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Two con­sec­u­tive ISP crash­es trashed all my posts, and the site has only been repaired thanks to work from sup­port­ers to reload text and graph­ics from the Way­Back machine. Unfor­tu­nate­ly the graph­ics for this page haven’t yet been restored, so if you want to read the argu­ment here prop­er­ly, please down­load the PDF:

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The fun­da­men­tal cause of the eco­nom­ic and finan­cial cri­sis that began in late 2007 was lend­ing by the finance sec­tor that pri­mar­i­ly financed spec­u­la­tion rather than invest­ment. The pri­vate debt bub­ble this caused is unprece­dent­ed, prob­a­bly in human his­to­ry and cer­tain­ly in the last cen­tu­ry (see Fig­ure 1). Its unwind­ing now is the pri­ma­ry cause of the sus­tained slump in eco­nom­ic growth. The recent growth in sov­er­eign debt is a symp­tom of this under­ly­ing cri­sis, not the cause, and the cur­rent polit­i­cal obses­sion with reduc­ing sov­er­eign debt will exac­er­bate the root prob­lem of pri­vate sec­tor delever­ag­ing.

Fig­ure 1

US pri­vate debt clear­ly rose faster than GDP from the end of World War II (when the debt to GDP ratio was 43%) until 2009 (when it peaked at 303%), but there is no intrin­sic rea­son why it (or the pub­lic sec­tor debt to GDP ratio) has to rise over time. I give a the­o­ret­i­cal expla­na­tion else­where (Keen 2010), but an empir­i­cal com­par­i­son will suf­fice here: 1945 till 1965 were the best years of the Aus­tralian economy—with unem­ploy­ment aver­ag­ing 2 percent—and dur­ing that time the pri­vate debt ratio remained rel­a­tive­ly con­stant at 25% of GDP (see Fig­ure 2).

Fig­ure 2

Amer­i­ca’s min­i­mum pri­vate debt ratio in 1945 may have been arti­fi­cial­ly low in the after­math of both the Great Depres­sion and World War II (and there are good rea­sons why the US econ­o­my should have a high­er sus­tain­able debt ratio than does Aus­tralia), but at some time between 1945 and Amer­i­ca’s first post-WWII finan­cial cri­sis in 1966 (Min­sky 1982, p. xiii), it passed this lev­el.

The explo­sion in spec­u­la­tive debt drove asset prices to all-time highs—relative to con­sumer prices—from which they are now inex­orably col­laps­ing (see Fig­ure 3 and Fig­ure 4).

Fig­ure 3

Fig­ure 4

The debt and asset price bub­bles were ignored by con­ven­tion­al “Neo­clas­si­cal” econ­o­mists on the basis of a set of a pri­ori beliefs about the nature of a mar­ket econ­o­my that are spu­ri­ous, but deeply entrenched. Under­stand­ing how this cri­sis came about will require a new, dynam­ic, mon­e­tary approach to eco­nom­ic the­o­ry that con­tra­dicts the neat, plau­si­ble and false Neo­clas­si­cal mod­el that cur­rent­ly dom­i­nates aca­d­e­m­ic eco­nom­ics and pop­u­lar polit­i­cal debate.

Escap­ing from the debt trap we are now in will require either a “Lost Gen­er­a­tion”, or poli­cies that run counter to con­ven­tion­al eco­nom­ic thought and the short-term inter­ests of the finan­cial sec­tor.

Pre­vent­ing a future cri­sis will require a rede­f­i­n­i­tion of finan­cial claims upon the real econ­o­my which elim­i­nates the appeal of lever­aged spec­u­la­tion.

These three obser­va­tions lead to the three pri­ma­ry objec­tives of Debt­watch:

  1. To devel­op a real­is­tic, empir­i­cal­ly based, dynam­ic mon­e­tary approach to eco­nom­ic the­o­ry and pol­i­cy;
  2. To devel­op and pro­mote a “mod­ern Jubilee” by which pri­vate debt can be reduced while doing the min­i­mum pos­si­ble harm to aggre­gate demand and social equi­ty; and
  3. To devel­op and pro­mote new def­i­n­i­tions of shares and prop­er­ty own­er­ship that will min­i­mize the destruc­tive insta­bil­i­ties of cap­i­tal­ism and pro­mote its cre­ative insta­bil­i­ties.

A realistic economics

The eco­nom­ic and finan­cial cri­sis has been caused by unen­light­ened self-inter­est and fraud­u­lent behav­iour on an unprece­dent­ed scale. But this behav­iour could not have grown so large were it not for the cov­er giv­en to this behav­iour by the dom­i­nant the­o­ry of eco­nom­ics, which is known as “Neo­clas­si­cal Eco­nom­ics”.

Though many com­men­ta­tors call this the­o­ry “Key­ne­sian”, one of Key­nes’s objec­tives in the 1930s was to over­throw this the­o­ry, but instead, as the mem­o­ry of the Great Depres­sion reced­ed, aca­d­e­m­ic econ­o­mists grad­u­al­ly con­struct­ed an even more extreme ver­sion of Neo­clas­si­cal eco­nom­ics than that against which Keynes had fought. This began with Hick­s’s “IS-LM” mod­el, which is still accept­ed as rep­re­sent­ing “Key­ne­sian” eco­nom­ics today, but which was in fact a Neo­clas­si­cal mod­el derived two years before the Gen­er­al The­o­ry was pub­lished:

The IS-LM dia­gram, which is wide­ly, but not uni­ver­sal­ly, accept­ed as a con­ve­nient syn­op­sis of Key­ne­sian the­o­ry, is a thing for which I can­not deny that I have some respon­si­bil­i­ty… “Mr. Keynes and the Clas­sics” (Hicks 1937) was actu­al­ly the fourth of the rel­e­vant papers which I wrote dur­ing those years… But there were two oth­ers that I had writ­ten before I saw The Gen­er­al The­o­ry… “Wages and Inter­est: the Dynam­ic Prob­lem” (Hicks 1935) was a first sketch of what was to become the “dynam­ic” mod­el of Val­ue and Cap­i­tal (Hicks 1939). It is impor­tant here, because it shows (I think quite con­clu­sive­ly) that that [IS-LM] mod­el was already in my mind before I wrote even the first of my papers on Keynes. (Hicks 1981, pp. 139–140; empha­sis added; see also Keen 2011)

As it grew more vir­u­lent, neo­clas­si­cal the­o­ry encour­aged politi­cians to remove the bar­ri­ers to fraud that were erect­ed in the wake of the last great eco­nom­ic cri­sis, the Great Depres­sion, in the naïve belief that a dereg­u­lat­ed econ­o­my nec­es­sar­i­ly reach­es a har­mo­nious equi­lib­ri­um:

Macro­eco­nom­ics was born as a dis­tinct field in the 1940’s, as a part of the intel­lec­tu­al response to the Great Depres­sion. The term then referred to the body of knowl­edge and exper­tise that we hoped would pre­vent the recur­rence of that eco­nom­ic dis­as­ter. My the­sis in this lec­ture is that macro­eco­nom­ics in this orig­i­nal sense has suc­ceed­ed: Its cen­tral prob­lem of depres­sion pre­ven­tion has been solved, for all prac­ti­cal pur­pos­es, and has in fact been solved for many decades.’ (Lucas 2003 , p. 1 ; empha­sis added)

Reg­u­la­tors in its thrall—such as Greenspan and Bernanke—rescued the finan­cial sec­tor from a series of crises, with each one lead­ing to yet anoth­er until ulti­mate­ly this one, from which no return to “busi­ness as usu­al” is pos­si­ble.

