The ABS house price data for December 2011 has just been released, and it shows that house prices fell 4.8% in nominal terms between December 2010 and December 2011. The usual suspects are already trying to see this as marking the bottom, while “just the facts, ma’am” reporting simply emphasises the scale of the downturn. A couple of media outlets have asked my views on the next calendar year, so here they are–along with some historical perspective on the house price bubble.

Figure 1 deflates the ABS series by the CPI, and sets the real price index at 100 in mid-1986, when the ABS Data began. The peak was 261 (which means that real house prices were 2.6 times as high in 2010 as they were in 1986), the December 2011 value was 237, a fall of 9.3%. That’s in the ballpark of the figure I anticipated at the beginning of 2011 for the fall from the peak; over the calendar year of 2011, real house prices fell 7.7% (from 256 to 237), which is still in the range of 10 percent (see Figure 1; the vertical blue lines on this chart mark the beginning of 4 of the 5 incarnations of the First Home Owners Scheme [ its introduction was under Hawke in 1983; its last spin was the doubling and trebling of it by Rudd in 2008-10]).

Figure 1

I expect this rate of decline to keep up for 2012, so I’d expect prices to be of up to 10 percent lower than they are now by the end of 2012, in inflation-adjusted terms.

The force driving prices down is the same one that drove them up. Houses are overwhelmingly bought with borrowed money, so keeping house prices where they are requires a constant supply of new mortgages at the same level (relative to GDP per household) as now; rising house prices require new mortgages to be growing compared to income; and house prices fall if mortgages grow more slowly than income. That we’re now in a period of mortgage debt falling relative to income is finally obvious; only the FHVB delayed this happening.

Figure 2

The key indicator of the direction in which house prices are likely to move is the Mortgage Accelerator, which is the change in the change in mortgage debt (scaled by GDP). The logic is that since the rate of change of mortgages determines the demand for houses—and hence the price level—the acceleration of mortgages determines the change in the demand for housing—and hence the change in the price level.

Mortgage debt is now decelerating almost as much as it was prior to the introduction of the First Home Vendors Boost—the rate of acceleration is now about minus 1.5% of GDP, versus -2% before the Rudd Government meddled with house prices in its attempt to sidestep the GFC. The annual rate of decline of house prices is also of much the same rate as it was before that intervention: they are now falling at a rate of about 8 percent per annum in real terms. So a fall of that magnitude—somewhere between 6 and 10 percent over 2012—is quite likely.

Figure 3

The government might well attempt to intervene again as it has in the past, but I don’t think it will and I doubt that intervention would work anyway.

The 2008 squeeze of the First Home Vendors Sauce Bottle was very successful, which makes another squeeze much less likely to work: potential buyers from 2011 and beyond were already dragged forward into 2009-10 by the last squeeze, and house prices rose so much—by over 18% in real terms from the early 2009 trough to the peak early 2010 peak—that another Scheme would be hard pressed to entice new buyers in.

The previous NSW State government did its bit for the bubble by abolishing Stamp Duty for First Home Buyers (and the O’Farrell Government’s limiting of the exemption to properties below $500K with an expiry in December 2011 caused a rush of NSW buyers late last year), but that’s so expensive for the bottom line of State budgets that I doubt that State Governments anywhere will contemplate a repeat.

So overall, the likely outcome is a fall of 6-10% in real terms over calendar year 2012.

The key objective of this position is to free up Steve’s time so that he can focus on his research. As one of my primary functions, I will take over communications with the Debtwatch blog and CfESI website. Matters that require a research input will of course still be dealt with directly by Steve himself.

I am honoured to be here, I have no doubt that as this economic crisis drags on, Steve’s analysis and policy alternatives will become more prominent.

This is the beginning of yet another volatile and uncertain year for economies and financial markets as we venture further into the Global Financial Crisis. Let us continue in our pursuit of building a more stable economic future without any major crises.

Should you wish to contact me, please email me at d_g_law@hotmail.com …soon to be info@cfesi.org.

Photo at the summit of Mount Kosciuszko, the finish line of the Keen Walk

The “Global Financial Crisis”, which began in late 2007, marked a turning point in the nature of market economies. Their performance from at least the mid-1960s had been under-written by a faster growth of private debt than of GDP: this was the “Age of Leverage”. In late 2007, the growth rate of private debt fell, and since then we have been in the Age of Deleveraging.

The statistics of the Ages are stark enough: private debt rose sixfold compared to GDP in America from 1945, and sixfold in Australia from 1965. Pre-1988 figures aren’t available for UK debt, but clearly it has exploded since 1988. All three ratios peaked after 2007, and have since been falling. The fall in the US ratio is clearly unprecedented in the post-WWII period: only the Great Depression compares.

Figure 1

The change in debt data is just as stark—and it points out one substantive difference between Australia on the one hand and the USA & UK and most of the Western OECD on the other. Australian private debt is still rising (though more slowly than nominal GDP), whereas US private debt has been falling in absolute terms, and the UK has fluctuated between rising and falling debt.

Figure 2

Non-economists might expect professional economists to pay great heed to these indicators—after all, surely private debt affects the economy? However, the dominant approach to economics—known as “Neoclassical Economics” —ignores them completely, on the a priori grounds that the aggregate level of private debt doesn’t matter: only its distribution can have macroeconomic impacts.

The argument is that a rise in debt merely indicates a transfer of spending power from a saver to a borrower. The debtor’s spending power rises, but saver’s spending power also falls, so in the aggregate there will only be a macroeconomic effect if there is a very large difference in behaviour between the saver and borrower. Therefore only the distribution of debt matters, not its level or rate of change.

US Federal Reserve Chairman Ben Bernanke provided precisely this rationale to explain why neoclassical economists ignored Irving Fisher’s “debt-deflation” explanation of the Great Depression (Fisher 1933), and he also asserted that the differences in behaviour between saver and borrower could not be large enough to explain the Great Depression:

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 macro-economic effects… (Bernanke 2000, p. 24)

Similarly, Nobel Prize winner Paul Krugman argued recently that the aggregate level of private debt was not a factor in the GFC: only its distribution could be. He therefore developed a model in which the distribution of debt, rather than its level, was the causal factor:

Ignoring the foreign component, or looking at the world as a whole, the overall level of debt makes no difference to aggregate net worth — one person’s liability is another person’s asset…

In what follows, we begin by setting out a flexible-price endowment model in which “impatient” agents borrow from “patient” agents, but are subject to a debt limit. If this debt limit is, for some reason, suddenly reduced, the impatient agents are forced to cut spending… (Krugman and Eggertsson 2010, p. 3)

He reasserted this analysis in a recent blog, arguing that the level of debt doesn’t matter, because most debt is “money we owe to ourselves”:

People think of debt’s role in the economy as if it were the same as what debt means for an individual: there’s a lot of money you have to pay to someone else. But that’s all wrong; the debt we create is basically money we owe to ourselves, and the burden it imposes does not involve a real transfer of resources.

