According to America's National Bureau of Economic Research, the "Great Recession” is now two years behind us, but the recovery that normally follows a recession has not yet occurred – worse still, US growth levels are already trending down.
Growth needs to exceed 3 per cent per annum to reduce unemployment and needs to be substantially higher still to make serious inroads. Instead, growth has barely peeped its head above the preferred level. It is now below it again, and heading south.
Obama was assured by his advisors that this wouldn’t happen. From the first Economic Report of the President he received from Bush’s outgoing Chairman of the Council of Economic Advisers Ed Lazear, he was told that real growth would probably exceed 5 per cent per annum – a detail confirmed to me by Lazear himself after my session at the Australian Conference of Economists in 2009.
I disputed this forecast then, and events have certainly borne out my viewpoint.
So why has the conventional wisdom been so wrong? Well, largely because it has ignored the role of private debt.
Neoclassical economists, like Ben Bernanke and Paul Krugman, ignore the level of private debt, on the basis of the argument that "one man’s liability is another man’s asset”. By their logic, the aggregate level of debt has no macroeconomic impact because the increase in the debtor’s spending power is offset by the fall in the lender’s spending power.
They are profoundly wrong on this point.
The empirical fact that "loans create deposits” means that the change in the level of private debt is matched by a change in the level of money, which boosts aggregate demand.
The fact that many economists ignored private debt levels (and, like Alan Greenspan running the Fed, at times actively promoted its growth) is why this is no "garden variety” downturn.
The downturn was supposed to end when the growth of private debt turned positive again and boosted aggregate demand. And for a while, it looked like a recovery was afoot as growth rebounded from the depths of the Great Recession.
Clearly the scale of government spending, and the enormous increase in base money by Bernanke, had some impact – but nowhere near as much as they were hoping for.
However the main factor that caused the brief recovery – and will also cause the dreaded "double dip” – is the Credit Accelerator, or the Credit Impulse.
The Credit Accelerator at any point in time is the change in the change in debt over the previous year, divided by the GDP figure for that point in time.
The rate of change of asset prices is related to the acceleration of debt. It’s not the only factor obviously – change in incomes is also a factor, and there will be a link between accelerating debt and rising income if that debt is used to finance entrepreneurial activity.
Our great misfortune is that accelerating debt hasn’t been primarily used for that purpose, but has instead financed asset price bubbles.
There isn’t a one-to-one link between accelerating debt and asset price rises: some of the borrowed money drives up production (think SUVs during the boom), consumer prices, the fraction of existing assets sold, and the production of new assets (think McMansions during the boom).
Accelerating debt should lead change in output in a well-functioning economy; we unfortunately live in a credit-drunk economy where accelerating debt leads to asset price bubbles.
In a well-functioning economy, periods of debt acceleration are followed by periods of deceleration, so that the ratio of debt-to-GDP cycled but did not rise over time.
In an unhealthy economy, like the US’s and many others, the acceleration of debt remains positive most of the time, leading not merely to cycles in the debt-to-GDP ratio, but a secular trend towards rising debt.
When that trend exhausts itself, an economic depression ensues – and that’s where we are now.
Deleveraging replaces rising debt, the debt-to-GDP ratio falls, and debt starts to reduce aggregate demand rather than increase it as happens during a boom.
However, even in such a situation, the economy can receive a temporary boost because debt is still accelerating even when aggregate private debt is falling – as it has since 2009. That’s the force that generated the apparent recovery from the Great Recession.
Pumping the pedal
The factor that makes the recent recovery phase different to all previous ones – save the Great Depression itself – is that this strong boost from the Credit Accelerator has occurred while the change in private debt is still massively negative.
The recent recovery in unemployment was largely caused by the dramatic reversal of the Credit Accelerator – from strongly negative to strongly positive – since late 2009:
The Credit Accelerator also caused the temporary recovery in house prices:
And it was the primary factor driving the Bear Market rally in the stock market:
Variance in the change in debt growth can impact rapidly on some markets – notably the stock market. And the already high correlations in the above graphs are higher still when we consider the causal role of the debt accelerator in changing the level of aggregate demand by lagging the data.
The confirmation of a casual relationship between the acceleration of debt and the change in asset prices exposes the dangerous positive feedback loop in which the economy is trapped.
This is similar to what George Soros calls a reflexive process: we borrow money to gamble on rising asset prices, and the acceleration of debt causes asset prices to rise.
This is the basis of a Ponzi Scheme – because it relies not merely on growing debt, but accelerating debt, ultimately that acceleration must end, otherwise debt would become infinite. When the acceleration of debt ceases, asset prices collapse.
From the more recent quarterly changes in the Credit Accelerator it’s apparent that the strong acceleration of debt in mid to late 2010 is petering out as stimulus from accelerating debt diminished.
Another quarter of that low a rate of acceleration in debt – or a return to more deceleration – will drive the annual Credit Accelerator down or even negative again.
In a well-functioning economy, the Credit Accelerator would be above zero in boom times, below during a slump, and over time tend to exceed zero slightly because positive credit growth is needed to sustain economic growth.
This would result in a private debt-to-GDP level that fluctuated around a positive level, as output grew cyclically in proportion to the rising debt.
From now on, unless we do the sensible thing of abolishing debt that should never have been created in the first place, we are likely to be subject to wild gyrations in the Credit Accelerator, and a general tendency for it to be negative rather than positive.
With debt still at levels that dwarf previous speculative peaks, the positive feedback between accelerating debt and rising asset prices can only last for a short time before it reaches its end point.
In the meantime, we’re likely to see period of strong acceleration in debt (caused by a slowdown in the rate of decline of debt) and rising asset prices – followed by a decline in the acceleration as the velocity of debt approaches zero.
With the Credit Accelerator going into reverse, asset prices plunge – which further reduces the public’s willingness to take on debt, which causes asset prices to fall even further.
The process eventually exhausts itself as the debt-to-GDP ratio falls. But given that the current private debt level is perhaps 170 per cent of GDP above where it should be, the end game here will be many years in the future.
The only sure road to recovery is debt abolition, but that will require defeating the political power of the finance sector and ending the influence of neoclassical economists on economic policy. That day is still a long way off.
Steve Keen is Associate Professor of Economics & Finance at the University of Western Sydney and author of Debunking Economics and the blog Debtwatch. This article has been edited, to read the full version click here.