Neo­clas­si­cal eco­nom­ics there­fore played an impor­tant role in mak­ing this cri­sis as extreme as it became. It is time to suc­ceed where Keynes failed, by both elim­i­nat­ing this the­o­ry and replac­ing it with a real­is­tic alter­na­tive.

Critiquing Neoclassical economics

Keynes was scathing about what he called “Clas­si­cal Eco­nom­ics”, and what we today call Neo­clas­si­cal Eco­nom­ics, lam­bast­ing its treat­ment of time, expec­ta­tions, uncer­tain­ty and mon­ey, and the sta­bil­i­ty or oth­er­wise of cap­i­tal­ism:

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…. a clas­si­cal econ­o­mist … has over­looked the pre­cise nature of the dif­fer­ence which his abstrac­tion makes between the­o­ry and prac­tice … par­tic­u­lar­ly the case in his treat­ment of Mon­ey…

This that I offer is, there­fore, a the­o­ry of why out­put and employ­ment are so liable to fluc­tu­a­tion.

The ortho­dox the­o­ry assumes that we have a knowl­edge of the future of a kind quite dif­fer­ent from that which we actu­al­ly pos­sess… The hypoth­e­sis of a cal­cu­la­ble future leads to a wrong inter­pre­ta­tion of the prin­ci­ples of behav­ior which the need for action com­pels us to adopt, and to an under­es­ti­ma­tion of the con­cealed fac­tors of utter doubt, pre­car­i­ous­ness, hope and fear (Keynes 1937, pp. 215–222)

Key­nes’s fail­ure to over­throw Neo­clas­si­cal eco­nom­ics led instead to its recon­struc­tion after the Great Depres­sion in an even more extreme form. This process cul­mi­nat­ed in “Ratio­nal Expec­ta­tions” macro­eco­nom­ics in which, rather than deal­ing with the present “by abstract­ing from the fact that we know very lit­tle about the future”, deals with it by assum­ing we can accu­rate­ly pre­dict the future!:

I should like to sug­gest that expec­ta­tions, since they are informed pre­dic­tions of future events, are essen­tial­ly the same as the pre­dic­tions of the rel­e­vant eco­nom­ic the­o­ry. (Muth 1961, p. 316)

In the pre­ced­ing sec­tion, the hypoth­e­sis of adap­tive expec­ta­tions was reject­ed as a com­po­nent of the nat­ur­al rate hypoth­e­sis on the grounds that, under some pol­i­cy [the gap between actu­al and expect­ed infla­tion] is non-zero. If the impos­si­bil­i­ty of a non-zero val­ue … is tak­en as an essen­tial fea­ture of the nat­ur­al rate the­o­ry, one is led sim­ply to adding the assump­tion that [the gap between actu­al and expect­ed infla­tion] is zero as an addi­tion­al axiom… or to assume that expec­ta­tions are ratio­nal in the sense of Muth. (Lucas 1972, p. 54; empha­sis added)

I wrote Debunk­ing Eco­nom­ics (Keen 2001; Keen 2011) to help pre­vent a Neo­clas­si­cal revival recur­ring after our cur­rent cri­sis is over. Here I have the advan­tage of time over Keynes: when he wrote The Gen­er­al The­o­ry, the flaws in neo­clas­si­cal eco­nom­ics were only vague­ly specified—and Keynes him­self kept many of those con­cepts alive, such as the mar­gin­al pro­duc­tiv­i­ty the­o­ry of income dis­tri­b­u­tion:

For every val­ue of [total employ­ment] there is a cor­re­spond­ing mar­gin­al pro­duc­tiv­i­ty of labour in the wage-goods indus­tries; and it is this which deter­mines the real wage. (Keynes 1936, p. 27)

Since then, the flaws have been ful­ly detailed, by crit­ics like Sraf­fa (Sraf­fa 1960) at one extreme to “own goals” like the Son­nen­schein-Man­tel-Debreu con­di­tions at the oth­er (Son­nen­schein 1973; Shafer and Son­nen­schein 1993). The ambi­tion of Debunk­ing Eco­nom­ics was to make the many flaws in neo­clas­si­cal eco­nom­ics so well known that, should the econ­o­my ever expe­ri­ence anoth­er Great Depres­sion, it would be that much hard­er for Neo­clas­si­cal eco­nom­ics to sur­vive (for more, see Debunk­ing Eco­nom­ics: the naked emper­or dethroned?;or buy the book: Ama­zon USA; Ama­zon UK; Kin­dle USA; Kin­dle UK; Abbey’s Aus­tralia).

I also pro­vide cri­tiques of con­ven­tion­al eco­nom­ic the­o­ry in my lec­tures, which I make more broad­ly avail­able via Youtube videos.

Developing an alternative

The seeds of an alter­na­tive, real­is­tic the­o­ry were devel­oped by Hyman Min­sky in the Finan­cial Insta­bil­i­ty Hypoth­e­sis (FIH), which itself reflect­ed the wis­dom of the great non-neo­clas­si­cal econ­o­mists Marx, Veblen, Schum­peter, Fish­er and Keynes, and the his­tor­i­cal record of cap­i­tal­ism that had includ­ed peri­od­ic Depres­sions (as well as the dra­mat­ic tech­no­log­i­cal trans­for­ma­tion of pro­duc­tion). As Min­sky argued, an eco­nom­ic the­o­ry could not claim to rep­re­sent cap­i­tal­ism unless it could explain those peri­od­ic crises:

Can “It”—a Great Depression—happen again? And if “It” can hap­pen, why did­n’t “It” occur in the years since World War II? These are ques­tions that nat­u­ral­ly fol­low from both the his­tor­i­cal record and the com­par­a­tive suc­cess of the past thir­ty-five years. To answer these ques­tions it is nec­es­sary to have an eco­nom­ic the­o­ry which makes great depres­sions one of the pos­si­ble states in which our type of cap­i­tal­ist econ­o­my can find itself. (Min­sky 1982, p. 5)

Min­sky devel­oped a coher­ent ver­bal mod­el of his hypoth­e­sis, but his own attempt to devel­op a math­e­mat­i­cal mod­el in his PhD (Min­sky 1957) was unsuc­cess­ful (Keen 2000), and he sub­se­quent­ly aban­doned that endeav­our.

Using insights from com­plex­i­ty the­o­ry, I devel­oped mod­els on the FIH that cap­ture its fun­da­men­tal propo­si­tion, that a mar­ket econ­o­my can expe­ri­ence a debt-defla­tion (Fish­er 1933) after a series of debt-financed cycles (Keen 1995; Keen 1996; Keen 1997; Keen 2000). These mod­els gen­er­at­ed a peri­od of declin­ing volatil­i­ty in employ­ment and wages with a ris­ing ration of debt to GDP, fol­lowed by a peri­od of ris­ing volatil­i­ty before an even­tu­al debt-induced break­down. They led me to cau­tion that:

From the per­spec­tive of eco­nom­ic the­o­ry and pol­i­cy, this vision of a cap­i­tal­ist econ­o­my with finance requires us to go beyond that habit of mind which Keynes described so well, the exces­sive reliance on the (sta­ble) recent past as a guide to the future. The chaot­ic dynam­ics explored in this paper should warn us against accept­ing a peri­od of rel­a­tive tran­quil­i­ty in a cap­i­tal­ist econ­o­my as any­thing oth­er than a lull before the storm. (Keen, 1995, p. 634; empha­sis added)

The empir­i­cal data and the impli­ca­tions of these mod­els led me to expect and warn of an impend­ing seri­ous eco­nom­ic cri­sis (Keen 2006; Keen 2007) at a time when Neo­clas­si­cal econ­o­mists were wax­ing lyri­cal about “The Great Mod­er­a­tion”(Bernanke 2004; Bernanke 2004; Sum­mers 2005; Camp­bell 2007; Benati 2008; D’Agosti­no and Whe­lan 2008; Gian­none, Lenza et al. 2008; Cano­va 2009; Gali and Gam­bet­ti 2009; Wood­ford 2009; Bean 2010).