That’s not to say that high debt can’t cause problems — it certainly can. But these are problems of distribution and incentives, not the burden of debt as is commonly understood. (Krugman 2011)

Bizarre as it may sound, these arguments by leading economists ignore decades of empirical research into and practical knowledge on banking, which have established that their fundamental premise is false: a new debt is not a transfer from one bank customer’s account to another’s—which is effectively what Krugman models and Bernanke assumes above—but a simultaneous creation of both a deposit and a debt by the bank. A bank loan thus gives a borrower additional spending power without forcing savers to reduce their spending power to compensate. As Joseph Schumpeter put it during the Great Depression:

‘It is always a question, not of transforming purchasing power which already exists in someone’s possession, but of the creation of new purchasing power out of nothing…’ (Schumpeter 1934, p. 73; see Keen 2011 , pp. 154-157, for more detail on this issue)

From this empirically confirmed perspective (Holmes 1969; Moore 1979; Kydland and Prescott 1990; Carpenter and Demiralp 2010), the change in debt therefore does have serious macroeconomic consequences, since an increase in debt adds to aggregate demand—and it is the primary means by which both investment (Fama and French 2002) and speculation (Minsky 1982, pp. 28-30) are funded.

In a credit-based economy, aggregate demand is therefore the sum of income plus the change in debt, with the change in debt spending new money into existence in the economy. This is then spent not only goods and services, but on financial assets as well—shares and property. Changes in the level of debt therefore have direct and potentially enormous impacts on the macroeconomy and asset markets, as the GFC—which was predicted only by a handful of credit-aware economists (Bezemer 2009)—made abundantly clear.

If the change in debt is roughly equivalent to the growth in income—as applied in Australia from 1945 to 1965, when the private debt to GDP ratio fluctuated around 25 per cent (see Figure 1)—then nothing is amiss: the increase in debt mainly finances investment, investment causes incomes to grow, and the economy moves forward in a virtuous feedback cycle. But when debt rises faster than income, and finances not just investment but also speculation on asset prices, the virtuous cycle gives way to a vicious positive feedback process: asset prices rise when debt rises faster than income, and this encourages more borrowing still.

The result is a superficial economic boom driven by a debt-financed bubble in asset prices. To sustain a rise in asset prices relative to consumer prices, debt has to grow more rapidly than income—in other words, if asset prices are to rise faster than consumer prices, then rather than merely rising, debt has to accelerate. This in turn guarantees that the asset price bubble will burst at some point, because debt can’t accelerate forever. When debt growth slows, a boom can turn into a slump even if the rate of growth of GDP remains constant.

This process is easily illustrated in a numerical example. Consider an economy with a GDP of $1 trillion that is growing at 10% per annum, with real growth of 5% and inflation of 5%, and in which private debt is $1.25 trillion and growing at 20% p.a. Total spending on both goods & services and financial assets is therefore $1.25 trillion: $1 trillion is financed by income, and $250 billion is financed by the 20% increase in debt.

In the following year, if the growth of debt simply slows down to the same rate at which nominal GDP is growing (without affecting the rate of economic growth), then the growth in debt will be $150 billion (10% of the $1.5 trillion level reached at the end of the previous year). Total spending will therefore be exactly the same as the year before: $1.25 trillion, consisting of $1.1 trillion in GDP plus a $150 billion growth in debt. However, since inflation is running at 5%, this amounts to a 5% fall in the real level of economic activity—which would be spread across both commodity and asset markets.

If instead the growth of debt stopped, then total spending the next year will be $1.1 trillion, a 15% fall from the level of the previous year in nominal terms, and 20% in real terms. This would cause a massive slump in demand for goods & services, assets, or both, even without a slowdown in the rate of growth of GDP.

This hypothetical example is not far removed from the actual experience of the GFC. As the US experience illustrates most clearly, the switch from rising to falling private debt ushered in the biggest economic downturn since the Great Depression, a prolonged period of high unemployment, and sharp falls in asset markets—all of which are plotted in Figure 3.

Figure 3

This is why the shift from the Age of Leverage to the Age of Deleveraging was so dramatic, and yet so unforeseen by conventional economists: it was caused by a huge reduction in aggregate demand from a factor they ignore. This debt-induced reduction in aggregate demand will persist as long as private debt levels are falling—as they still are in the USA, though at a much reduced rate from the peak rate of fall in early 2010.

Until private debt levels are substantially reduced, the economy will always tend towards what Richard Koo called a “balance sheet recession” (Koo 2009), where the desire of the private sector to reduce its leverage will suppress aggregate demand, causing both recessions and falling asset prices. The Western OECD is thus “turning Japanese”—replicating the crisis that led to Japan’s “Lost Decade”, which is now two decades old.

Koo argues that whether the world experiences the relatively minor decline in Japanese economic performance or achieves something much worse depends in part on whether the world mimics Japan’s policy response or not. But whereas conventional wisdom argues that Japan has failed by running huge government deficits, Koo argues that without these deficits, Japanese GDP would have fallen far more.

His reasoning is that, just as private sector borrowing spends additional money into existence, so too does a government deficit. But if the private sector is deleveraging—as it has done in Japan since 1991 and is now doing in the USA—then the change in private debt is actually subtracting from demand. Japan’s public sector deficits therefore attenuated the decline in aggregate demand:

Although this fiscal action increased government debt by … 92 percent of GDP during the 1990–2005 period, the amount of GDP preserved by fiscal action compared with a depression scenario was far greater. For example, if we assume, rather optimistically, that without government action Japanese GDP would have returned to the pre-bubble level of 1985, the difference between this hypothetical GDP and actual GDP would be over 2,000 trillion yen for the 15-year period. In other words, Japan spent 460 trillion yen to buy 2,000 trillion yen of GDP, making it a tremendous bargain. And because the private sector was deleveraging, the government’s fiscal actions did not lead to crowding out, inflation, or skyrocketing interest rates. (Koo 2011, p. 23)

On the other hand, Koo cautions that if the government attempts to run a surplus while the private sector is deleveraging, there will be two factors reducing economic activity at the same time. He therefore argues that deficits are sensible when the private sector is deleveraging, while attempting to run surpluses will make a bad situation worse:

Although shunning fiscal profligacy is the right approach when the private sector is healthy and is maximizing profits, nothing is worse than fiscal consolidation when a sick private sector is minimizing debt. (Koo 2011, p. 27)

However, fiscal consolidation is the policy prescription that is being applied in the Euro zone and the UK, and supported by politicians in both Australia and the USA. The likely outcome of public austerity is thus a further decrease in the growth rate of countries practicing it. Given that most of the Western OECD is already under severe economic stress, the pain that austerity inflicts upon already stressed societies is likely to mean drastic political change.

The most obvious location for political turmoil is Europe, where the Maastricht Treaty’s rules force countries to attempt to restrain fiscal deficits to 3% of GDP. This was always a bad idea, predicated on the belief that severe economic crises could not occur. Though the treaty was applauded by neoclassical economists, I was far from the only non-neoclassical economist to observe that this treaty could lead to the breakup of Europe when a recession hit, since “Europe’s governments may be compelled to impose austerity upon economies which will be in desperate need of a stimulus” (Keen 2001, pp. 212–13; see also Keen 2011, pp. 2-3).

Though continental Europe is the most obvious location for economically inspired political instability in 2012, another dark horse may also be the UK. As Figure 1 shows, its private debt level is staggeringly high—one and a half times the peak level of the USA’s—and yet it did not suffer as severe a downturn as the USA when the crisis began because, as Figure 2 indicates, it did not fall as deeply into deleveraging. The maximum decline in aggregate demand caused by falling private debt in the UK was only 6 percent of GDP, versus 20 percent in the USA.

However the rate of deleveraging in the UK has again hit this level, while the USA has recovered from the worst of the initial downturn and is deleveraging at a rate of only 3% of GDP. Governments in both the USA and the UK are favouring austerity policies, but the UK is already imposing them—with thus far negative results—and is far more likely to be able to maintain them than the politically hamstrung USA. This means that private sector deleveraging and public sector austerity may coincide in the UK in 2012, which from a “balance sheet recession” perspective indicates that the UK could fall into recession from an already depressed level of economic activity. This is especially likely if the rate of private sector deleveraging accelerates.

