Christopher Joye's reply to my last post on housing provides a neat segue into the broader topic of why I first entered the public debate on economics. It was because in December 2005 I became convinced that a major global economic crisis was about to hit. I felt that someone had to raise the alarm – and that in Australia at least, I was probably that person.

Two years later that crisis did hit. Called ‘the Global Financial Crisis’ by Australians and ‘the Great Recession’ by Americans, it is now universally regarded as the worst economic crisis since the Great Depression.

The vast majority of economists were taken completely by surprise by this crisis – not only Chris Joye and the ubiquitous market economists who pepper the evening news, but the big fish of academic, professional and regulatory economics.

As late as June 2007, the OECD’s chief economist, Jean-Philippe Cotis, forecast that "sustained growth in OECD economies would be underpinned by strong job creation and falling unemployment”. In Australia, the Reserve Bank was equally confident of a rosy local and global future, saying in its August 2007 statement on monetary policy that "current expectations of official and private-sector observers are that the world economy will continue to grow at an above-average pace in both 2007 and 2008.”

But the award for the worst timing has to go to Oliver Blanchard, now International Monetary Fund chief, who in August 2008 published a glowing review of conventional macroeconomics, concluding that "the state of macro is good".

How wrong they were. The economic and financial crisis that is now the defining social context of our times began months after the OECD declared the future "benign”, days after the RBA predicted above-average growth, and one year before Blanchard’s hapless paean. Unemployment rose rather than fell – dramatically so in the US. Four years later, US unemployment remains stubbornly high, despite the biggest economic stimulus packages in history, while recent data even shows an unemployment uptick in Australia, the OECD country that has weathered the crisis with the least damage to date.


Figure 1: Conventional economics forecasts of falling unemployment in 2007-08 were dramatically wrong

Why did conventional economists not see this crisis coming, while I and a handful of non-orthodox economists did? It’s because we focus upon the role of private debt, while they ignore it, for three main reasons:

– Firstly, they believe that the private sector is rational in everything it does, including the amount of debt it takes on.

– Secondly, they believed that the level of private debt – and therefore its rate of change – had no major macroeconomic significance. For example, Ben Bernanke argued in his Essays on the Great Depression that "debt-deflation represented no more than a redistribution from one group (debtors) to another (creditors)”, so "pure redistributions should have no significant macro-economic effects”.

– Finally, the most remarkable reason of all is that debt, money and the financial system itself play no role in conventional neoclassical economic models, with money seen merely as a ‘veil over barter’. Only economic dissidents from other schools of thought, like Post Keynesians and Austrians, take money seriously and only a handful of them – including myself – formally model money creation in their macroeconomics.

Even when he attempted to break from this mould, one of the most ‘avant-garde’ of neoclassical economists, Paul Krugman, did so from the same point of view as Bernanke – that the level of debt doesn’t matter, only its distribution.

In contrast, I have dedicated my academic life to extending the Financial Instability Hypothesis first developed by Hyman Minsky, so I was always aware that private debt plays a much more important role in the economy than neoclassical economists comprehend.

What I saw in December 2005 shocked me. Although five years earlier, when writing Debunking Economics, I had commented that I expected a debt-induced financial crisis at some stage in the future, the sheer scale and rate of growth of debt was staggering. The 40-year long trend for private debt to rise 4.2 per cent faster than GDP simply couldn’t be sustained forever, and I felt that its breaking was imminent. I expected that when it broke the Australian economy would enter a slump far worse than that of the early 1990s.


Figure 2: Australian private debt rose 4.2% faster than GDP from 1965 till 2006

Meanwhile, in the US, the private debt to GDP ratio was growing more slowly, though over a much longer timeframe (at an average 2.25 per cent per annum since 1945). The US ratio was almost twice as high as Australia’s, and five times as high as it was at the end of World War II. I felt that when these trends of rising private debt ended, we were certain to experience an economic downturn whose severity would be unprecedented in the post-World War II period – and which could even rival the Great Depression.


Figure 3: A five-fold increase in US private debt to GDP since 1945

The reason I believed a change in the rate of growth of debt could cause a crisis, while conventional economists (in which category I include everyone from Paul Krugman and Ben Bernanke to Chris Joye) saw no problem with a higher level of private debt, is because the economic tradition to which I belong acknowledges that the growth in private debt boosts aggregate demand. When a bank lends money, it creates spending power by creating a deposit at the same time. This additional money adds to spending power of the borrower, without reducing the spending power of savers.

