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.