The cri­sis itself emphat­i­cal­ly makes the point that a new the­o­ry of eco­nom­ics is need­ed, in which cap­i­tal­ism is seen as a dynam­ic, mon­e­tary sys­tem with both cre­ative and destruc­tive insta­bil­i­ties, where those destruc­tive insta­bil­i­ties emanate over­whelm­ing­ly from the finan­cial sec­tor.

Specific projects

The Center for Economic Stability Incorporated

With the sup­port of blog mem­bers, I have formed the Cen­ter for Eco­nom­ic Sta­bil­i­ty Incor­po­rat­ed. Our objec­tive is to devel­op CfE­SI into an empir­i­cal­ly-ori­ent­ed think-tank on eco­nom­ics that will devel­op real­is­tic analy­sis of cap­i­tal­ism, and pro­mote poli­cies based upon that analy­sis. The suc­cess of CfE­SI is depen­dent upon rais­ing suf­fi­cient fund­ing to enable staff to be hired who can take over the admin­is­tra­tive and web duties from me, and sup­ple­ment my research efforts.


Named in hon­or of Hyman Min­sky, this is a com­put­er pro­gram that enables a com­plex mon­e­tary sys­tem to be mod­elled with rel­a­tive ease. The pro­gram imple­ments the tab­u­lar approach to mod­el­ling finan­cial flows devel­oped in (Keen 2008; Keen 2010; Keen 2011), and com­bines this with the “flow­chart” par­a­digm devel­oped by engi­neers to mod­el phys­i­cal process­es, and imple­ment­ed in numer­ous soft­ware pro­grams (Simulink, Vis­sim, Ven­sim, Ithink, Stel­la, etc.). It will be both a ped­a­gog­ic tool to make dynam­ic mon­e­tary mod­el­ling easy and attrac­tive to new stu­dents, and a pow­er­ful research tool that will enable the con­struc­tion of real­is­tic, mon­e­tary mod­els of cap­i­tal­ism.

Fig­ure 5

  • A first ver­sion of Min­sky is already under devel­op­ment, with fund­ing pro­vid­ed by a grant from the Insti­tute for New Eco­nom­ic Think­ing. This ver­sion, to be com­plet­ed in mid-2012, will enable the mod­el­ling of the econ­o­my as a mon­e­tary dynam­ic sin­gle com­mod­i­ty sys­tem. A pro­to­type will be released in ear­ly 2012. A Source­forge page is now oper­at­ing, and we will short­ly be open­ing it up for col­lab­o­ra­tion by Open Source devel­op­ers.
  • Ver­sion 2.0 will enable mul­ti-com­mod­i­ty input-out­put dynam­ics to be mod­elled, as well as a dis­ag­gre­gat­ed bank­ing sec­tor. A seed­ing grant to help devel­op ver­sion 2.0 has been recent­ly been received from the Insti­tute for New Eco­nom­ic Think­ing. This will be com­bined with grants from oth­er pri­vate enti­ties to make an appli­ca­tion for sup­port under the Aus­tralian Research Coun­cil’s Link­age pro­gram for up to A$500,000 p.a. of fur­ther fund­ing. One Aus­tralian firm has already com­mit­ted to be an Indus­try Part­ner in this appli­ca­tion, and I wel­come addi­tion­al sup­port from oth­er firms, whether Aus­tralian or oth­er­wise (a min­i­mum con­tri­bu­tion of A$50,000 over 3 years is required to qual­i­fy as an Indus­try Part­ner under ARC rules).
  • Ver­sion 3.0 will add the capa­bil­i­ty to mod­el inter­na­tion­al trade and finan­cial flows.

The pro­gram will be plat­form inde­pen­dent, and freely avail­able under the GPL licence.

Integrating Minsky with biophysical data

Min­sky as it stands is pure­ly a sim­u­la­tion tool. How­ev­er, as part of a Unit­ed Nations Envi­ron­ment Pro­gram projectResource Effi­cien­cy: Eco­nom­ics and Out­look for Asia-Pacif­ic”, a pre­cur­sor to Min­sky has been linked to a bio­phys­i­cal data­base known as ASFF (for “Aus­tralian Stocks and Flows Foun­da­tion”) devel­oped by the CSIRO (Turn­er, Hoff­man et al. 2011),. Our long term ambi­tion is to com­bine the two sys­tems seam­less­ly, so that the phys­i­cal para­me­ters of Min­sky will be derived direct­ly from empir­i­cal data (which can be derived for any nation­al econ­o­my) and so that Min­sky’s fit to empir­i­cal data can be test­ed.



Fig­ure 6
The sec­ond stage of this process is part of the pro­pos­al for which I have just received fur­ther fund­ing from INET.

Finance and Economic Breakdown

This will be a book-length treat­ment of the Finan­cial Insta­bil­i­ty Hypoth­e­sis that I hope will form one of the foun­da­tions of a post-Neo­clas­si­cal macro­eco­nom­ics. Writ­ing a book like this takes time and iso­la­tion, two things I have had very lit­tle of in the past six years since I first start­ed warn­ing of an impend­ing eco­nom­ic cri­sis (Keen 2005). I have delayed the writ­ing of this “mag­num opus” for over a decade; in 2012–13 I intend devot­ing as much time as I can to writ­ing it, which neces­si­tates min­imis­ing time spent on oth­er activ­i­ties such as the main­te­nance of this blog.


Cur­rent­ly I pull in data from over 1500 dif­fer­ent sources into a Math­cad work­sheet on my PC. Math­cad, with a lit­tle help from my pro­gram­ming, does a won­der­ful job of analysing and dis­play­ing the data. But the nam­ing con­ven­tions in my pseu­do-data­base are … a joke, there are none. Con­se­quent­ly, only some­one inti­mate­ly acquaint­ed with the data can use my sys­tem, and at the moment that’s just me. I also have to man­u­al­ly down­load files when they are updat­ed. Thanks to Math­cad’s vis­i­ble equa­tions, audit­ing the data is cer­tain­ly eas­i­er than with a spread­sheet, but it is still dif­fi­cult com­pared to a well-struc­tured rela­tion­al data­base.

A sup­port­er has devel­oped an online sys­tem, cur­rent­ly called Econ­o­da­ta, to over­come these lim­i­ta­tions:

  • The data is stored in a “Ruby on Rails” rela­tion­al data­base;
  • The sys­tem auto­mat­i­cal­ly updates data when it is altered by providers;
  • The rela­tion­al data­base sys­tem and a 4GL for derived data series makes audit­ing straight­for­ward, and the sys­tem gen­er­ates a tinyURL so that a com­plex data series or chart can be eas­i­ly repli­cat­ed by any­one; and
  • It will be eas­i­ly acces­si­ble and usable by sub­scribers to Debt­watch and CfE­SI.