Neoclassical economics, on the other hand, treats banks as simple intermediaries between savers and lenders. A loan is seen to increase the spending power of the borrower, but reduce the spending power of the saver.

If the neoclassical model of banking were correct the macroeconomic effects of debt would be muted, as Bernanke and Krugman argued. However, there is overwhelming empirical evidence that this model is wrong.

Strictly speaking, it’s untrue to say neoclassical economists chose their assumptions over reality. Most neoclassical economists have no idea that this empirical evidence even exists, but even if they had, most would have dismissed it anyway because it undermines numerous core beliefs in neoclassical economics, (including the belief known as Walras’ Law – that a specific market must be in equilibrium if all other markets in the same economy are). Once it is acknowledged that the growth in credit can expand aggregate demand, then:

– In place of a necessary equivalence between (notional) aggregate demand and aggregate supply, aggregate demand will exceed aggregate supply if debt is rising, and fall below it if debt is falling.

– The nominal amount of money matters, and banking and debt dynamics have to be included in macroeconomic models, while neoclassical economics ignores them.

– The neat separation of macroeconomics from finance can no longer be maintained, since the change in debt finances purchases of assets, as well as purchases of newly produced goods and services.

– Worst of all, the belief that everything happens in equilibrium has to be abandoned. Rising debt is not necessarily bad – in fact it is an essential aspect of a growing economy – but it is necessarily a disequilibrium process, as Schumpeter argued long ago in The Theory of Economic Development.

Working from the perspective that the economy is driven by aggregate demand, and that aggregate demand is GDP plus the change in debt, I therefore expected the crisis to begin when the rate of growth of debt slowed down substantially. In August 2007, when the RBA published its optimistic forecast for 2007 and 2008, I published the following observation on the Australian economy:

"Reducing the rate of growth of debt from its current level of 15 per cent to the 7 per cent rate of growth of nominal GDP would mean a reduction in spending next year, compared to the current trend, of over $100 billion. That is equivalent to an 8 per cent reduction in aggregate demand compared to trend, and would have the same impact on the economy as a 10 per cent fall in nominal GDP. This realisation is why I first observed in early 2006 that an eventual recession is inevitable – and why, in mock honour of Paul Keating’s famous phrase, I gave it the moniker of ‘The Recession We Can’t Avoid’.”

That hypothetical process began in the US in early 2008 (although Australia did in fact technically avoid a recession). Aggregate demand fell sharply in 2008 even though debt was still rising; then in mid-2009 the change in debt actually turned negative.


Figure 4: A slowdown in the rate of growth of debt caused the Great Recession

Meanwhile, since aggregate demand determines employment, the rate of unemployment exploded as the debt-financed portion of aggregate demand collapsed.



Figure 5: Change in debt-financed demand and unemployment, USA

And since debt finances asset purchases as well as purchases of goods and services, I expected the turnaround in the growth of debt to cause asset markets to tank – which they did, in spectacular fashion.

Here the causation was complex – because as well as rising debt causing asset prices to rise, rising asset prices also encourage would-be speculators to enter the stock and housing markets with borrowed money. There was therefore what engineers call a "positive feedback loop” between the change in asset prices, and debt.


Figure 6: A positive feedback between rising (and falling) debt and rising (and falling) asset prices

But these aspects of capitalism remain completely abstracted from neoclassical economics, since its macroeconomic analysis only considers the buying and selling of newly produced commodities. To be properly aware of the likelihood of future crises, we have to transcend the core concepts of neoclassical thinking. Otherwise, we remain in danger of being taken by surprise once again.

