose 1.4%—the latter being the basis for Andrew “Always Look On the Bright Side” Wilson’s latest piece “Confidence rises as prices bounce back” (SMH April 28). Yeah, right.

Australian House prices have now fallen 6.1% from their peak, and have been falling for 21 months, which is the longest downturn in nominal prices ever recorded by the ABS—the previous longest being the 12 months from the beginning of the GFC (which was terminated by my favourite government policy of all time, the First Home Vendors Boost).

Figure 1: Nominal house prices have fallen 6.1% since June 2010

I’m sure the usual spruikers will come out with why this is now the bottom, and it’s a good time to buy, and there wasn’t an Australian house price bubble, and the shortage will drive up prices, and… So let’s put the current data in the context of the bursting of acknowledged overseas house price bubbles.

Firstly the inflation adjusted data: in real terms, house prices have now fallen 10% from their June 2010 peak, and are back to a level they first reached in late 2007.

Figure 2: Real house prices have fallen 10% since June 2010

Now let’s compare the Australian experience to date with the Japanese and US experiences—where no-one, not even Alan Greenspan, denies that there was a housing bubble. The Japanese bubble peaked in June 1991; the US bubble peaked in in May 2006; and Australian house prices peaked in June 2010. Figure 3 shows the three declines from the peak, and while the Australian experience so far is clearly better than the USA’s, it’s only a whisker better than the Japanese experience to the same date after the peak.

Figure 3: Comparing Japanese, US and Australian house prices from their peaks

Anyone who takes comfort from that should also consider the longer term perspective—see Figure 4.

Figure 4: The long term picture for Japan and the USA

The motive force behind Australia’s bubble was the same as in the USA and Japan: accelerating debt drove rising house prices during the boom. Now in both those countries, decelerating debt is driving house prices down. The same pattern applies in Australia—see Figure 5 .

Figure 5: Mortgage acceleration drives change in house prices

Don’t take heart from the uptick in acceleration at the end of the series there: for that to be sustained into the future, ultimately Australian mortgage debt would need to start rising (compared to GDP). But mortgage debt grew more rapidly here and reached a higher peak than in the USA (see Figure 6); the odds that it will rise again are slim.

Figure 6: Australian mortgage debt exceeded the USA’s

And even though the actual level of mortgage debt is still rising, it’s doing so at the slowest rate ever recorded by the RBA (see Figure 7).

Figure 7: Annual growth in mortgage debt (with series break in 1991)

The odds are that the rate of decline will accelerate in the next year—since as Leith van Onselen pointed out yesterday, many Baby Boomers are relying on rising house prices to secure their retirements. Now that house prices are falling, and have been doing so for almost 2 years, many of these Boomers—74% of whom earn less than $80,000 a year, with the average investor losing over $9,000 a year on these “investments”—could decide to get out rather than continue to absorb losses. The unwinding of their leveraged positions could push mortgage growth below zero, and of course accelerate the house price fall.

Financial stability, or the lack thereof. Leading thinkers speak out on what they feel is at the core of the problem.

It is likely that Tuesday’s meeting will be the point at which the RBA will have to abandon their expectations of rising interest rates to tame an Inflation bogie that has turned out to be Noflation in practice. In the April meet minutes, the RBA board finished with:

…If slower growth in demand could be expected to result in a more moderate inflation outcome, then a case could be made for a further easing of monetary policy. The Board would have the opportunity at its next meeting to review the inflation outlook based on comprehensive new data on prices, as well as information on demand and output. Members judged it prudent to evaluate those data before considering a further policy adjustment.

Can an annualised inflation rate of 1.6% make this case? Interestingly enough, it was less than one year ago when commercial news headlines were still talking about a rate rise – RBA’s Stevens hints at August interest rate rise:

The market has been paying more attention to a recent run of mixed domestic data which has shown jobs growth slowing, weakness in housing and credit and a sharp contraction in the economy in the first quarter as flooding hit coal exports.

Mr Stevens, however, made it very clear that he remains focused on the longer term impact of a huge trade and mining boom that should boost incomes and investment over time.

One could be almost certain that such a decision is off the cards now, especially given the recent decline in government bond yields for the month of April.

There will also be no fiscal stimulus for the month of April, thanks to the recent austerity measures of the Australian Government. This leaves monetary policy to take up the slack for a slow down in Government deficit funded growth.

*As at 20 April 2012

It seems Wayne Swan is playing ball with the big rating agencies to protect the nation’s AAA rating.

Noflation clearly indicates that excessive consumer debt and a lack of liquidity in present market are causing downward pressure on prices. The standout noflationary phenomenon has been the decline in house prices of 4.8% per cent over the year to December 2011, which is straining many households as many homes fall into negative equity. Graph 3.6 from the RBA Financial Stability Review for March 2012 shows a noticeable increase in LVRs greater than or equal to 90%. According to Perth Now, Western Australia is the second highest state in Australia in terms of negative equity, where 8.5% of homes are currently worth less than was paid for them. Having said this, Graph 3.10 shows home loan arrears appear to have taken a sharp turn from the increasing trend in the 2011 Financial Stability Reviews.

It seems quite transparent that without a stimulus to liquidity via a rate cut next Tuesday, noflation could easily become deflation in months to come. Some mining boom…

The Just Banking conference organised by the Friends of the Earth Scotland was a fitting finale. I won’t write too much about it here–I’m too tired–but I’m sure Beth and friends will do a good write-up. For now, here is a screen recording of my presentation and the Powerpoint slides; later we’ll add the video as well.

Alan introduces the book saying:

‘The purpose of this book is to lay out an economics that makes sense of history, including the revolutionary history of the present time. This “Demand Side” economics is not new. It was originated and developed by the great British economist John Maynard Keynes and by the acolytes of the pragmatic programs of the New Deal. It is called Demand Side economics because demand is the fundamental driver of economic progress and constraint in economic stagnation. The organization of demand is the organization of the economy. What is demanded is what is supplied, in scale and in selection. Employment, investment, growth and development occur along the path of what is demanded. That demand can be for public or private goods. We describe and display the demand side framework by following its development through the thought of a series of influential economists, beginning with Keynes and ending with Steve Keen and Nouriel Roubini. Through their work, concepts and analytical tools we can look in on the development of the modern economy since 1930.’

Chapter 11 is Steve’s feature chapter entitled, Steve Keen and the Great Recession, opening with a quote: