1. Does my definition that “aggregate demand equals GDP plus the change in debt” involve double-counting?
2. My figures for the USA are difficult to reconcile with the published US Flow of Funds data.

On the second point first, I produce an aggregate level of private sector debt in the USA from Table L1 of the Flow of Funds (on page 60 of the June 2010 PDF, and in ltab1d.prn in the ltabs.zip data archive) by adding together debt data for the following sectors:

• Household
• Non-financial corporations
• Nonfarm non-corporate
• Farm
• Financial Corporations

This omits some of the debt included in the aggregate debt level in the same table—notably government debt and debt owed by the “rest of the world”. In the interests of making it easier to reconcile my table with the data in the Flow of Funds, here’s the same exercise applied simply to the very first row in Table L1 (and the first column in ltab1d), “Total credit market debt owed by:”

US Flow of Funds Table L1, row 1 (column 1 in the file ltabs1d.prn)

I also transform the data to monthly by interpolation, and the way my data is stored the figure I give for 2006 corresponds to the figure stored for the end of the quarter 200504 by the Fed. I’ve highlighted these numbers in the two tables here to make that more obvious.

Change in debt and aggregate demand

On the first point, since I consider that aggregate demand is spent on both goods & services (which are counted in GDP) and the net sum expended purchasing existing assets (which is not counted in GDP), then there is no double counting. A standard textbook aggregate demand figure is the sum spent buying goods and services (for the expenditure definition), which omits of course the sum spent buying existing assets as well. That would be all well and good if we lived in a world without asset sale—which of course we don’t.
Another reason people see a potential error here is that they think that a loan simply represents the transfer of spending power from a saver to a borrower, so that overall there’s no change in spending power because of a loan: money is simply transferred from one group that will therefore spend less (creditors), to another that will therefore spend more (debtors). This is clearly the thinking that Bernanke applied when he, in common with most all neoclassical economists, dismissed Fisher’s “debt deflation” explanation for the Great Depression:

“Absent implausibly large differences in marginal spending propensities among the groups, it was suggested, pure redistributions should have no significant macroeconomic effects. ” (Bernanke 2000, p. 24)

This is not the case in the real world, for two reasons:

1. Credit Money is created by banks “out of nothing” by the act of giving a borrower purchasing power (a loan of money) in return for recording a liability by that borrower to the bank (a bank debt). This creates new spending power “ab initio” without removing it from other agents. For the mechanics of this process, see my “Roving Cavaliers of Credit” blog entry (click here for the PDF).
2. As Schumpeter argues cogently, the endogenous creation of money by the banking sector lending to entrepreneurs is an essential reason that capitalism can grow, and it creates spending power that does not originate in the existing “circular flow of commodities”:

   “From this it follows, therefore, that in real life total credit must be greater than it could be if there were only fully covered credit. The credit structure projects not only beyond the existing gold basis, but also beyond the existing commodity basis.”

   “[T]he entrepreneur needs credit … [T]his purchasing power does not flow towards him automatically, as to the producer in the circular flow, by the sale of what he produced in preceding periods. If he does not happen to possess it … he must borrow it… He can only become an entrepreneur by previously becoming a debtor… his becoming a debtor arises from the necessity of the case and is not something abnormal, an accidental event to be explained by particular circumstances. What he first wants is credit. Before he requires any goods whatever, he requires purchasing power. He is the typical debtor in capitalist society.” (Schumpeter 1934, pp. 101-102)

So there is no double-counting in “aggregate demand equals GDP plus the change in debt”: the rise in debt adds new demand to that generated by the sale of commodities alone (and is a good thing here because it finances a large part of investment); and the increase in debt is spent financing part of investment and consumption (an overlap that could give rise to double-counting) and also on purchases of existing assets (where no overlap is possible).

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

Schumpeter, J. A. (1934). The theory of economic development : an inquiry into profits, capital, credit, interest and the business cycle. Cambridge, Massachusetts, Harvard University Press.