What could the future hold for Australia? To date, sangfroid has dominated Australian attitudes towards the GFC—based partly on our avoidance of a deep downturn in 2008, which was unique amongst OECD nations, and partly on our lucky dependence on China. At the beginning of 2011, the RBA expected to be raising rates to restrain inflation in a booming economy, while Treasury expected unemployment to fall towards full employment levels. Economic policies proposed by the major political parties were based on expectations of managing a boom, and the only debate was over how quickly the Budget should return to surplus.

Figure 4: Treasury forecasts (& projections of a return to equilibrium) in the 2011-12 budget

Unfortunately, recent economic data hasn’t followed the sangfroid script. Inflation—as measured by the RBA’s preferred indicators, the weighted and trimmed means—has fallen rather than risen, while unemployment has risen from a low of 4.9% to 5.3% (versus expectations of 4.75% in June 2012) and appears likely to trend up rather than down in coming months.

If this does happen, it will not be an indication that Government deficits are the problem—or even that they have failed to stimulate the economy—but a caution that Australia is not so different after all. Though it was delayed by policy and the mining boom, Australia is now on the cusp of a balance sheet recession too.

To see this, we need to take a closer look at the Australian private debt level. Figure 5 considers both the level (compared to GDP) and rate of change of Australian private debt since 2000.

Figure 5

After initially falling in 2008, Australia’s private debt to GDP ratio actually rose from mid-2009 till mid-2010; so Australia re-levered while the USA in particular de-levered. This rising debt boosted aggregate demand after its initial fall during the GFC, but the growth of debt is now at levels well below the pre-GFC peak.

Anticipating what might happen from now on involves considering one of the trickiest aspects of debt, its acceleration. Since aggregate demand is income plus the change in debt, the change in aggregate demand is the change in income plus the acceleration of debt. I define the “Credit Accelerator” (initially called the “Credit Impulse” by Biggs and Mayer 2010; Biggs, Mayer et al. 2010) as the ratio of the acceleration of debt to GDP, and use this as an indication of how strongly the dynamics of private debt are going to impact upon economic performance and asset markets.

Figure 6 illustrates why the “GFC” (which Americans call the “Great Recession”) was so much more devastating in the USA than Australia: the deceleration of debt was far more extreme, and lasted for much longer.

Figure 6

Figure 7 shows the relationship between credit acceleration and change in employment in Australia since 2000. Though the difference between the mild Australian and the severe American downturn was due to the much more severe deceleration of debt in America, private debt is now decelerating in Australia, and the level of employment is falling as a result.

Figure 7 (Mea culpa–R^2 should be “Correlation Coefficient”)

A similar phenomenon applies to the most important asset class in Australia, housing. Mortgage debt was the only component of private debt to rise during the GFC—under the influence of what I call the First Home Vendors Boost. Mortgage debt is now decelerating, and house prices are falling as a result. As experience has shown in the USA and Japan, this tends to be a runaway process, as falling house prices encourage further falls in debt.

Figure 8 (R^2 should be “Correlation Coefficient”)

Clearly, economic policy is now far more complex than it appeared to be before the GFC. As we enter this Age of Deleveraging, the worst thing we can do is apply policies that appeared to work during the preceding Age of Leverage—but were in fact predicated on ever-rising private sector indebtedness. Politicians should be sceptical of conventional economic advice at this time; it would be much wiser to study the history of the 1930s instead.

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

Bezemer, D. J. (2009). “No One Saw This Coming”: Understanding Financial Crisis Through Accounting Models. Groningen, The Netherlands, Faculty of Economics University of Groningen.

Biggs, M. and T. Mayer (2010). “The Output Gap Conundrum.” Intereconomics/Review of European Economic Policy
45(1): 11-16.

Biggs, M., T. Mayer, et al. (2010). “Credit and Economic Recovery: Demystifying Phoenix Miracles.” SSRN eLibrary.

Carpenter, S. B. and S. Demiralp (2010). Money, Reserves, and the Transmission of Monetary Policy: Does the Money Multiplier Exist? Finance and Economics Discussion Series. Washington, Federal Reserve Board.

Fama, E. F. and K. R. French (2002). “Testing Trade-Off and Pecking Order Predictions about Dividends and Debt.” Review of Financial Studies
15(1): 1-33.

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

Holmes, A. R. (1969). Operational Constraints on the Stabilization of Money Supply Growth. Controlling Monetary Aggregates. F. E. Morris. Nantucket Island, The Federal Reserve Bank of Boston: 65-77.

Keen, S. (2001). Debunking economics: The naked emperor of the social sciences. Annandale Sydney & London UK, Pluto Press Australia & Zed Books UK.

Keen, S. (2011). Debunking economics: The naked emperor dethroned? London, Zed Books.

Keen, S. (2011). “Debunking Macroeconomics.” Economic Analysis & Policy
41(3): 147-167.

Koo, R. (2009). The Holy Grail of Macroeconomics: Lessons from Japan’s Great Recession. Wiley.

Koo, R. (2011). “The world in balance sheet recession: causes, cure, and politics ” Real-World Economics Review
58(58): 19-37.

Krugman, P. (2011). “Debt Is (Mostly) Money We Owe to Ourselves.” The Conscience of a Liberal
http://krugman.blogs.nytimes.com/2011/12/28/debt-is-mostly-money-we-owe-to-ourselves/ 2012.

Krugman, P. and G. B. Eggertsson (2010). Debt, Deleveraging, and the Liquidity Trap: A Fisher-Minsky-Koo approach [2nd draft 2/14/2011]. New York, Federal Reserve Bank of New York & Princeton University.

Kydland, F. E. and E. C. Prescott (1990). “Business Cycles: Real Facts and a Monetary Myth.” Federal Reserve Bank of Minneapolis Quarterly Review
14(2): 3-18.

Minsky, H. P. (1982). Can “it” happen again? : essays on instability and finance. Armonk, N.Y., M.E. Sharpe.

Moore, B. J. (1979). “The Endogenous Money Stock.” Journal of Post Keynesian Economics
2(1): 49-70.

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.

For its entire history, macroeconomics has been dominated by mathematical models that ignore the existence of money, debt and banking, and that perceive the economy’s movement through time as transitions from one state of equilibrium to another.

At any point in history, these would be heroic assumptions. Could it really be true that models without either money or instability are provably superior at predicting the economy’s future course than models in which money and banking exist, and in which the model economy can be out of equilibrium? If not, is it the case then that such models are simply too difficult to construct—that the best we can do is pretend that the economy doesn’t have banks or money, and that it’s always in equilibrium, even if we know these assumptions are false?

Before the crisis of 2007, few non-economists even asked those questions, because there seemed to be no need to challenge what economists did. The economy, after all, was going gangbusters. Professional economists, using the very latest mathematical models of the economy, took credit for its sterling performance, and predicted more of the same for the foreseeable future.