Econ­o­da­ta is cur­rent­ly unavail­able since it is being port­ed to a new serv­er, and the data­base is rel­a­tive­ly unpop­u­lat­ed. The data­base will also sup­port my book Finance and Eco­nom­ic Break­down, by mak­ing it pos­si­ble for read­ers to ver­i­fy any empir­i­cal charts for them­selves sim­ply by typ­ing its TinyURL into a brows­er.

Credit-aware Economic Indicators

My debt-aware per­spec­tive on eco­nom­ics makes it easy to explain what Bernanke has admit­ted is still inex­plic­a­ble to him: where the cri­sis came from, and why it is per­sist­ing:

Part of the slow­down is tem­po­rary, and part of it may be longer-last­ing. We do believe that growth is going to pick up going into 2012 but at a some­what slow­er pace than we had antic­i­pat­ed in April. We don’t have a pre­cise read on why this slow­er pace of growth is per­sist­ing… ” His admis­sion of igno­rance reflects gen­uine puz­zle­ment with the econ­o­my’s fail­ure to reach what he likes to call escape veloc­i­ty. (G.I. 2011)

In a nut­shell, the change in total pri­vate debt is a key deter­mi­nant of aggre­gate demand, and the turn­around from increas­ing debt boost­ing demand from incomes alone by 28% in 2008 to reduc­ing demand below this lev­el by 20 per­cent in ear­ly 2010 was the cause of the cri­sis.

Fig­ure 7

Sim­i­lar­ly, the slow­down in the rate of decline of debt from its max­i­mum rate of decline of almost US$3 tril­lion p.a. to a mere $340 bil­lion p.a. is—along with the growth in gov­ern­ment debt—the main rea­son why the cri­sis has atten­u­at­ed slight­ly, rather than plung­ing into Great Depres­sion depths of unem­ploy­ment.

Fig­ure 8

One indi­ca­tor that has arisen out of my work—building on orig­i­nal work by Big­gs, May­er and Pick (Big­gs and May­er 2010; Big­gs, May­er et al. 2010)—is the “Cred­it Accel­er­a­tor” (Keen 2011, pp. 160–165), which was first called the “Cred­it Impulse”. Both the change in income and the accel­er­a­tion of cred­it deter­mine the rate of change of eco­nom­ic activ­i­ty, and these are cor­re­lat­ed with each oth­er (the R2 since 1980 is 0.56), but the eco­nom­ics col­lapse in late 2007 was clear­ly dri­ven pri­mar­i­ly by the rapid and unprece­dent­ed decel­er­a­tion of debt.

[NOTE: “R^2” in the fol­low­ing fig­ures should be “Cor­re­la­tion coef­fi­cient”. When draft­ing these fig­ures, I changed from “Cor­re­la­tion=” to “R^2=” to save space on the head­ers, and then for­got to change the num­bers! I’m leav­ing the errors here though to keep the doc­u­ment as close to the orig­i­nal as I can–this is the only edit I’ve done since I first post­ed this page on Jan­u­ary 5 2012 (apart from not­ing the impact of the ISP crash)]

Fig­ure 9

Debt accel­er­a­tion is the main fac­tor in deter­min­ing asset prices. Asset bub­bles there­fore have to burst, because debt accel­er­a­tion can­not remain pos­i­tive for­ev­er.

Fig­ure 10

This causal rela­tion­ship is much more obvi­ous with mort­gage debt and change in house prices (see Fig­ure 11).

Fig­ure 11

Fur­ther devel­op­ment of this indi­ca­tor is there­fore high­ly warranted—both as an indi­ca­tor of what trends can be expect­ed in asset prices now, and as a means to iden­ti­fy whether a bub­ble is devel­op­ing in future. At present, the Cred­it Accel­er­a­tor’s def­i­n­i­tion is quite simple—the change in change in debt over a time peri­od, divid­ed by GDP at the mid­point of that period—and the nois­i­ness of finan­cial data makes it dif­fi­cult to use short time peri­ods, which would obvi­ous­ly be supe­ri­or for fore­cast­ing. A sophis­ti­cat­ed fil­ter­ing process and for­ward indi­ca­tors for cred­it would make the Cred­it Accel­er­a­tor a much more pow­er­ful tool.

A Modern Jubilee

Michael Hud­son’s sim­ple phrase that “Debts that can’t be repaid, won’t be repaid” sums up the eco­nom­ic dilem­ma of our times. This does not involve sanc­tion­ing “moral haz­ard”, since the real moral haz­ard was in the behav­iour of the finance sec­tor in cre­at­ing this debt in the first place. Most of this debt should nev­er have been cre­at­ed, since all it did was fund dis­guised Ponzi Schemes that inflat­ed asset val­ues with­out adding to soci­ety’s pro­duc­tiv­i­ty. Here the irresponsibility—and Moral Hazard—clearly lay with the lenders rather than the bor­row­ers.

The only real ques­tion we face is not whether we should or should not repay this debt, but how are we going to go about not repay­ing it?

The stan­dard means of reduc­ing debt—personal and cor­po­rate bank­rupt­cies for some, slow repay­ment of debt in depressed eco­nom­ic con­di­tions for others—could have us mired in delever­ag­ing for one and a half decades, giv­en its cur­rent rate (see Fig­ure 12).

Fig­ure 12

That fate would in turn mean one and a half decades where the boost to demand that ris­ing debt should provide—when it finances invest­ment rather than speculation—will not be there. The econ­o­my will tend to grow more slow­ly than is need­ed to absorb new entrants into the work­force, inno­va­tion will slow down, and jus­ti­fied polit­i­cal unrest will rise—with poten­tial­ly unjus­ti­fied social con­se­quences.

We don’t need to spec­u­late about the eco­nom­ic and social dam­age such a future his­to­ry will cause—all we have to do is remem­ber the last time.

We should, there­fore, find a means to reduce the pri­vate debt bur­den now, and reduce the length of time we spend in this dam­ag­ing process of delever­ag­ing. Pre-cap­i­tal­ist soci­eties insti­tut­ed the prac­tice of the Jubilee to escape from sim­i­lar traps (Hud­son 2000; Hud­son 2004), and debt defaults have been a reg­u­lar expe­ri­ence in the his­to­ry of cap­i­tal­ism too (Rein­hart and Rogoff 2008). So a pri­ma facie alter­na­tive to 15 years of delever­ag­ing would be an old-fash­ioned debt Jubilee.

But a Jubilee in our mod­ern cap­i­tal­ist sys­tem faces two dilem­mas. First­ly, in any cap­i­tal­ist sys­tem, a debt Jubilee would paral­yse the finan­cial sec­tor by destroy­ing bank assets. Sec­ond­ly, in our era of secu­ri­tized finance, the own­er­ship of debt per­me­ates soci­ety in the form of asset based secu­ri­ties (ABS) that gen­er­ate income streams on which a mul­ti­tude of non-bank recip­i­ents depend, from indi­vid­u­als to coun­cils to pen­sion funds.

Debt abo­li­tion would inevitably also destroy both the assets and the income streams of own­ers of ABSs, most of whom are inno­cent bystanders to the delu­sion and fraud that gave us the Sub­prime Cri­sis, and the myr­i­ad fias­cos that Wall Street has per­pe­trat­ed in the 2 decades since the 1987 Stock Mar­ket Crash.