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Mr Keen's focus on the significance of the level of private debt and the rate of change in its accumulation is warranted (See Retracing the Great Recession, September 30).
I have noticed that when asset prices are believed to be rising people only talk about the level of the repayments on a loan. The size of loan does not concern them.
But once a belief takes root that asset prices may no longer be rising people suddenly start focusing on the level of outstanding debt they have even if the level of repayments has not changed.
This tendency to switch focus from the relationship between the level of repayments and income to the relationship between outstanding loan size and income may explain why when asset prices have stagnated for a period, reducing interest rates has a much more limited impact than might be expected.
The question is then whether Australians have lost faith in the great housing souffle. Probably not completely, but clearly the ranks of the doubters are growing rapidly.
Some interesting US numbers (See Retracing the Great Recession, September 30). Argument kind of falls short with the "although Australia did in fact technically avoid a recession" line. Steve - we did avoid recession in 2008/09. You may believe that you are a maverick sage, there may be supporting evidence for many of your arguments, but it doesn't make your conclusions right. Your dogged negativity is admirable for its relentless persistence though - surely a sign of these times!
Ray Wilder (September 30, 10:45 AM) writes, "there may be supporting evidence for many of your arguments but it doesnt make your conclusions right", then goes on to talk about Keens "dogged negativity". In my opinion Steve Keen may have been negative in his projections but the thing that matters was his projections about the GFC etc were completely right! QED.(See Retracing the Great Recession , September 30.)
Why is it that when someone talks about the potential for growth to decline or retreat they are labelled negative/pessimist and those who talk-up the markets positive/optimists (See Retracing the Great Recession , September 30)? Are there no realists left in these arguments?
Thanks Mr Keen for 'keepin it real'. As for Chris Joye, his own hedonic or headachic thing is showing house retractions is it not? Good thing the super industry doesn't invest much in residential RE, otherwise we may end up even poorer than we are going to be when we retire, at least they got that right. I am talking in real, inflation adjusted, terms by the way.
The power of vested interests and intellectual inertia never ceases to amaze me. That financial 'sages' who completely missed the events of the last four years still hold any credibility over those that have a proven track record in their prognostications is a surreal testament to this (See Retracing the Great Recession, September 30). I commend Mr Keen on his work; as well as his courage to persist in the face of overwhelming ignorance and folly.
Great article Professor Keen - fascinating stuff (See Retracing the Great Recession, September 30).
I always thought that people like Ben Bernanke, our RBA and Chris Joye (and numerous others) were 'twisting' the truth in the name of vested interests – but as you point out, it's not that they are lying, it's that they really don't understand the situation themselves.
Keep it up - great reading.
As a baby born of the Great Depression, a child of careful parents, and a young woman of necessity living on overdrafts secured by carefully purchased real estate, restored and resold I instinctively endorse Steve Keen's writings as truthful (so rare in these times) and wise (See Retracing the Great Recession, September 30). However having lived from Recession to GFC I would observe that there has been a long cycle when judicious borrowing worked.
Predictably the financial whizz kids who have lived with the profits of this cycle believe their complex financial instruments are the way to go. Truth is, times change - and theories based on everlasting growth are just plain silly. Balloons burst, inevitable overpopulation invokes the laws of nature and lead to extermination by various means.
Just because Steve Keen and Chris Joye don't see eye to eye does not make either of their contributions wrong or bad. In fact their debate has assisted greatly in my evaluation and understanding of the economic factors we are dealing with post 2008. I suspect that Steve and Chris have both benefitted from this debate because the personal barbs that they have exchanged have added more interest to the dry economic argument - therefore making the subject more entertaining (See Retracing the Great Recession, September 30).
Keep debating gentlemen – you both have important contributions to make! (though I suspect Chris Joye has the best of the argument so far..)
Great article (See Retracing the Great Recession, September 30), I agree with notion of a debt fueled increase in aggregate demand that is not sustainable when debt growing faster than GDP. I also think that the easy money or debt will cause speculation in asset markets and that its reduction could cause a downward demand shock on prices. I would be interested to know if there are any statistics or theories into the proportion of the increase in debt that contributes to an increase in aggregate demand. I think it would be limited to the proportion that is borrowed for investment or consumption purposes and the amount borrowed for the purchase of existing assets, such as residential mortgages and margin loans should be deducted.
This theory would substantially reduce the $100bn reduction quoted in the article.
Thank you Prof. Keen (See Retracing the Great Recession, September 30). Yes, of course, how can property prices continually grow faster than the economy. Likewise credit also cannot exorably grow faster than the economy grows. Professor, prepare, to be very famous when within few years, worldwide...
Hey - we have $400 billion in pipeline development for resources. I have been saying we are insane. Good to know I'm not the only one who thinks it's insane (See Retracing the Great Recession, September 30).
Steve sounds to me to be a real economist - one who knows how a market economy truly works (See Retracing the Great Recession, September 30).