Robert Lucas, the father of “Rational Expectations Macroeconomics”, asserted that the “macroeconomics … has succeeded. Its central problem of depression prevention has been solved, for all practical purposes, and has in fact been solved for many decades.”[1]  Ben Bernanke lauded “improved control of inflation” as the cause of “the Great Moderation”, which he described as “this welcome change in the economy.” [2] In June 2007, the OECD, guided by its macroeconomic model, opined that “the current economic situation is in many ways better than what we have experienced in years… Our central forecast remains indeed quite benign”. [3]

Then all hell broke loose, and almost five years later, it shows no signs of abating. Now non-economists are challenging what economists do, and finally realizing what a minority of dissidents within economics have long known: these assumptions are not merely heroic, they are both false and unnecessary. Money, debt and disequilibrium dynamics play crucial roles in the actual behaviour of the economy, and it is relatively easy to develop mathematical models which include money and banks, and in which the economy is always in disequilibrium. I should know: it’s what I do, and it’s why I was one of two mathematical economists who saw this crisis coming, and warned of it publicly before it happened (the other was the late Wynne Godley). [4]

For economics to have a future, it has to abandon the obsession with equilibrium modelling, and realistically incorporate money, banking and finance into macroeconomics. Both things are, as I’ve said, not hard to do.

The starting point for modelling any process in a true science is a position of disequilibrium—Newton, after all, modelled gravity by considering a falling apple, not one at rest! Economists have to abandon their fetish with “comparative statics” and instead model processes of change. Dynamics has to be the core of economic analysis, not equilibrium.

Money is also easily modelled by borrowing the basic tool of the accountant, double-entry bookkeeping. [5] Money and debt are created by bookkeeping entries, and the same paradigm can be used to derive dynamic models of the flow of money in one direction, propelling the movement of goods and financial assets in the other.

The difficulty in developing a monetary dynamic macroeconomics comes not from the tools themselves, but from the beliefs that have to be abandoned to employ them sensibly—from other assumptions that Neoclassical economists have made to “simplify” analysis that instead have made it almost impossible to understand the real world. There are enough of these to literally fill a book—to whit, my Debunking Economics [6]—but I’ll single out just three:

• “Rational” expectations—which really means assuming that everyone can accurately predict the future (and therefore avoid any calamities like the one we are in right now);
• Representative agents—which really means assuming that there’s only one person in the economy, who produces and consumes just one commodity; and
• Perceiving macroeconomics as applied microeconomics

This last false belief, and not a quest for greater realism, was the driving force behind the development of macroeconomics since WWII. It was a fool’s errand, since as physicists realized decades ago, “More Is Different”—to quote the title of a famous paper from Physics Nobel Laureate Philip Anderson. [7] Biology cannot be treated as merely applied chemistry, even though the elementary building blocks of living entities are chemicals, because properties emerge from the interactions of these chemicals that can’t be explained from the chemicals alone.

We call one of these emergent properties “Life”. We know a great deal about chemistry, but no chemist has as yet created life. The attempt to reduce macroeconomics to applied microeconomics was as futile a quest.

—————————————————–

[1] Robert E. Lucas, Jr, “Macroeconomic Priorities”, his 2003 Presidential Address to the American Economic Association, January 10, 2003. http://oldweb.econ.tu.ac.th/archan/chaiyuth/New%20growth%20theory%20Review%20in%20Thai/macro%20perspectives_lucas.pdf.

[2] Bernanke, B. S. (2004). Panel discussion: What Have We Learned Since October 1979? Conference on Reflections on Monetary Policy 25 Years after October 1979, St. Louis, Missouri, Federal Reserve Bank of St. Louis. http://www.federalreserve.gov/boarddocs/speeches/2004/20041008/default.htm.

[3] Cotis, J.-P. (2007). Editorial: Achieving Further Rebalancing. OECD Economic Outlook. OECD. Paris, OECD. 2007/1: 7-10. http://www.scribd.com/doc/43756565/Oecd-Economic-Outlook-2007

[4] Fortunately Godley (http://en.wikipedia.org/wiki/Wynne_Godley), has many young followers carrying on his work. For the list of economists who warned of the crisis, see Bezemer, D. J. (2009). “No One Saw This Coming”: Understanding Financial Crisis Through Accounting Models. Groningen, The Netherlands, Faculty of Economics University of Groningen. http://mpra.ub.uni-muenchen.de/15892/1/MPRA_paper_15892.pdf.

[5] For an example of modelling a simple 19^th century paper money system, see http://www.economics-ejournal.org/economics/journalarticles/2010-31.

[6] Steve Keen (2011), Debunking Economics: the naked emperor dethroned?, Pluto Press, London. http://www.amazon.com/Debunking-Economics-Revised-Expanded-Dethroned/dp/1848139926/ref=sr_1_1?s=books&ie=UTF8&qid=1326839803&sr=1-1

[7] Anderson, P. W. (1972). “More Is Different.” Science 177(4047): 393-396. http://www.andersonlocalization.com/pdf/more_is_different.pdf.

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Figure 1: Excerpt from the 1st Debtwatch Report in November 2006

From humble beginnings, the blog has grown like Topsy to have over 12,500 subscribers, about 60,000 unique visitors, amost one million page views and six million hits per month.

Figure 2: Debtwatch readership stats for 2011

The readership is international. The majority of readers are American, with my home country of Australia second, and the UK third.

Figure 3: Top ten countries by page views in December 2011 (till December 18^th)

The audience is also highly educated, both in general and in comparison to sites of prominent media outlets.

Figure 4: Alexa demographic data on Debtwatch

Ironically, given that my sympathies are firmly with “the 99%”, and that my objectives include drastically reducing the power and size of the financial sector, this blog is popular with both the well-paid and the financial sector.

Figure 5: Alexa income level data

In fact, my blog is now so popular with the finance sector that I am being approached by funds that are interested in sponsoring both Debtwatch and the Center for Economic Stability.

So I am now presented with a paradox: my objectives are to drastically reduce the size and power of the financial sector—hedge funds included—and yet organisations within that sector now want to sponsor my work.

The motivations behind such offers of financial support undoubtedly range from simply wanting to have a corporate logo appear in front of blog readers’ eyeballs at one extreme, to sharing some of the same objectives I have at the other—as George Soros clearly does in his funding of the Institute for New Economic Thinking.

I certainly need funding to be able to achieve my own aims. I can’t do the work needed to overthrow neoclassical economics and develop a realistic alternative on my own, and the work involved in maintaining this blog and handling correspondence from the public means I now spend far more time working out the intricacies of the internet and answering emails than I spend doing original research. So funding is necessary, which is the main reason I instituted a membership scheme on Debtwatch: to raise sufficient funds to employ assistants who can take those tasks off my hands, so that I can focus on that research.

That fund raising has been mildly successful—about $18,500 has been raised since membership schemes for Debtwatch and CfESI commenced in September 2011, of which about $10,000 is recurring funding.

Figure 6: Recurring Funding for Debtwatch as of mid-December 2011

Figure 7: One-off Funding for Debtwatch as of mid-December 2011

Figure 8: Recurring funding for CfESI as of mid-Deccember 2011

This funding has been useful—amongst other activities, it funded my trips to London to launch Debunking Economics II and to be interviewed by the BBC—but at this rate it will be decades before I can afford to hire staff as well. I haven’t got that long.

So I will accept corporate sponsorship—including, but certainly not limited to, sponsorship from the FIRE sector—but only on my terms. These are spelt out in The Debtwatch Manifesto, which is now a permanent page of this blog. Any corporate sponsor has to accept that those are the aims to which sponsorship will be put.

There are at least two reasons for stating my objectives in this manner.