We there­fore need a way to short-cir­cuit the process of debt-delever­ag­ing, while not destroy­ing the assets of both the bank­ing sec­tor and the mem­bers of the non-bank­ing pub­lic who pur­chased ABSs. One fea­si­ble means to do this is a “Mod­ern Jubilee”, which could also be described as “Quan­ti­ta­tive Eas­ing for the pub­lic”.

Quan­ti­ta­tive Eas­ing was under­tak­en in the false belief that this would “kick start” the econ­o­my by spurring bank lend­ing.

And although there are a lot of Amer­i­cans who under­stand­ably think that gov­ern­ment mon­ey would be bet­ter spent going direct­ly to fam­i­lies and busi­ness­es instead of banks – “where’s our bailout?,” they ask – the truth is that a dol­lar of cap­i­tal in a bank can actu­al­ly result in eight or ten dol­lars of loans to fam­i­lies and busi­ness­es, a mul­ti­pli­er effect that can ulti­mate­ly lead to a faster pace of eco­nom­ic growth. (Oba­ma 2009, p. 3; empha­sis added)

Instead, its main effect was to dra­mat­i­cal­ly increase the idle reserves of the bank­ing sec­tor while the broad mon­ey sup­ply stag­nat­ed or fell, (see Fig­ure 13), for the obvi­ous rea­sons that there is already too much pri­vate sec­tor debt, and nei­ther lenders nor the pub­lic want to take on more debt.

Fig­ure 13

A Mod­ern Jubilee would cre­ate fiat mon­ey in the same way as with Quan­ti­ta­tive Eas­ing, but would direct that mon­ey to the bank accounts of the pub­lic with the require­ment that the first use of this mon­ey would be to reduce debt. Debtors whose debt exceed­ed their injec­tion would have their debt reduced but not elim­i­nat­ed, while at the oth­er extreme, recip­i­ents with no debt would receive a cash injec­tion into their deposit accounts.

The broad effects of a Mod­ern Jubilee would be:

  1. Debtors would have their debt lev­el reduced;
  2. Non-debtors would receive a cash injec­tion;
  3. The val­ue of bank assets would remain con­stant, but the dis­tri­b­u­tion would alter with debt-instru­ments declin­ing in val­ue and cash assets ris­ing;
  4. Bank income would fall, since debt is an income-earn­ing asset for a bank while cash reserves are not;
  5. The income flows to asset-backed secu­ri­ties would fall, since a sub­stan­tial pro­por­tion of the debt back­ing such secu­ri­ties would be paid off; and
  6. Mem­bers of the pub­lic (both indi­vid­u­als and cor­po­ra­tions) who owned asset-backed-secu­ri­ties would have increased cash hold­ings out of which they could spend in lieu of the income stream from ABS’s on which they were pre­vi­ous­ly depen­dent.

Clear­ly there are numer­ous com­plex issues to be con­sid­ered in such a pol­i­cy: the scale of mon­ey cre­ation need­ed to have a sig­nif­i­cant pos­i­tive impact (with­out exces­sive neg­a­tive effects—there will obvi­ous­ly be such effects, but their impor­tance should be judged against the alter­na­tive of con­tin­ued delever­ag­ing); the mechan­ics of the mon­ey cre­ation process itself (which could repli­cate those of Quan­ti­ta­tive Eas­ing, but may also require changes to the legal pro­hi­bi­tion of Reserve Banks from buy­ing gov­ern­ment bonds direct­ly from the Trea­sury); the basis on which the funds would be dis­trib­uted to the pub­lic; man­ag­ing bank liq­uid­i­ty prob­lems (since though banks would not be made insol­vent by such a pol­i­cy, they would suf­fer sig­nif­i­cant drops in their income streams); and ensur­ing that the pro­gram did not sim­ply start anoth­er asset bub­ble.

Taming the Finance Sector

Finance per­forms gen­uine, essen­tial ser­vices in a cap­i­tal­ist econ­o­my when it lim­its itself to (a) pro­vid­ing work­ing cap­i­tal to non-finan­cial cor­po­ra­tions; (b) fund­ing invest­ment and entre­pre­neur­ial activ­i­ty, whether direct­ly or indi­rect­ly; © fund­ing hous­ing pur­chase for strict­ly res­i­den­tial pur­pos­es, whether to own­er-occu­piers for pur­chase or to investors for the pro­vi­sion of rental prop­er­ties; and (d) pro­vid­ing finance to house­holds for large expen­di­tures such as auto­mo­biles, home ren­o­va­tions, etc.

It is a destruc­tive force in cap­i­tal­ism when it pro­motes lever­aged spec­u­la­tion on asset or com­mod­i­ty prices, and funds activ­i­ties (like lev­ered buy­outs) that dri­ve debt lev­els up and rely upon ris­ing asset prices for their suc­cess. Such activ­i­ties are the over­whelm­ing focus of the non-bank finan­cial sec­tor today, and are the pri­ma­ry rea­son why finan­cial sec­tor debt has risen from triv­ial lev­els of below 10 per­cent of GDP before the 1970s to the peak of over 120 per­cent in ear­ly 2009.

Fig­ure 14

Return­ing cap­i­tal­ism to a finan­cial­ly robust state must involve a dra­mat­ic fall in the lev­el of pri­vate debt—and the size of the finan­cial sec­tor— as well as poli­cies that return the finan­cial sec­tor to a ser­vice role to the real econ­o­my.

The size of the finan­cial sec­tor is direct­ly relat­ed to the lev­el of pri­vate debt, which in Amer­i­ca peaked at 303% of GDP in ear­ly 2009 (see Fig­ure 15). Using his­to­ry as our guide, Amer­i­ca will only return to being a finan­cial­ly robust soci­ety when this ratio falls back to below 100% of GDP. Most oth­er OECD coun­tries like­wise need to dras­ti­cal­ly reduce their lev­els of pri­vate debt.

Fig­ure 15

The per­cent­age of total wages and prof­its earned by the FIRE sec­tor (as defined in the NIPA tables) gives anoth­er guide. Amer­i­ca’s peri­od of robust eco­nom­ic growth coin­cid­ed with FIRE sec­tor prof­its being between 10 and 20 per­cent of total prof­its, and wages in the FIRE sec­tor being below 5 per­cent of total wages. Finance sec­tor prof­its peaked at over 50% of total prof­its in 2001, while wages in the FIRE sec­tor peaked at over 9 per­cent of total wages.

Fig­ure 16

Since finance sec­tor prof­its are pri­mar­i­ly a func­tion of the lev­el of pri­vate debt, this implies that the lev­el of debt needs to shrink by a fac­tor of 3–4, while employ­ment in the finance sec­tor needs to rough­ly halve. At the max­i­mum, the finance sec­tor should be no more than 50% of its cur­rent size.

Fig­ure 17

Such a large con­trac­tion in the size of the sec­tor means that the major­i­ty of those who cur­rent­ly work there will need to find gain­ful employ­ment else­where. Indi­vid­u­als who can actu­al­ly eval­u­ate invest­ment proposals—generally speak­ing, engi­neers rather than finan­cial engineers—will need to be hired in their place. Many of the stan­dard prac­tices of that sec­tor today will have to be elim­i­nat­ed or dras­ti­cal­ly cur­tailed, while many prac­tices that have been large­ly aban­doned will have to be rein­stat­ed.