Click here for a PDF of this post

]]> http://www.debtdeflation.com/blogs/2010/09/07/gdp-plus-change-in-debt%e2%80%94and-the-us-flow-of-funds/feed/ 68 http://www.debtdeflation.com/blogs/2010/09/05/back-to-the-future/ http://www.debtdeflation.com/blogs/2010/09/05/back-to-the-future/#comments Sun, 05 Sep 2010 08:29:44 +0000 Steve Keen http://www.debtdeflation.com/blogs/?p=4299 Things are looking grim indeed for the US economy. Unemployment is out of control—especially if you consider the U-6 (16.7%, up 0.2% in the last month) and Shadowstats (22%, up 0.3%) measures, which are far more realistic than the effectively public relations U-3 number that passes for the “official” unemployment rate (9.6%, up 0.1%).

The US is in a Depression, and the sooner it acknowledges that—rather than continuing to pretend otherwise—the better. Government action has attenuated the rate of decline, but not reversed it: a huge fiscal and monetary stimulus has put the economy in limbo rather than restarting growth, and the Fed’s conventional monetary policy arsenal is all but depleted.

This prompted MIT professor of economics Ricardo Cabellero to suggest a more radical approach to monetary easing, in a piece re-published last Wednesday in Business Spectator (reproduced from Vox). Conventional “Quantitative Easing” involves the Treasury selling bonds to the Fed, and then using the money to fund expenditure—so public debt increases, and it has to be serviced. We thus swap a private debt problem for a public one, and the boost to spending is reversed when the bonds are subsequently retired. Instead, Caballero proposes

a fiscal expansion (e.g. a temporary and large cut of sales taxes) that does not raise public debt in equal amount. This can be done with a “helicopter drop” targeted at the Treasury. That is, a monetary gift from the Fed to the Treasury. (Ricardo Caballero)

The government would thus spend without adding to debt, with the objective of causing inflation by having “more dollars chasing goods and services”. This is preferable to the deflationary trap that has afflicted Japan for two decades, and now is increasingly likely in the US. So on the face of it, Cabellero’s plan appears sound: inflation will reduce the real value of financial assets, shift wealth from older to younger generations, and stimulate both supply and demand by making it more attractive to spend and invest than to leave dollars languishing, and losing real value, in the bank.

However, though this is indeed the right time to consider radical solutions, Cabellero’s proposal would do only half the required job. Focusing on the good bit, one reason we got into this predicament in the first place was because private sector, debt-based money swamped public sector, fiat money. Ultimately we need to return to the public-private money balance we had in the 1950s and early 1960s.

But if getting “Back to the Future” was all we needed to do, then our problems would already be over, because Ben’s Helicopter Drop of late 2008 has got us there already: the ratio of M0 to M2 is now almost 0.25, far higher than the 1960 level of 0.14, while the ratio to M3 is back where it was then (using Shadowstats data, which I can’t publish here since it’s proprietary).

So why aren’t we “Back To The Future” already? Why isn’t the economy booming once more, and why is inflation giving way to deflation?

Because, though the money supply is back to where it was in 1960, the debt to money ratio is utterly different. Even after Ben’s Helicopter Drop, the debt to base money ratio is almost twice what it was in 1960, and over 3 times what it was back in the Golden Days of the 1950s.

This points out the blind spot in the thinking of even progressive Neoclassicals like Cabellero, who are willing to consider unconventional policies: they don’t understand how money is created in our credit-driven economy. Because of that, they don’t appreciate how much of that credit has financed a glorified Ponzi Scheme rather than investment, nor do they comprehend the impact that private sector deleveraging is having on aggregate demand.

I’ve covered the first topic ad nauseam in my post “The Roving Cavaliers of Credit”, so I won’t repeat myself here. Instead I’ll focus on the obvious message from the above chart: if the government simply pumps its money into the system without restraining the financial system from financing speculation on asset markets, the best we can hope for is a repeat of this crisis, on an even larger scale, some years down the track. To see that, all we have to do is look at what happened back in the 1980s.