Firstly, I am aware of the danger of letting commercial sponsorship alter one’s message, and I want to make it clear that I will not let that happen to me. As someone who has spent 40 years opposing the conventional wisdom in economics, I’m not about to let sponsorship persuade me to do otherwise, or to resile from policy positions that I believe are justified by good analysis and empirical data. For that reason I’m putting my objectives on public view before sponsorship becomes an important source of revenue for my work.

Secondly, I know that this is in the interests of those who might sponsor me—even if some of what I hope to achieve works against those interests. I have developed the following I now have because of my empirically-oriented analytic realism. I would be doing a disservice not only to myself, but to sponsors themselves if I let sponsorship affect my analysis or my views.

Levels of sponsorship

There are 3 levels of sponsorship:

Figure 9: Sponsorship Levels

Sponsorship funding is allocated between my blog Debtwatch and CfESI. If you are interested in sponsorship, please contact me at ProfSteveKeen AT gmail DOT com.

First Sponsor

The first Foundation Sponsor for Debtwatch and CfESI is Sabretooth Capital Management, whose logo now appears on both sites.

Benefits of sponsorship

The primary benefit is an altruistic one: by sponsorship, you contribute to my efforts to build a new realistic theory of economics to replace the myths of neoclassical economics that have played such a major role in causing the crisis we are now in.

The funding will make it easier for me to devote my time and energies to developing the theoretical and empirical analysis that made this blog influential in the first place, but which today receives so little of my personal time because of the sheer workload that my success has generated.

Other benefits include:

• Acknowledgement of your support on Debtwatch & CfESI (if required; I have been contacted about sponsorship by some institutions that do not want their support publicly acknowledged);
• An annual seminar by me on economics for your staff or customers, as requested;
• Early access to my analysis (but not exclusive access—I am committed to informing the public about realistic economics, and this is not going to change);
• Informal access for analysis and data (but not consulting unless separately arranged; I am loathe to undertake consulting, given that this takes time away from fundamental analysis);
  • By doing this I am not offering financial advice. Apart from the legal restrictions on offering financial advice in Australia—for which I am not licenced—giving financial advice involves having knowledge of a customer’s financial situation and needs, which I do not have and will not seek; and
• Signed copies of my latest book (currently Debunking Economics: the naked emperor dethroned)—2 dozen, 4 dozen and 10 dozen copies respectively for each level of membership.

How Sponsorship will be used

Part will go to my income. I didn’t start the blog to make money, but to warn about its destruction on a global scale. However, now that I have succeeded in that aim, I want to be able to continue working on developing an alternative economics full-time, without having to consider my financial security while I do it.

Well before I reach that level of funding, sponsorship will enable me to reduce my teaching commitments and focus on writing Finance and Economic Breakdown, with the hope that it can be published in 2014.

I need to hire staff for a range of purposes. Major priorities are a personal assistant, a webmaster to take over maintenance of Debtwatch (three cheers for WordPress—as a computer amateur, I couldn’t have reached the audience I have without this brilliant Open Source program—but the blog itself desperately needs a professional makeover), a research assistant to populate Econodata, and a statistician to help with the design of leading indicators and the empirical verification of my dynamic models. The development of the Minsky software program will be on-going, and with sufficient funding full-time programmer(s) will be hired for this purpose.

The funding to date has mostly been expended on travel, computer hardware and software. Once sufficient funds, standard ancillary expenses like office rental will also arise.

Changes to the blog

There will be some changes to the blog in coming months. Some of these are long overdue cosmetic changes, which I can now finally afford to hire a professional designer to undertake. Others will be designed to increase the revenue generated by the blog.

This may include requiring browsers to register to read, but it will not include restricting readership to paying subscribers (as, for example, Nouriel Roubini has done). My primary objective will always be developing a realistic theory of economics, and public knowledge of both the flaws in neoclassical analysis and the existence of alternatives is vital to that objective. That’s why my current membership scheme is a “Clayton’s” one, where the only restriction is on downloading documents.

I am no accountant–I never studied accounting at university (I did an Arts/Law degree as an undergraduate, majoring in Economics with minors in Maths & Psychology), and have never had to develop the skills subsequently–so I am happy to take advice from someone like Neil about how to conform to proper double-entry standards.

Neil notes below that a number of monetary theory types rejected my model out of hand because it didn’t conform to those standards–and they therefore assumed it had to be intrinsically wrong.

I, on the other hand, developed these models in the first instance as systems of differential equations–an area where I do have some training–and was confident they were correct.

Neil decided to see whether the basic Circuit model (as outlined in Debunking Economics II and this downloadable academic paper) could be expressed in proper double-entry-bookkeeping form. His end conclusion was yes: the model could be rejigged into double-entry form, and the resulting simulations were numerically identical.

In a future post, Neil and I will jointly extend this research–including publishing the system of equations that result. But in the meantime, I’m very happy to cross-post Neil’s blog entry here.

A Double Entry View on the Keen Circuit Model

Over the last few months I’ve enjoyed Steve Keen’s lecture series on You Tube, which are definitely recommended for anybody wanting a solid understanding of why neo-classical macroeconomics is complete bunkum.

In there is an iteration of Steve’s horizontal money circuit and the tables and equations he uses to build that model. He’s rejigged those models in response to a challenge by Scott Fullwiler to fit the model into double entry bookkeeping tables.Now Steve is a great speaker, a good writer and formidable mathematician. But I’m afraid he would get a fail in a bookkeeping exam. For something to be consistent with double entry there has to be at least two entries in the journal and the journal must sum to zero. To abuse Minsky’s words: a double entry model with a single entry in it isn’t a double entry model.So its easy to see why the presentation of this particular model causes a few fireworks in schools of thought who are more fastidious in their bookkeeping.My background is in Information System design and architecture, with a dose of accountancy thrown in for good measure, and I’ve worked in and around the Free Software movement for over twenty years. So my natural tendency is to look at ways of re-integrating ‘forks’. I believe all the issues commonly complained about in this model can be reconciled by making the tables double entry complaint and extending the model slightly. I hope this will show to all sides that they are talking about the same thing.And by doing so I am almost certain to upset everybody. Such is life.

First the current tables. This is a copy of table 14.1 in Debunking Economics (similar to table 1 on this post at Steve’s site):

	Assets		Liabilities		Equity
Operation	Vault	Loan Ledger	Firms	Workers	Safe
Lend Money	-Lend Money		+Lend Money
Record Loans		+Lend Money
Charge Interest		+Charge Interest
Pay Interest			-Charge Interest		+Charge Interest
Record Payment		-Charge Interest
Deposit Interest			+Deposit Interest		-Deposit Interest
Hire Workers			-Wages	+Wages
Bankers Consume			+Bankers Consumption		-Bankers’ Consumption
Workers Consume			+Workers’ Consumption	-Workers’ Consumption
Loan Repayment	+Loan Repayment		-Loan Repayment
Record Repayment		-Loan Repayment

From a double entry viewpoint there are a few things that feel uncomfortable with this table.

1. the liabilities side is strictly the wrong sign. Liabilities are generally shown negative so that when you add them to assets you get zero. You can run them as a positive balance but that means the check of simply making sure the row adds up to zero doesn’t work so well (you have to multiply the sum of liabilities by -1 first). Also ‘-’ is generally a credit and ‘+’ a debit. So in the table you can see that firms appear to pay wages by ‘crediting’ and workers receive wages by ‘debiting’ which is inconsistent with the way bank accounts are usually described.