Taming the Credit Accelerator

Cap­i­tal­is­m’s crises have always been a prod­uct of the finan­cial sec­tor fund­ing spec­u­la­tion on asset prices rather than fund­ing busi­ness and inno­va­tion. This allows finan­cial sec­tor prof­its to grow far larg­er than is war­rant­ed, on the foun­da­tion of a far larg­er lev­el of pri­vate debt than soci­ety can sup­port. This lend­ing caus­es a pos­i­tive feed­back loop between accel­er­at­ing debt and ris­ing asset prices, lead­ing to both a debt and asset price bub­ble. The asset price bub­ble must burst—because it relies upon accel­er­at­ing debt for its maintenance—but once it bursts, soci­ety is still left with the debt.

The under­ly­ing cause is the rela­tion­ship between debt and asset prices in a cred­it-based econ­o­my. As I explain in numer­ous places (“A much more neb­u­lous con­cep­tion”, “Debunk­ing Macro­eco­nom­ics”), aggre­gate demand is the sum of income (Y) plus the change in debt , and this is expend­ed on both new­ly pro­duced goods and ser­vices and buy­ing finan­cial claims on exist­ing assets—which I call “Net Asset Turnover” . At a very gen­er­al lev­el, this implies the fol­low­ing rela­tion­ship:

Net Asset Turnover can be bro­ken down into the price index for assets , times their quan­ti­ty , times the turnover —expressed as a frac­tion of the num­ber of assets

It there­fore fol­lows that there is a rela­tion­ship between the accel­er­a­tion of debt and change in asset prices.

Some accel­er­a­tion of debt is vital for a grow­ing econ­o­my. As good empir­i­cal work by Fama and French has con­firmed (Fama and French 1999; Fama and French 2002), change in debt is the main source of funds for invest­ment, and as Schum­peter explains (Schum­peter 1934, pp. 95–107), the inter­play between invest­ment and the endoge­nous cre­ation of spend­ing pow­er by the bank­ing sys­tem ensures that this will be a cycli­cal process. Debt accel­er­a­tion dur­ing a boom and decel­er­a­tion dur­ing a slump are thus essen­tial aspects of cap­i­tal­ism.

How­ev­er this rela­tion also implies that the accel­er­a­tion of debt is a fac­tor in the rate of change of asset prices (along with the change in income) and that when asset prices grow faster than incomes and con­sumer prices, the motive force behind it will be the accel­er­a­tion of debt. At the same time, the growth in asset prices is the major incen­tive to accel­er­at­ing debt: this is the pos­i­tive feed­back loop on which all asset bub­bles are based, and it is why they must ulti­mate­ly burst (see Fig­ure 10 and Fig­ure 11). This is the foun­da­tion of Ponzi Finance (Min­sky 1982, p. 29), and it is this aspect of finance that has to be tamed to reduce the destruc­tive impact of finance on cap­i­tal­ism.

I do not believe that reg­u­la­tion alone will achieve this aim, for two rea­sons.

  • Min­sky’s propo­si­tion that “sta­bil­i­ty is desta­bi­liz­ing” applies to reg­u­la­tors as well as to mar­kets. If reg­u­la­tions actu­al­ly suc­ceed in enforc­ing respon­si­ble finance, the rel­a­tive tran­quil­li­ty that results from that will lead to the belief that such tran­quil­li­ty is the norm, and the reg­u­la­tions will ulti­mate­ly be abol­ished. After all, this is what hap­pened after the last Great Depres­sion.
  • Banks prof­it by cre­at­ing debt, and they are always going to want to cre­ate more debt. This is sim­ply the nature of bank­ing. Reg­u­la­tions are always going to be attempt­ing to restrain this ten­den­cy, and in this strug­gle between an “immov­ably object” and an “irre­sistible force”, I have no doubt that the force will ulti­mate­ly win.

If we rely on reg­u­la­tion alone to tame the finan­cial sec­tor, then it will be tamed while the mem­o­ry of the cri­sis it caused per­sists, only to be over­thrown by a resur­gent finan­cial sec­tor some decades hence (scep­tics on this point should take a close look at Fig­ure 2, show­ing the debt to GDP graph for Aus­tralia from 1860 till today).

There are thus only two options to lim­it cap­i­tal­is­m’s ten­den­cies to finan­cial crises: to change the nature of either lenders or bor­row­ers in a fun­da­men­tal way. There are pro­pos­als for the for­mer, which I’ll dis­cuss lat­er, but (for rea­sons I’ll dis­cuss now) my pref­er­ence is to address the lat­ter by reduc­ing the appeal of lever­aged spec­u­la­tion on asset prices.

There are, I believe, no prospects for fun­da­men­tal­ly alter­ing the behav­iour of the finan­cial sec­tor because, as already not­ed, the key deter­mi­nant of prof­its in the finance sec­tor is the lev­el of debt it can gen­er­ate. How­ev­er it is organ­ised and what­ev­er lim­its are put upon its behav­iour, it will want to cre­ate more debt.

There are prospects for alter­ing the behav­iour of the non-finan­cial sec­tor towards debt because, fun­da­men­tal­ly, debt is a bad thing for the bor­row­er: the spend­ing pow­er of debt now is an entice­ment, but with it comes the draw­back of ser­vic­ing debt in the future. For that rea­son, when either invest­ment or con­sump­tion is the rea­son for tak­ing on debt, bor­row­ers will be restrained in how much they will accept. Only when they suc­cumb to the entice­ment of lever­aged spec­u­la­tion will bor­row­ers take on a lev­el of debt that can become sys­tem­i­cal­ly dan­ger­ous.

This can eas­i­ly be illus­trat­ed using dis­ag­gre­gat­ed bor­row­ing data for Aus­tralia. At first glance, though per­son­al debt appears quite volatile, and strong­ly relat­ed to the busi­ness cycle—rising dur­ing booms and falling dur­ing slumps—there is clear­ly no trend across busi­ness cycles (see Fig­ure 18; “R90” refers to the start of the 1990s reces­sion, and “GFC” to the start of the cur­rent eco­nom­ic cri­sis for which Aus­tralians use the acronym “GFC”—or “Glob­al Finan­cial Cri­sis”).

Fig­ure 18

How­ev­er there clear­ly is a trend in mort­gage debt across busi­ness cycles, and when rescaled by this trend, the volatil­i­ty of per­son­al debt is a non-event (see Fig­ure 19).

Fig­ure 19

The dif­fer­ence between the two series is obvi­ous. Regard­less of the end­less induce­ments from the finance sec­tor to enter into per­son­al debt, com­mit­ments by the pub­lic to per­son­al debt are gen­er­al­ly relat­ed to and reg­u­lat­ed by income. Com­mit­ments to debt for the pur­chase of assets, on the oth­er hand, are relat­ed not to income, but to expec­ta­tions of lever­aged prof­its on ris­ing asset prices—when the fac­tor most respon­si­ble for caus­ing growth in asset prices is accel­er­at­ing debt.

