Start your US Depression engines

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.

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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.

Culpable drivers?

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.

Full throttle

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.

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Our great misfortune is that accelerating debt hasn’t been primarily used for that purpose, but has instead financed asset price bubbles.

Accelerated assets

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:

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The Credit Accelerator also caused the temporary recovery in house prices:

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And it was the primary factor driving the Bear Market rally in the stock market:

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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.

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Emergency braking

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.

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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.

Remedial course

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.

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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.

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Anonymous,

Steve, you use the term "well-functioning economy" (See Start your US depression engines, June 15). Does one actually exist? To me with all the intervention that occurs within economies most economic theory is just clutching at straws. However, I do agree that paying down private debt is good. Keep writing. I enjoy your articles.

Anonymous,

If the minimum value of the DJIA change occurs 10 months before the minimum value of the "Credit Accelerator", it is hard to see how the latter causes the former (See Start your US depression engines, June 15).
Then again, I am not a Professor of Economics.

Anonymous,

'Cometh the debt, cometh the economist'. Good one Steve keep batting away and don't forget to tell us where we should be salting our assets away (See Start your US depression engines, June 15).

Anonymous,

Another, often ignored, factor is the illusion of the rational market (See Start your US depression engines, June 15).
To give one example that grows out of the 'One man's debt is another man's asset' notion.
If 1,000 individuals' debts make up one man's huge asset, then we've got one extremely happy potential spender, and 1,000 potentially nervous non-spenders.
In today's world, markets are based mostly on consumer driven economic models, and in reality it isn't 1 to 1,000, it's a relatively few banks to tens of millions of nervous debtors, who used to be enthusiastic consumers.
We're seeing the same thing, but to a lesser extent, here in Australia.
Economic thinkers who ignore market psychology are doomed to getting it wrong more than they get it right because markets are ultimately about people, and a century of research shows beyond doubt that we humans apply rational thinking in inverse proportion to the levels of pressure we're feeling at the moment of decision.

Anonymous,

Please tell us which of your alarmist forecasts have been correct in the past (See Start your US depression engines, June 15)?
Australia's house prices crashed 40 per cent yet?
No one is debating they have some large debt issues that are hard to imagine, but one quarter of data is insufficient to foretell the end of the world. Certainly not quite ready to call the current state of affairs a Depression.
The alternative is that after a slight slowdown in growth, the stimulus multiplier effect will kick back in and the US recovery will continue – and you will still be renting and holding cash that is being eaten away by inflation.

Anonymous,

Anthony Element hit the nail on the head when used the Term "Rational Market" (See 'market illusions', Conversation contribution, June 15).
How can basically 'unsophisticated' speculators, run up huge amounts of debt, whilst chanting the irrational mantras 'property only ever goes up', and 'you can't lose on Property'.
I hope you've upped the ante on your bet Steve, and that a few of your detractors walk from Sydney to Melbourne when they lose (See Start your US depression engines, June 15).

Anonymous,

My own take on all this is that we really don't know what the hell is happening and only have a superficial grasp on what actually happened (See Start your US depression engines, June 15).
I include the experts as well as us plonkers. It reads as gobbledy gook trying to rationalise after the event. And it doesn't read very well. Nor does it augur well for the future.
As long as we have people wanting to make a 'fast buck' we will have repeats of lesser or greater severity of the GFC. No amount of legislation, hand wringing or bailing out our mates is going to get rid of the the cycle of greed and grief.

Anonymous,

Another great article (See Start your US depression engines, June 15). +1 sending this to Adam "The Black Knight" Carr (he of Pythonesque aspect).
Goodness I hope Greece (then Ireland) default. The shameful, immoral transfer of irresponsible debt onto the public is an egregious wrong. It stuns me that people don't rise up against this. It is shocking.
US should default and the Fed should be abolished.
Gold standard.

Anonymous,

Start your engines? Problem is the US economy is not producing enough combustion Steve (See Start your US depression engines, June 15). They are all in the back while Ben Bernanke is driving, but his GPS directions are flawed as it is an outdated version they used in the 1930s Great Depression.
They appear to be destined to repeat the mistakes that caused the 1930s depression.
They need a new driver - maybe use Ron Paul's GPS. It seems to point in the right direction.