1. The bank only gets paid when the firm pays the interest. Yet in accounting the bank will ‘recognise’ the income (ie credit its profit and loss account) as soon as it charges interest and this will allow it to spend before it gets paid. This isn’t seigniorage as the bank has indeed earned that money. So the table has a minor temporal error in it which may or may not be important.

1. The initial conditions on a balance sheet must be created by a series of journals and must balance to zero. Money shouldn’t magically appear in a Vault.

1. But most importantly there are a lot of single entries in the rows. That makes this table inconsistent with the fundamentals of double entry that requires every transaction to sum to zero. To be double entry there must be at least two entries and the journal rows must sum to zero – or it is not a double entry table. So there is something missing from this model to balance those lines.

Bear in mind that this is a limited horizontal circuit model with a lot of heuristic assumptions. It is has static parameters and ignores everything other than a simple private credit circuit. So there is no initial capital for the bank or equity considerations and all the parameters have a fixed value. Those are all deliberate.

It’s job is to show that a private credit circuit with a fixed stock of money can exist standalone which was, prior to Steve’s work, thought impossible.

My job is to reconcile this table so that it works from a double entry viewpoint, still have loans creating the equivalent deposits and have them both destroyed and not destroyed at the same time all while satisfying as many viewpoints as possible.

In other words the perennial accountant’s dilemma – how to present a set of accounts.

So let’s have a go at fixing this and see how many people we can upset.

Let’s start with the first line and fix the signs. We’re going to impose a ‘all rows sum to zero’ restriction on this table.

	Assets	Liabilities			Equity
Operation	Vault	Loan Ledger	Firms	Workers	Safe
Lend Money	+Lend Money		-Lend Money

So we have an accurate journal on the firm side – crediting their account with money is definitely correct. But the balancing entry now appears wrong – why would crediting a Firm account increase a vault asset?

Answer: it wouldn’t. Vault is on the wrong side of the balance sheet. Paper notes in a Vault are a stock of non-circulating bank liabilities – as are the electronic equivalent. So let’s move Vault.

	Assets	Liabilities			Equity
Operation	Loan Ledger	Vault	Firms	Workers	Safe
Lend Money		+Lend Money	-Lend Money

Now it makes sense, the flow is moving the liabilities from the non-circulating stock in the Vault to the circulating stock at the Firm.

Which then leads onto the next question. How are there any liabilities in the Vault in the first place?

Well, thinking in paper for a moment, notes have to be made and there will be a limit to how many can be made. And only banks can make these notes, not firms. So what’s the difference?

The banks have a ‘licence to print money’ that the firms don’t have  (even if its one they gave themselves – as a truly independent central or private bank would do for example). Technically of course this is a ‘licence to create money’ – they are not required to print it. A licence is an ‘intangible asset’. The value of the licence to create money will vary over time depending upon the terms of the licence, the amount of outstanding loans and various other factors. And, like the intrinsic goodwill of the firm or its ‘human resources’, you don’t usually see the value on a bank balance sheet.

But in this model we want to know how much ‘potential money’ is in the system at any point in time so let’s add in a journal to give the bank the ability to create a fixed amount of money (remember this model is operating under fixed parameter heuristic assumptions). This neatly solves the problem of where the ‘initial value’ comes from and makes new money and old money the same thing – the value of the licence can vary dynamically like any other variable.

	Assets		Liabilities			Equity
Operation	Licence Value	Loan Ledger	Vault	Firms	Workers	Safe
Grant Licence	+Grant Value		-Grant Value
Lend Money			+Lend Money	-Lend Money

And then finally add in the recording of the loan.

	Assets		Liabilities			Equity
Operation	Licence Value	Loan Ledger	Vault	Firms	Workers	Safe
Grant Licence	+Grant Value		-Grant Value
Lend Money			+Lend Money	-Lend Money
Record Loan	-Lend Money	+Lend Money

So now we have an extended balance sheet with the money creation system declared explicitly on the face of the balance sheet. A credit licence has value and that initial value is added to the balance sheet as a non-circulating intangible asset and the associated non-circulating revaluation reserve liability – which we have called Vault in this model for want of a better name.

Issuing Loans reduces the remaining value of the credit licence and at the same time the Deposit reduces the remaining amount in the Vault. Loans still create deposits – but by changing non-circulating liabilities into circulating ones.

So far so good. Let’s add some interest.

Interest can be seen as an extension to the loan, where the associated deposit is immediately paid over to the Bank. So we can add that in.

	Assets		Liabilities			Equity
Operation	Licence Value	Loan Ledger	Vault	Firms	Workers	Safe
Charge Interest			+Interest Charge			-Interest Charge
Record Interest	-Interest Charge	+Interest Charge

Generally there is no separate paying of interest. As anybody who has a mortgage knows you just make one repayment which covers the principal and accrued interest.

But this is really a stylistic point at this stage as the value of the payment is the Loan Repayment + Interest Charge anyway.

	Assets		Liabilities			Equity
Operation	Licence Value	Loan Ledger	Vault	Firms	Workers	Safe
Repay Loan and Interest			-Loan Repayment ?Interest Charge	+Loan Repayment +Interest Charge
Record Loan and Interest Repayment	+Loan Repayment +Interest Charge	-Loan Repayment ?Interest Charge

So the revised Lending table looks like this in total:

	Assets		Liabilities			Equity
Operation	Licence Value	Loan Ledger	Vault	Firms	Workers	Safe
Grant Licence	+Licence Value		-Licence Value
Lend Money			+Lend Money	-Lend Money
Record Loan	-Lend Money	+Lend Money
Charge Interest			+Interest Charge			-Interest Charge
Record Interest	-Interest Charge	+Interest Charge
Repay Loan and Interest			-Loan Repayment ?Interest Charge	+Loan Repayment +Interest Charge
Record Loan and Interest Repayment	+Loan Repayment +Interest Charge	-Loan Repayment ?Interest Charge

As a check let’s remove the intangible asset and associated journals from the balance sheet and see what we get:

	Assets	Liabilities	Equity
Operation	Loan Ledger	Firms	Safe
Lend Money	+Lend Money	-Lend Money
Repay Loan and Interest	-Repayment	+Repayment
Charge Interest	+Interest Charged		-Interest Charged

Which should look familiar to anybody on the MMT side of the debate.

That’s the bank lending items sorted. Let’s adding the spending elements and complete the circuit. So for the expanded balance sheet the final table looks like this:

	Assets		Liabilities			Equity
Operation	Licence Value	Loan Ledger	Vault	Firms	Workers	Safe
Grant Licence	+Licence Value		-Licence Value
Lend Money			+Lend Money	-Lend Money
Record Loan	-Lend Money	+Lend Money
Charge Interest			+Interest Charge			-Interest Charge
Record Interest	-Interest Charge	+Interest Charge
Repay Loan and Interest			-Loan Repayment ?Interest Charge	+Loan Repayment +Interest Charge
Record Loan and Interest Repayment	+Loan Repayment +Interest Charge	-Loan Repayment ?Interest Charge
Pay Firm Deposit Interest				-Firm Interest		+Firm Interest
Pay Worker Deposit Interest					-Worker Interest	+Worker Interest
Hire Workers				+Pay Workers	-Pay Workers
Workers’ Consumption				-Workers’ Consumption	+Workers’ Consumption
Bankers’ Consumption				-Bankers’ Consumption		+Bankers’ Consumption

Write out the intangible assets and you get this:

	Assets	Liabilities		Equity
Operation	Loan Ledger	Firms	Workers	Safe
Lend Money	+Lend Money	-Lend Money
Charge Interest	+Interest Charge			-Interest Charge
Repay Loan and Interest	-Loan Repayment ?Interest Charge	+Loan Repayment +Interest Charge
Pay Firm Deposit Interest		-Firm Interest		+Firm Interest
Pay Worker Deposit Interest			-Worker Interest	+Worker Interest
Hire Workers		+Pay Workers	-Pay Workers
Workers’ Consumption		-Workers’ Consumption	+Workers’ Consumption
Bankers’ Consumption		-Bankers’ Consumption		+Bankers’ Consumption

So as you can see the balance sheets that ‘create’ and ‘destroy’ horizontal money are consistent with the one where horizontal money merely changes state to dormant, and the difference is simply to introduce an accounting policy requiring an intangible asset to represent potential loan capacity that currently isn’t in circulation.