This rela­tion­ship between debt accel­er­a­tion and change in asset prices is espe­cial­ly appar­ent for mort­gage debt. The R2 between mort­gage debt accel­er­a­tion and change in real house prices is 0.78 in the USA over 25 years, and 0.6 in Aus­tralia over 30 years (see Fig­ure 11 and Fig­ure 22). Though debt accel­er­a­tion can enable increased con­struc­tion or turnover , the far greater flex­i­bil­i­ty of prices, and the treat­ment of hous­ing as a vehi­cle for spec­u­la­tion rather than accom­mo­da­tion, means that the brunt of the accel­er­a­tion dri­ves house price appre­ci­a­tion. The same effect applies in the far more volatile share mar­ket: accel­er­at­ing debt leads to ris­ing asset prices, which encour­ages more debt accel­er­a­tion.

Fig­ure 20

Fig­ure 21

The link between accel­er­at­ing debt lev­els and ris­ing asset prices is there­fore the basis of cap­i­tal­is­m’s ten­den­cy to expe­ri­ence finan­cial crises. That link has to be bro­ken if finan­cial crises are to be made less likely—if not avoid­ed entire­ly. This requires a rede­f­i­n­i­tion of finan­cial assets in such a way that the temp­ta­tions of Ponzi Finance can be elim­i­nat­ed.

Jubilee Shares

The key fac­tor that allows Ponzi Schemes to work in asset mar­kets is the “Greater Fool” promise that a share bought today for $1 can be sold tomor­row for $10. No inter­est rate, no reg­u­la­tion, can hold against the charge to insan­i­ty that such a fea­si­ble promise fer­ments, and on such a foun­da­tion the now almost for­got­ten fol­ly of the Dot­Com Bub­ble was built. Both the promise and the fol­ly are well illus­trat­ed in Yahoo’s share price (see Fig­ure 22).

Fig­ure 22

I pro­pose the rede­f­i­n­i­tion of shares in such a way that the entice­ment of lim­it­less price appre­ci­a­tion can be removed, and the pri­ma­ry mar­ket can take prece­dence over the sec­ondary mar­ket. A share bought in an IPO or rights offer would last for­ev­er (for as long as the com­pa­ny exists) as now with all the rights it cur­rent­ly con­fers. It could be sold once onto the sec­ondary mar­ket with all the same priv­i­leges. But on its next sale it would have a life span of 50 years, at which point it would ter­mi­nate.

The objec­tive of this pro­pos­al is to elim­i­nate the appeal of using debt to buy exist­ing shares, while still mak­ing it attrac­tive to fund inno­v­a­tive firms or star­tups via the pri­ma­ry mar­ket, and still mak­ing pur­chase of the share of an estab­lished com­pa­ny on the sec­ondary mar­ket attrac­tive to those seek­ing an annu­ity income.

I can envis­age ways in which this basic pro­pos­al might be refined, while still main­tain­ing the pri­ma­ry objec­tive of mak­ing lever­aged spec­u­la­tion on the price of exist­ing share unat­trac­tive. The ter­mi­na­tion date could be made a func­tion of how long a share was held; the num­ber of sales on the sec­ondary mar­ket before the Jubilee effect applied could be more than one. But the basic idea has to be to make bor­row­ing mon­ey to gam­ble on the prices of exist­ing shares a very unat­trac­tive propo­si­tion.

The Pill”

At present, if two indi­vid­u­als with the same sav­ings and income are com­pet­ing for a prop­er­ty, then the one who can secure a larg­er loan wins. This real­i­ty gives bor­row­ers an incen­tive to want to have the loan to val­u­a­tion ratio increased, which under­pins the finance sec­tor’s abil­i­ty to expand debt for prop­er­ty pur­chas­es.

Since the accel­er­a­tion of debt dri­ves the rise in house prices, we get both the bub­ble and the bust. But since hous­es turn over much more slow­ly than do shares, this process can go on for a lot longer.

Fig­ure 23

The buildup of mort­gage debt there­fore also goes on for much longer (see Fig­ure 24 and Fig­ure 25).

Fig­ure 24

Fig­ure 25

Lim­its on bank lend­ing for mort­gage finance are obvi­ous­ly nec­es­sary, but while those con­trols focus on the income of the bor­row­er, both the lender and the bor­row­er have an incen­tive to relax those lim­its over time. This relax­ation is in turn the fac­tor that enables a house price bub­ble to form while dri­ving up the lev­el of mort­gage debt per head.

Fig­ure 26

I instead pro­pose bas­ing the max­i­mum debt that can be used to pur­chase a prop­er­ty on the income (actu­al or imput­ed) of the prop­er­ty itself. Lenders would only be able to lend up to a fixed mul­ti­ple of the income-earn­ing capac­i­ty of the prop­er­ty being purchased—regardless of the income of the bor­row­er. A use­ful mul­ti­ple would be 10, so that if a prop­er­ty rent­ed for $30,000 p.a., the max­i­mum amount of mon­ey that could be bor­rowed to pur­chase it would be $300,000.

Under this regime, if two par­ties were vying for the same prop­er­ty, the one that raised more mon­ey via sav­ings would win. There would there­fore be a neg­a­tive feed­back rela­tion­ship between lever­age and house prices: an gen­er­al increase in house prices would mean a gen­er­al fall in lever­age.

I call this pro­pos­al The Pill, for “Prop­er­ty Income Lim­it­ed Lever­age”. This pro­pos­al is a lot sim­pler than Jubilee Shares, and I think less in need of tin­ker­ing before it could be final­ized. Its real prob­lem is in the imple­men­ta­tion phase, since if it were intro­duced in a coun­try where the prop­er­ty bub­ble had not ful­ly burst, it could cause a sharp fall in prices. It would there­fore need to be phased in slow­ly over time—except in a coun­try like Japan where the house price bub­ble is well and tru­ly over (even though house prices are still falling).

There are many oth­er pro­pos­als for reform­ing finance, most of which focus on chang­ing the nature of the mon­e­tary sys­tem itself. The best of these focus on insti­tut­ing a sys­tem that removes the capac­i­ty of the bank­ing sys­tem to cre­ate mon­ey via “Full Reserve Bank­ing”.

Full Reserve Banking

The for­mer could be done by remov­ing the capac­i­ty of the pri­vate bank­ing sys­tem to cre­ate mon­ey. This is the sub­stance of the Amer­i­can Mon­e­tary Insti­tute’s pro­pos­als, which are now embod­ied in the Nation­al Emer­gency Employ­ment Defense Act of 2011 (HR 2990), a Bill which was sub­mit­ted to Con­gress by Con­gress­man Den­nis Kucinich on Sep­tem­ber 21st 2011. This bill would remove the capac­i­ty of the bank­ing sec­tor to cre­ate mon­ey, along the lines the the 100% reserve pro­pos­als first cham­pi­oned by Irv­ing Fish­er dur­ing the Great Depres­sion (Fish­er 1936), and vest the capac­i­ty for mon­ey cre­ation in the gov­ern­ment alone.

A sim­i­lar sys­tem is pro­posed by the UK’s New Eco­nom­ic Foun­da­tion with its Pos­i­tive Mon­ey pro­pos­al.

Tech­ni­cal­ly, both these pro­pos­als would work. I won’t go into great detail on them here, oth­er than to note my reser­va­tion about them, which is that I don’t see the bank­ing sys­tem’s capac­i­ty to cre­ate mon­ey as the causa cau­sans of crises, so much as the uses to which that mon­ey is put. As Schum­peter explains so well, the endoge­nous cre­ation of mon­ey by the bank­ing sec­tor gives entre­pre­neurs spend­ing pow­er that exceeds that com­ing out of “the cir­cu­lar flow” alone. When the mon­ey cre­at­ed is put to Schum­peter­ian uses, it is an inte­gral part of the inher­ent dynam­ic of cap­i­tal­ism. The prob­lem comes when that mon­ey is cre­at­ed instead for Ponzi Finance rea­sons, and inflates asset prices rather than enabling the cre­ation of new assets.