Anonymous,

You are still absolutely correct Steve (See Start your US depression engines, June 15), regardless of what propaganda for self benefit your detractors peddle.
How is it possible for our western world economies to increase productivity sufficiently enough to overcome this 'economic cancer', when the popular acceptance of the term 'productivity' is the productive equivalent of repeatedly digging a hole in the ground in order to bury it?
Is accepted practical usefulness now an exercise in eating the food rather than growing it?

Anonymous,

Not a bad analysis, but one very important correction (See Start your US depression engines, June 15). Putting Bernanke and Krugman together, and calling Krugman neo-classical is ignorant and wrong. The two stand on opposite ends of the economics spectrum and Krugman has been advocating debt-focused relief measures loudly and clearly for years.

Anonymous,

Thanks Steve. I enjoy reading your articles very much. (See Start your US depression engines, June 15). The weight of the finance sector and its control over politics and asset prices (like mentioned in your closing paragraph) has interested me much - especially its corrupt ways.

Anonymous,

Steve Keen's analysis remains as lightweight as ever. (See Start your US depression engines, June 15.) Fed Chairman (and full professor) Ben Bernanke supposedly ignores "the level of private debt" and the booms and busts in credit through history.
Moreover, extraordinarily, Keen pretends that he invented the 'Credit Accelerator' and that everyone else has been too dumb to notice. Yet Bernanke was publishing serious papers on "The financial accelerator and the credit channel" and "Credit, money and Aggregate Demand" more than two decades ago. Check out the references at http://www.bis.org/review/r070621a.pdf.
Most of us try to hide our ignorance – great or small – from the world but, awkwardly, Keen seems unaware that he is way out of his depth on his own chosen special subject.

Anonymous,

It's not rocket science, to get the economy moving you need someone spending (See Start your US depression engines, June 15). The ones with the money (CEOs, board members et al), the ones that caused the GFC need to redistribute their wealth by spending big time, or cut their salaries in half give a little bit to the workers or shareholders so they have something to spend. Then try to rein in inflation when the economy is moving. As long as you don't pay multi million dollar salaries they and the world will be fine. It shouldn't be the government (us taxpayers) paying for the greedy's greed.

Anonymous,

In response to Rory Robertson (See Start your US depression engines, June 15):
Bernanke's financial accelerator is not the same as Prof Keen's. Bernanke describes his term (from your link): "The inverse relationship of the external finance premium and the financial condition of borrowers creates a channel through which otherwise short-lived economic shocks may have long-lasting effects. In the hypothetical case that Gertler and I analyzed, an increase in productivity that improves the cash flows and balance sheet positions of firms leads in turn to lower external finance premiums in subsequent periods, which extends the expansion as firms are induced to continue investing even after the initial productivity shock has dissipated. This "financial accelerator" effect applies in principle to any shock that affects borrower balance sheets or cash flows."
Bernanke's other paper you cite (Credit, money and Aggregate Demand) was also a tangential idea about the differential treatment of credit and money in the IS-LM model. If you had read any of Keen's articles you would see what his term means – "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." So much for hiding our ignorance.

Anonymous,

It was Ben Bernanke who decided to copy the Japanese in using liquidity to treat insolvency (which hasn't worked for 20 years), and expect a different result. History will judge him a fool, also those who stick up for him (See Start your US depression engines, June 15).

Anonymous,

Why don't you have another bet, Rory? Even you must admit the government stimulus artificially inflated property prices. ANZ bankers have openly acknowledged this fact. http://www.theaustralian.com.au/business/first-home-stimulus-inflated-property-prices-says-banker/story-e6frg8zx-1226068248920
I don't think you would be so lucky this time around.

Anonymous,

"We unfortunately live in a credit-drunk economy where accelerating debt leads to asset price bubbles" (See Start your US Depression engines, June 15). There we have it in a nutshell. Keep on challenging your critics, Steve Keen. Your well researched work cannot be dismissed as simple ignorance at any level. Mentioning the 'D' word will always ruffle a few feathers. It's the debt, stupid.

Anonymous,

Contrary to what Rory Robertson says above (See 'Debt mountain no real discovery', Conversation contribution, June 16), Steve Keen has always attributed the 'invention' of the Credit Impulse to Biggs, Mayer et al., http://ssrn.com/paper=1595980 - see his blog posting at http://www.debtdeflation.com/blogs/2010/09/20/deleveraging-with-a-twist/. The Bernanke deliberations have nothing to do with what Steve Keen is talking about (See Start your US depression engines, June 15).