This is a very similar to the approach taken in accounting under IFRS 3 when reporting purchased goodwill. Prior to 2005 purchased goodwill was written out of the balance sheet and essentially combined with the intrinsic goodwill of the purchasing business. After 2005 it had to be carried explicitly on the face of the balance sheet. To get to the prior position you just take a IFRS 3 compliant balance sheet and write out the carried goodwill.

But what benefit does carrying the amount of ‘potential loans’ give us in the model? Well it helps to show how ‘hungry’ a bank is to lend. A bank with a high valuation on its credit licence has a lot of capacity to make loans, whereas one with a low valuation hasn’t. It is very likely that the first is going to be selling loans as hard as its can whereas the second is more likely to be putting its efforts into lobbying regulators to relax the cap on its lending capacity.

As I see it, the key point from the expanded model is that although it is easy to add credit potential to a system, it is somewhat more difficult (and may even be impossible in practice) to get rid of it again as it embeds itself deeply into the dynamic structure of the system.

In addition, by explicitly recording the value we can graph it over time and see how close to potential the economy gets, and as the model evolves we can compare dynamic caps on the credit licence to static caps and see what effect they have. Particularly as our current credit licences in the real world are linked to the amount of ‘regulatory capital’ a bank has and are therefore dynamic in their own right.

So whether you use an expanded balance sheet for your horizontal circuit or a collapsed one depends on what you’re trying to find out with your model.

I’ve created the double entry model using the QED program from Steve’s site (which is based on the simplest stable model created in Steve’s crash course lecture.). QED likes to see things positive (or it suffers an assertion failure), so the liability side has all been multiplied by -1 compared to the tables above.

The double entry model converges nicely and ends up looking like this (click for the full size version):

Whereas the original model ended up like this:

As you can see the figures converge to the same value – demonstrating that they are the same model at this level of dynamism. The double entry version shows the circulation between the assets and the liabilities happening separately (although in step of course) once the credit licence has created the initial stock of credit money. And if you add up the pots in each circulation at any point in time the total stocks should be the same value. The balance sheet now balances as it should.

Click here for this post in PDF

Figure 1: Excerpt from the 1st Debtwatch Report in November 2006

From humble beginnings, the blog has grown like Topsy to have over 12,500 subscribers, about 60,000 unique visitors, amost one million page views and six million hits per month.

Figure 2: Debtwatch readership stats for 2011

The readership is international. The majority of readers are American, with my home country of Australia second, and the UK third.

Figure 3: Top ten countries by page views in December 2011 (till December 18^th)

The audience is also highly educated, both in general and in comparison to sites of prominent media outlets.

Figure 4: Alexa demographic data on Debtwatch

Ironically, given that my sympathies are firmly with “the 99%”, and that my objectives include drastically reducing the power and size of the financial sector, this blog is popular with both the well-paid and the financial sector.

Figure 5: Alexa income level data

In fact, my blog is now so popular with the finance sector that I am being approached by funds that are interested in sponsoring both Debtwatch and the Center for Economic Stability.

So I am now presented with a paradox: my objectives are to drastically reduce the size and power of the financial sector—hedge funds included—and yet organisations within that sector now want to sponsor my work.

The motivations behind such offers of financial support undoubtedly range from simply wanting to have a corporate logo appear in front of blog readers’ eyeballs at one extreme, to sharing some of the same objectives I have at the other—as George Soros clearly does in his funding of the Institute for New Economic Thinking.

I certainly need funding to be able to achieve my own aims. I can’t do the work needed to overthrow neoclassical economics and develop a realistic alternative on my own, and the work involved in maintaining this blog and handling correspondence from the public means I now spend far more time working out the intricacies of the internet and answering emails than I spend doing original research. So funding is necessary, which is the main reason I instituted a membership scheme on Debtwatch: to raise sufficient funds to employ assistants who can take those tasks off my hands, so that I can focus on that research.

That fund raising has been mildly successful—about $18,500 has been raised since membership schemes for Debtwatch and CfESI commenced in September 2011, of which about $10,000 is recurring funding.

Figure 6: Recurring Funding for Debtwatch as of mid-December 2011

Figure 7: One-off Funding for Debtwatch as of mid-December 2011

Figure 8: Recurring funding for CfESI as of mid-Deccember 2011

This funding has been useful—amongst other activities, it funded my trips to London to launch Debunking Economics II and to be interviewed by the BBC—but at this rate it will be decades before I can afford to hire staff as well. I haven’t got that long.

So I will accept corporate sponsorship—including, but certainly not limited to, sponsorship from the FIRE sector—but only on my terms. These are spelt out in The Debtwatch Manifesto, which is now a permanent page of this blog. Any corporate sponsor has to accept that those are the aims to which sponsorship will be put.

There are at least two reasons for stating my objectives in this manner.

Firstly, I am aware of the danger of letting commercial sponsorship alter one’s message, and I want to make it clear that I will not let that happen to me. As someone who has spent 40 years opposing the conventional wisdom in economics, I’m not about to let sponsorship persuade me to do otherwise, or to resile from policy positions that I believe are justified by good analysis and empirical data. For that reason I’m putting my objectives on public view before sponsorship becomes an important source of revenue for my work.

Secondly, I know that this is in the interests of those who might sponsor me—even if some of what I hope to achieve works against those interests. I have developed the following I now have because of my empirically-oriented analytic realism. I would be doing a disservice not only to myself, but to sponsors themselves if I let sponsorship affect my analysis or my views.

Levels of sponsorship

There are 3 levels of sponsorship:

Figure 9: Sponsorship Levels

Sponsorship funding is allocated between my blog Debtwatch and CfESI. If you are interested in sponsorship, please contact me at ProfSteveKeen AT gmail DOT com.

First Sponsor

The first Foundation Sponsor for Debtwatch and CfESI is Sabretooth Capital Management, whose logo now appears on both sites.

Benefits of sponsorship

The primary benefit is an altruistic one: by sponsorship, you contribute to my efforts to build a new realistic theory of economics to replace the myths of neoclassical economics that have played such a major role in causing the crisis we are now in.

The funding will make it easier for me to devote my time and energies to developing the theoretical and empirical analysis that made this blog influential in the first place, but which today receives so little of my personal time because of the sheer workload that my success has generated.

Other benefits include:

• Acknowledgement of your support on Debtwatch & CfESI (if required; I have been contacted about sponsorship by some institutions that do not want their support publicly acknowledged);
• An annual seminar by me on economics for your staff or customers, as requested;
• Early access to my analysis (but not exclusive access—I am committed to informing the public about realistic economics, and this is not going to change);
• Informal access for analysis and data (but not consulting unless separately arranged; I am loathe to undertake consulting, given that this takes time away from fundamental analysis);
  • By doing this I am not offering financial advice. Apart from the legal restrictions on offering financial advice in Australia—for which I am not licenced—giving financial advice involves having knowledge of a customer’s financial situation and needs, which I do not have and will not seek; and
• Signed copies of my latest book (currently Debunking Economics: the naked emperor dethroned)—2 dozen, 4 dozen and 10 dozen copies respectively for each level of membership.