My cau­tion with respect to full reserve bank­ing sys­tems is that this endoge­nous expan­sion of spend­ing pow­er would become the respon­si­bil­i­ty of the State alone. Here, though I am a pro­po­nent of gov­ern­ment counter-cycli­cal spend­ing, I am scep­ti­cal about the capac­i­ty of gov­ern­ment agen­cies to get the cre­ation of mon­ey right at all times. This is not to say that the pri­vate sec­tor has done a bet­ter job—far from it! But the pri­vate bank­ing sys­tem will always be there—even if changed in nature—ready to exploit any slipups in gov­ern­ment behav­iour that can be used to jus­ti­fy a return to the sys­tem we are cur­rent­ly in. Slipups will sure­ly occur, espe­cial­ly if the new sys­tem still enables spec­u­la­tion on asset prices to occur.

Since in the real world, peo­ple for­get and die, the mem­o­ry of the chaos we are liv­ing through now won’t be part of the mind­set when those slipups occur, espe­cial­ly if the end of the Age of Delever­ag­ing ush­ers in a peri­od of eco­nom­ic tran­quil­li­ty like the 1950s. We could well have 100% mon­ey reforms “reformed” out of exis­tence once more.

Schum­peter­ian bank­ing also inher­ent­ly includes the capac­i­ty to make mis­takes: to fund a ven­ture that does­n’t suc­ceed, and yet to be will­ing to take that risk again in the hope of fund­ing one that suc­ceeds spec­tac­u­lar­ly. I am wary of the capac­i­ty of that mind­set to co-exist with the bureau­crat­ic one that dom­i­nates gov­ern­ment.

So though I am not opposed to the 100% Reserve Bank­ing pro­pos­al, I am not enthu­si­as­tic either. I believe they need curbs on the capac­i­ty to finance asset price spec­u­la­tion like Jubilee Shares and The Pill, and if they have them, these alone might achieve most of what mon­e­tary reform­ers hope to achieve with far more exten­sive change to the finan­cial sys­tem.

Other issues

As Dou­glas Adams once bril­liant­ly remarked, most of our solu­tions to human prob­lems involve move­ments of small green pieces of paper, and my solu­tions clear­ly fall into that camp:

This plan­et has—or rather had—a prob­lem, which was this: most of the peo­ple liv­ing on it were unhap­py for pret­ty much of the time. Many solu­tions were sug­gest­ed for this prob­lem, but most of these were large­ly con­cerned with the move­ments of small green pieces of paper, which is odd because on the whole it was­n’t the small green pieces of paper that were unhap­py. (Adams 1988)

I have said noth­ing here about Glob­al Warm­ing and Peak Oil. Clear­ly these fac­tors will shape the post-Great Con­trac­tion world far more pow­er­ful­ly than would my reforms. The rea­sons for not men­tion­ing them include specialisation—I am an econ­o­mist after all, not a spe­cial­ist on the cli­mate or energy—and the fact that these issues will ulti­mate­ly make the finan­cial cri­sis look triv­ial by com­par­i­son. Dis­cussing them while dis­cussing the finan­cial cri­sis would have swamped the lat­ter top­ic almost entire­ly.

End­ing the dom­i­nance of the FIRE sec­tor will also expose the extent to which Amer­i­ca and the UK in par­tic­u­lar have been de-indus­tri­alised in the last 30 years. Though the relo­ca­tion of pro­duc­tion from the West­ern OECD to devel­op­ing nations could have occurred inde­pen­dent­ly of the growth of Ponzi Finance, Ponzi Finance enabled this trend to go on for much longer than it could have oth­er­wise done. It is high­ly like­ly that reforms to end Ponzi Finance will be blamed for caus­ing the cri­sis in unem­ploy­ment that has in fact exist­ed for decades, and would mere­ly be exposed by sud­den­ly reduc­ing the size of the FIRE sec­tor.

On the bright side

All of the above makes for bleak read­ing. I cer­tain­ly do expect a bleak future his­to­ry for humankind in most of the rest of this cen­tu­ry, which I believe will bear out the pre­dic­tions first made by the “Lim­its to Growth” report in 1972 (Mead­ows, Ran­ders et al. 1972; Mead­ows, Mead­ows et al. 2005; Turn­er 2008).

Fig­ure 27: From Turn­er 2008. 2 sol­id cir­cle series rep­re­sent upper and low­er bound esti­mates respec­tive­ly

Despite this, I am a long term opti­mist for human­i­ty. We have a depress­ing ten­den­cy to learn about the unsus­tain­abil­i­ty of cumu­la­tive process­es only after a cri­sis (Dia­mond 2005), but we also have an extra­or­di­nary intel­li­gence, and a species nature that val­ues empathy—along with our equal­ly obvi­ous ten­den­cy to let hier­ar­chy and per­son­al gain take the ascen­dan­cy in human affairs. Ulti­mate­ly I believe we’ll work out a means to live sus­tain­ably on this plan­et and, in the very dis­tant future, to live beyond it as well. But to do so, we have to under­stand our cur­rent sit­u­a­tion prop­er­ly. There is no chance to move towards a bet­ter future if we mis­un­der­stand the sit­u­a­tion we are cur­rent­ly in. That’s why I keep on going.

In this work, I find myself fol­low­ing the lead of the physi­cist and applied math­e­mati­cian Pro­fes­sor John Blatt—a fel­low Aus­tralian (a Syd­neysider even!) whom I nev­er met, but whose writ­ings were the foun­da­tion of my first for­ays into eco­nom­ic dynam­ics and com­plex­i­ty:

We close this intro­duc­tion with a philo­soph­i­cal point. Karl Marx said: “The philoso­phers hith­er­to have only inter­pret­ed the world in var­i­ous ways; the thing, how­ev­er, is to change it.” There have been many changes in the world since this was writ­ten… But only the fool­hardy could claim that these changes have all, or even most­ly, been for the bet­ter.

It is not the task of this book to change the world. Let us try to under­stand just a small part of it, name­ly the dynam­ics of com­pet­i­tive cap­i­tal­ism. It is by no means cer­tain that the human race has a future at all. But if it does, that future can not be harmed, and may even be aid­ed, by an hon­est attempt to under­stand our past. (Blatt 1983, p. 15)


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Essential Readings from Debtwatch

Financial Instability

Rov­ing Cav­a­liers of Cred­it
Read Some Min­sky
Mon­e­tary Prof­its Para­dox
Are We “It” Yet?
Mon­e­tary Mul­ti­sec­toral Mod­el

The New Depression

No-one saw this com­ing”?
Why the Cri­sis is not over
Delever­ag­ing with a twist
Bernanke does­n’t under­stand the Great Depres­sion
The Case Against Bernanke

Australian Housing

Res­cu­ing the Bub­ble
Aus­tralian house prices
Com­pe­ti­tion No Panacea
House Prices & Banks I
House Prices & Banks II

Video overview

Lec­tures on Endoge­nous Mon­ey
Debt and Aus­tralian hous­ing
HARDtalk inter­view
INET Inter­view on why I saw “It” com­ing