Anonymous,

In response to Rory Robertson (See 'Debt mountain no real discovery', Conversation contribution, June 15):
It's interesting that the paper spends a deal of time on information, credit worthiness and business loans... This is not really a big issue for the Australian banking system because most of the Australian banks loans are housing loans.
Housing loans require no credit skills what-so-ever, which is why Australian banks have gorged themselves with them. All you need to know is what the other houses in the neighbourhood recently sold for and the household free cash flow minus the level of the Henderson poverty line divided by the mortgage rate plus 1 per cent for amortization (cross your fingers they tell you no lies) but it doesn't really matter because you can re-sell the asset at the present market price.
Why bother with lending to difficult-to-understand risky businesses requiring a brain and analysis of difficult information? So I don't see much relevance in the Bernancke's paper to the Australian economy and banking system.

Anonymous,

To commenter Rory Robertson (See 'Debt mountain no real discovery', Conversation contribution, June 16), I'm not sure if you read your own link, but Bernanke's financial accelerator is not the same as Professor Keen's (See Start your US depression engines, June 15).
Bernanke describes his term (from your link):
"The inverse relationship of the external finance premium and the financial condition of borrowers creates a channel through which otherwise short-lived economic shocks may have long-lasting effects. In the hypothetical case that Gertler and I analysed, an increase in productivity that improves the cash flows and balance sheet positions of firms leads in turn to lower external finance premiums in subsequent periods, which extends the expansion as firms are induced to continue investing even after the initial productivity shock has dissipated. This "financial accelerator" effect applies in principle to any shock that affects borrower balance sheets or cash flows."
Bernanke's other paper you cite (Credit, money and Aggregate Demand) was also a tangential idea about the differential treatment of credit and money in the IS-LM model.
If you had read any of Keen's articles you would see what his term means:
"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."
So much for hiding ignorance.

Anonymous,

Rory Robertson claims that "Moreover, extraordinarily, Keen pretends that he invented the 'Credit Accelerator' and that everyone else has been too dumb to notice" (See ‘Debt mountain no real discovery’, Conversation contribution, June 15). In fact, on his blog Keen references three economists from Deutsche Bank as having "invented" it (See Start your US depression engines, June 15).

Anonymous,

I did my economics degree many years ago when Friedman's monetary theory was beginning to be recognised. I completed my degree part-time at a real university and I paid my fees myself in after tax dollars.
That was in 1972 just before the 1974 recession so I have seen much change over the years.
My concern with this current situation is that just like the great empires of past eras we are now in the midst of the fall of yet another 'world power' and we are simply the pawns in the game (See Start your US depression engines, June 15).
Napoleon said that China was "a sleeping giant". He also warned against waking the sleeping giant, for whoever did would be sorry. Today, China is awake.
Go to youtube and search 'chinese professor' for an interesting point of view.

Anonymous,

Where extraction from an economy is not balanced by contribution to the economy, then the economy weakens. (See Start your US depression engines, June 15). Far too much is being extracted by non-producers, e.g. the illegal drug market , the legal market , professional sports , gambling , the alcohol and cigarette markets. Income from production is constrained by economic realities further limited by taxation and interest rates.
Huge incomes tend to be spent on foreign exotica or drift into 'legal' tax havens, but where it is invested locally competes with tax depleted income, diminishing the value such that workers and the middle class are forced to borrow to survive.
The professional classes are becoming a liability to taxpayers rather than service providers. Banks do not appear to be wealth creators, except for staff. The record indicates banks as a cause of catastrophic losses for middle America, millions unemployed, millions of homes repossessed, thousands of businesses bankrupted. Surely it is the clients who bring wealth into a bank together with the investors. This the wealth bankers play with -- the losses are enormous, yet bankers award themselves bonuses!

Anonymous,

We know the US had a recession fuelled by debt followed by a stimulus-induced dead cat bounce and now faces a long soft patch (See Start your US depression engines, June 15). But tell me Steve, what does your credit accelerator say about China? Loan growth in China is decelerating fast. Should we be worried?
http://eiudatapoints.wordpress.com/2011/06/14/bank-loans-in-china-tapping-the-brakes/