The Debt to M0 ratio, which had risen sixfold since the 1950s, went into sudden reverse as the economy imploded when the Savings and Loans fiasco ended. The growth of debt collapsed, and the State tried to rescue the financial sector from its follies by fiscal policy and boosting the money supply. That rescue ultimately succeeded when the recession of the 1990s finally ended, but since finance was emboldened rather than reformed, it simply financed two further fiascos: the DotCom madness and then the Subprime scam.

The reason why the 1990s rescue isn’t working this time stands out more clearly when you look at the changes in debt and M0 in raw dollar terms (the scale of the change in M0 is 1/5th that for the change in debt in next two graphs). In the 1990s crisis, the rate of growth of private debt slowed by 2/3rds, but it didn’t actually fall; and a quadrupling of the rate of growth of M0 (starting half a year after debt growth slowed down) was enough, after several years, to let the Wall Street party resume.

This time, the change in debt has turned solidly negative—having growth at up to $4 trillion p.a., it is now shrinking at over $2 trillion. Ben’s far larger quantitative easing (when compared to Alan’s back in 1990-94) simply hasn’t been enough to fight a private sector that is now seriously deleveraging.

QE2 could nonetheless work, if Cabellero’s plan was executed with gusto. But if all we do is effect a monetary rescue, and yet leave the finance sector untouched, then it will reborn once again as an even bigger Ponzi Scheme.

Do we really want to go through all that again?

I’ll explain two truly major financial reforms that could prevent another credit and asset bubble in a subsequent piece.

Click here for this post in a PDF document.

To see this re-recording, please click on either of the following links:

Phil Dobbie’s BTNet page “Aussie Rules”; or

A direct link to GoToMeeting.

You have to register with GoToMeeting to see the recording, but it’s well worth it. I found the medium and the software so effective that I plan to use it here–or possibly on the Centre for Economic Stability when that’s up and running–as a way of giving regular web lectures.

I used this PowerPoint slideshow (this is the PDF), and these Excel worksheets to illustrate one of the basic points, that it’s not just the level of debt, or its rate of change that matters, but the rate of change of the rate of change of debt: you can have a recession simply because the rate of change of debt slows down–even if debt is still growing–and a boom because the rate of decline of debt slows down–even if debt is falling. The files here are:

• A basic example (with a “Goldilocks” economy in which GDP is unaffected by the change of Debt–thanks to blog member bb who first developed an example like this in the discussion on this blog);
• The US in the 1930s
• The US now
• Australia now

On another note, I am getting closer to formally declaring the Centre for Economic Stability open for business. We have formed an Non-Profit Association, it is now registered for tax exemption as a charitable research institution, and shortly we’ll also be registered to offer tax-deductibility for donations. Once that last step is in place I will try to move a lot of the activity across to that organisation, and I’ll also put out a call for membership at the rate (decided by the original meeting of the Association) of A$100 p.a. for those with wage or other full-time income, and A$25 p.a. for others.

I hope that a reasonable proportion of the now almost 6,000 members of this blog will sign up. The ambition of the Centre is to enable the non-orthodox research that I do into monetary dynamics to be developed more effectively, and for the Centre to become an empirically based alternative to the rather ideologically focused “think tanks” (“opinion tanks”?) that tend to dominate the public discourse on economics today.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The idea of debt-deflation goes back to Irving Fisher (1933). Fisher envisioned a dynamic process in which falling asset and commodity prices created pressure on nominal debtors, forcing them into distress sales of assets, which in turn led to further price declines and financial difficulties. His diagnosis led him to urge President Roosevelt to subordinate exchange-rate considerations to the need for reflation, advice that (ultimately) FDR followed.

Fisher’s idea was less influential in academic circles, though, because of the counterargument that debt-deflation represented no more than a redistribution from one group (debtors) to another (creditors). Absent implausibly large differences in marginal spending propensities among the groups, it was suggested, pure redistributions should have no significant macroeconomic effects. ” (Bernanke 2000, p. 24)

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

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

It is as absurd to assume that, for any long period of time, the variables in the economic organization, or any part of them, will “stay put,” in perfect equilibrium, as to assume that the Atlantic Ocean can ever be without a wave. (Fisher 1933, p. 339)

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

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

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

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

Click here to download this post as a PDF file.