In 2006 & 2007 you only had to observe the buying behaviour of everyday Australians - to determine that they were unsustainably living beyond their means - and why, because they had easy access to relatively cheap finance. And what are they doing now - paying down debt as quickly as they can. Neoclassical economists remind me of investment bankers. I think they seem like salesmen promoting 'product'.
Two things beggar belief (See Retracing the Great Recession, September 30).
Without taking anything away from Professor Keen, it is unbelievable that professional economists can miss the obvious connections between debt and money supply on the one hand and asset prices and demand on the other. I doubt an engineer or scientist would have failed to have comprehended the mechanics of this system.
Secondly, how is it that the economists who are not Steve Keen, the ones who failed completely to make anything even approaching correct assessments and predictions, have the gall to have not torn down their shingles and melted away out of shame in their incompetence.
That Bernanke, Summers and Greenspan aren't on the dole is a sorry comment on accountability in modern human society.
I am still waiting for any of the economists to take into account ecological collapse (See Retracing the Great Recession, September 30).
Use of debt means that ecosystems collapse faster as they do not increase productivity when people borrow money to invest, they just get used up faster. My theory is that people invest debt in bubbles because of the lack of productive places to invest due to the destruction of forests, fisheries, soil, and weather.
I'd like to thank Prof Keen for being one of the economists who convinced me to move our super into cash...late last year! We have really saved ourselves a lot of money and angst (See Retracing the Great Recession, September 30).
Debt must be paid back in time. Not financial instruments out of thin air. Simple really (See Retracing the Great Recession, September 30).
And if not time, then blood.
Some, in fact, are predicting war.
As Eureka Report once said, "Look Left For Danger".
Some interesting comments above on all the theories being expounded by the experts (See Retracing the Great Recession, September 30). I have a question for you experts and commentators: What economic theories do you think the guys at Goldman Sachs are using?
The other side of the story is, however, that flushing new cash into the system to the highest bidders reveals new winners in the production game, whose techniques are modelled, advancing productivity, the only real economic advancement (See Retracing the Great Recession, September 30).
The problem is that only works if we stop propping up those who rolled the dice and lost by those who didn't. The backstop is the basics needed to live.
For example, government assistance to the banking system [where necessary] should be limited to loans associated with owner occupiers.
With the Soros solution, for example, the "temporary guarantee and permanent recapitalisation" in return for "maintain[ing] credit lines and outstanding loans" would be restricted to that part of the book that relates to owner occupied loans.
"If your upkeep [including debt repayments] exceeds your income your upkeep will become your downfall." E. James Rohn.
This applies at both the personal and national levels. Ignore it at your peril (See Retracing the Great Recession, September 30). Labor strategists please note well. You were elected to pursue the interests of the nation not simply to further your own political ambitions.
Mulling over Steve Keen's excellent overview of his own development and the comments it has provoked, it seems to me that the kindest adjective for neoclassical economists would be self-deceiving (See Retracing the Great Recession, September 30).
In response to conventional upbringing based on behaviour and reward, these perfectly intelligent people have learned to endorse the status quo and push its limits for the short-term benefit of themselves and those they advise. Fundamentally, they seem to avoid the obvious containment of the economy within human society in all its diversity, itself restricted by the biosphere and its limitations.
Until university curricula demonstrate the wisdom of, for example, training students regarding the capital value of ecosystems and their correct location on balance sheets, I think there is not much hope, ultimately, for the human race.
Great article Steve (See Retracing the Great Recession, September 30).
I'd be interested in your future articles upon the level and change in debt that you included not just domestic debt, but offshore lending by the banks. Your thoughts about the affect this has on the way up and the way down would be appreciated.
I have to say that I read both Chris and Steve's contributions keenly (See Waging a property price war , August 31; See Retracing the Great Recession, September 30).
I'm interested in economics personally and professionally and feel like so far the 'arguments' reflect what I was brought up to believe in my family can be applied here in a financial sense: "There are 3 sides to every story. Yours, mine and the truth"
I think that at either side of the housing argument we have valid points but in my case I'm a bit of a property bear. I'm a believer in the "fundamentals" eventually setting the pace when all the greed/fear is averaged out over time and the property market is still full of people that only have experience of investing in this latest property boom cycle and doggedly hang on to the "bricks and mortar" mantra. Steve has my vote when it comes to this "Great recession" piece as well although my rudimentary economic knowledge is very basic, it seems to make quite a lot of sense to me.
By the way my view – for what it's worth – the technical avoidance of recession is never going to be a point of the argument to pin a victory on for either "side" as realistically, the policy response of the federal government and of course the RBAs decisions can't be predicted.
I mean who would have thought the government of the time would have thrown so much money at covering school grounds and insulating homes? (Personally I thought both were a joke and handled extremely poorly - but that's not my point with this response.)
Seems there are a few macro economic assumptions/formulas that need to be reviewed, including; the one that says we must have perpetual "growth", tied to population and consumption growth, which contradicts the realisation we have finite resources, one planet (so far) and sustainability staring us in the face. (See Retracing the Great Recession, September 30)