How Sponsorship will be used

Part will go to my income. I didn’t start the blog to make money, but to warn about its destruction on a global scale. However, now that I have succeeded in that aim, I want to be able to continue working on developing an alternative economics full-time, without having to consider my financial security while I do it.

Well before I reach that level of funding, sponsorship will enable me to reduce my teaching commitments and focus on writing Finance and Economic Breakdown, with the hope that it can be published in 2014.

I need to hire staff for a range of purposes. Major priorities are a personal assistant, a webmaster to take over maintenance of Debtwatch (three cheers for WordPress—as a computer amateur, I couldn’t have reached the audience I have without this brilliant Open Source program—but the blog itself desperately needs a professional makeover), a research assistant to populate Econodata, and a statistician to help with the design of leading indicators and the empirical verification of my dynamic models. The development of the Minsky software program will be on-going, and with sufficient funding full-time programmer(s) will be hired for this purpose.

The funding to date has mostly been expended on travel, computer hardware and software. Once sufficient funds, standard ancillary expenses like office rental will also arise.

Changes to the blog

There will be some changes to the blog in coming months. Some of these are long overdue cosmetic changes, which I can now finally afford to hire a professional designer to undertake. Others will be designed to increase the revenue generated by the blog.

This may include requiring browsers to register to read, but it will not include restricting readership to paying subscribers (as, for example, Nouriel Roubini has done). My primary objective will always be developing a realistic theory of economics, and public knowledge of both the flaws in neoclassical analysis and the existence of alternatives is vital to that objective. That’s why my current membership scheme is a “Clayton’s” one, where the only restriction is on downloading documents.

Mortgage debt is by far the largest component of debt in Australia today—government debt, which is the focus of political debate, is trivial by comparison (a quick caveat though—finance sector debt may be larger again than mortgage debt, if this claim, sourced from Morgan Stanley, is accurate—since it shows Australia’s aggregate private debt ratio as almost equal to the USA’s).

Figure 1

The household debt to income ratio may have topped out now, after growing fivefold in the last two decades. Figure 2 shows the ratio of household debt to disposable income, which peaked at 149% of disposable income back in late 2008. Despite the enticement into debt given by the First Home Vendors Boost, aggregate household debt never exceeded this pre-Boost peak as a percentage of disposable income, since the fall in personal debt outweighed the rise in mortgage debt.

Figure 2

This huge rise in household debt compared to income has more than offset the falls in interest rates that occurred since the 1990s. The perennial argument from property spruikers that the rise in debt has simply been a rational reaction to the fall in interest rates is pure bunkum—especially when you take a less-than-myopic look at the data, and consider mortgage rates back in the 1960s, which were well below today’s rates (see Figure 3).

Figure 3

This comparison stands even when inflation is taken into account. The average real mortgage rate in the relatively low-inflation 1960s was 3 percent—a full percent below the low inflation level of the last decade (see Figure 4). Why wasn’t mortgage debt higher back then, if the increase since the 1990s was a “rational response to lower interest rates”?

Figure 4

I date the Australian house price bubble from 1988, when it was spiked by the reintroduction of the First Home Owners Scheme by the Hawke Government in reaction to the Stock Market Crash of 1987 (the Scheme works by encouraging would-be buyers to take on mortgage debt, and then hand the leveraged sum over to the vendors—which is why I prefer to call it the First Home Vendors Scheme [FHVS]). It then really took off in 2001, when Howard doubled the Grant in response to a feared recession (see Figure 5, which combines Nigel Stapledon’s long term index with the ABS data from 1976 on; “Hawke” and “Howard” respectively mark the re-introduction of the grant in 1988 and Howard’s doubling of it in 2001), though it was already running hot again from 1997 when—without any additional help from the government—the financial sector had enticed Australians to go from a 50% to a 70% mortgage debt to GDP ratio (at a time of rising interest rates).

Figure 5

The combination of higher rates and much higher debt levels means that paying the mortgage is taking far more out of the family purse than it used to do back in the pre-Housing Bubble years. Readily available data from the RBA shows that interest payments on household debt are five times as high as they were back in the 1970s.

The RBA data for mortgage debt only start in 1976; in the spirit of countering spruiker myopia, I’ve estimated pre-1976 mortgage debt as 30% of total debt, from the RBA’s long-term data (the average from 1977-1980 was 31%). Interest payments on mortgage debt are as much as ten times as high now as in the 1960s (see Figure 6).

Figure 6

Spruikers also prefer to ignore the fact that debt has to be repaid, and focus on the interest payments alone. In the past mortgages been paid off after 5-7 years via the resale of the property, but that will be a lot more difficult in future as house prices fall. Figure 7 shows household debt service as a percentage of disposable income with mortgage debt being repaid over 25 years and personal debt over 10. On this basis, there has been a twelve-fold increase in the proportion of family income that has to be devoted to servicing mortgages since 1970. Even compared to the high interest days of 1990, mortgage debt service is now 2.5 times as burdensome.

Figure 7

There is clearly no capacity for debt service to take a larger slice of the family income pie, which in turn is taking the wind out of the housing market. Spruikers happily make a “supply and demand” argument about why house prices have risen, but obsess about regulation-impaired supply and equate demand with population growth. In fact, demand for housing doesn’t come from population growth: it comes from the growth in the number and value of mortgages. That growth rate in fact peaked back in 2004, and it has been trending down ever since: the First Home Vendors Boost merely delayed this process without stopping it.

Figure 8

That in turn is the main factor driving house prices down—just as rising mortgage debt drove prices up, falling mortgage debt is driving them down. As I’ve explained elsewhere, the causal factor behind asset prices is not just rising but accelerating debt. This is an extension of my basic proposition that macroeconomic analysis must include the role of credit—which is ignored by conventional neoclassical economics. In a credit-driven economy, aggregate demand is the sum of incomes plus the change in debt, and this monetary demand is expended buying commodities and claims on existing assets—basically, shares and property.

Part of demand for housing thus comes from income—the focus of the property spruikers—and part comes from the increase in mortgage debt—which they ignore.

Figure 9

For prices to rise, demand must also be rising, and this requires not merely rising mortgage debt but accelerating debt. Of course variations in income (and variations in supply too) can play a role, but in the overwhelmingly speculative, overly-leveraged market that Australian housing has become, accelerating mortgage debt trumps the lot (see Figure 10).

Figure 10

This is especially so since such a large percentage of buyers are so-called investors—”so-called” because a better description is speculators. Actual investors aim to make a profit out of the income flow generated by an investment. Australia’s property “investors” instead lose money on their rental income, and hope to recoup the loss as capital gains via a later sale. With the days of house prices rising faster than incomes well and truly over, this percentage of the market could drop back to pre-1990s levels.

Figure 11

Both sources of demand are now falling strongly from the artificial boost given by Rudd’s spin of the FHVS sauce bottle.

Figure 12

One of the world’s last and greatest house price bubbles is thus finally ending.

Figure 13

Click here for this post in PDF

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.

“Minsky”

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 project “Resource 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.

KeenData

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.

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; (c) 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 21^st 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