]]> http://www.debtdeflation.com/blogs/2010/08/29/what-bernanke-doesn%e2%80%99t-understand-about-deflation/feed/ 203 http://www.debtdeflation.com/blogs/2010/08/18/giving-the-bird-to-the-stimulus/ http://www.debtdeflation.com/blogs/2010/08/18/giving-the-bird-to-the-stimulus/#comments Tue, 17 Aug 2010 22:23:47 +0000 Steve Keen http://www.debtdeflation.com/blogs/?p=4249 Peter Martin reports in The Age today that Professor Ron Bird of UTS has weighed into the debate over the Rudd stimulus package. Professor Bird claimed that the stimulus was far less important than our strong economy prior to the crisis, and the secondary effect on our exports of stimulus packages undertaken elsewhere.

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

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

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

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

“the current economic situation is in many ways better than what we have experienced in years. Against that background, we have stuck to the rebalancing scenario. Our central forecast remains indeed quite benign…” (OECD Economic Outlook June 2007).

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

I hope to see some of you there.

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

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

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

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

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

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

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

Yves found the model scary, not because it revealed anything about the economy that she didn’t already know, but because it so easily reproduced the Ponzi features of the economy she knows so well.

I have yet to attempt to fit the model to data–and given its nonlinearity, that won’t be easy–but its qualitative behavior is very close to what we’ve experienced. As in the real world, a series of booms and busts give the superficial appearance of an economy entering a “Great Moderation”–just before it collapses.

The motive force driving the crash is the ratio of debt to GDP–a key feature of the real world that the mainstream economists who dominate the world’s academic university departments, Central Banks and Treasuries ignore. In the model, as in the real world, this ratio rises in a boom as businesses take on debt to finance investment and speculation, and then falls in a slump when things don’t work out in line with the euphoric expectations that developed during the boom. Cash flows during the slump don’t allow borrowers to reduce the debt to GDP ratio to the pre-boom level, but the period of relative stability after the crisis leads to expectations–and debt–taking off once more.

Ultimately, such an extreme level of debt is accumulated that debt servicing exceeds available cash flows, and a permanent slump ensues–a Depression.

There are 4 behavioural functions in the model that mimic the behaviour of the major private actors in the economy–workers, capitalists and bankers. Workers wage rises are related to the level of employment and the rate of inflation; capitalists investment and debt repayment plans are related to the rate of profit; and the willingness of banks to lend is also a function of the rate of profit.

The model is explicitly monetary–with bank accounts for workers, bankers and capitalists–and the crisis is marked by a collapse in deposits and a rise in inactive bank reserves.

The same phenomenon is evident in the data, though the sharpness of the turnaround is far greater than can be replicated by the smooth functions in my model.

There’s a lot more work to do before the model is complete–notably including the impact of a goverment sector that can add its own spending power to a depressed economy–but its basic features fulfil Minsky’s challenge:

Can “It”-a Great Depression-happen again? And if “It” can happen, why didn’t “It” occur in the [first 35] 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 the¬ory which makes great depressions one of the possible states in which our type of capitalist economy can find itself.

This is the first economic model ever that meets Minsky’s standards for realism. Its final stage emphasises a message that Michael Hudson, one of the very few others to see this crisis coming, puts very simply: “Debts that can’t be repaid, won’t be repaid”. As Americans now seem to be realising, the financial crisis has not gone away, because the debt that caused it is still there.

Having got ourselves into a debt-induced economic crisis, the only permanent way out is to reduce the debt–either directly by abolishing large slabs of it, or indirectly by inflating it away. I have very little confidence in the ability of the Federal Reserve to do the latter, while the former will take a level of political fortitude that is far beyond our current politicians.