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I stumbled out into the autumn sunshine, figures ricocheting around my head, still trying to absorb what I had heard. I felt as if I had just attended a funeral: a funeral at which all of us got buried.
I cannot claim to have understood everything in the lecture: Sonnenschein-Mantel-Debreu theory and the 41-line differential equation were approximately 15.8 metres over my head.
Professor Steve Keen was one of the few economists to predict the financial crisis. While the Organisation for Economic Co-operation and Development and the United States Federal Reserve foresaw a “great moderation”, unprecedented stability and steadily rising wealth, he warned that a crash was bound to happen. Now he warns that the same factors that caused the crash show that what we’ve heard so far is merely the first rumble of the storm. Without a radical change of policy, another Great Depression is all but inevitable.
The problem is spelled out at greater length in the new edition of his book Debunking Economics. Like his lecture, it is marred by some unattractive boasting and jostling. But the graphs and figures it contains provide a more persuasive account of the causes of the crash and of its likely evolution than anything that has yet emerged from Constitution Avenue or Threadneedle Street. This is complicated, but it’s in your interests to understand it. So please bear with me while I do my best to explain.
The official view, as articulated by Ben Bernanke, the chairman of the Federal Reserve, is that both the first Great Depression and the current crisis were caused by a lack of base money. Base money, or M0, is money that the central bank creates. It forms the reserves held by private banks, on the strength of which they issue loans to their clients.
This practice is called fractional reserve banking: by issuing amounts of debt several times greater than their reserves, private banks create money that didn’t exist before.
Conventional economic theory predicts that when the central bank raises M0, this triggers a “money multiplier”: private banks generate more credit money (M1, M2 and M3), boosting economic growth and employment. Bernanke, echoing claims by Milton Friedman, believed that the first Great Depression in the United States was propelled by a fall in the supply of M0, which, he said, “reinforced ... declines in the money multiplier”. But, Keen shows, there is a weak association between M0 supply and depression.
There were six occasions after World War II when M0 supply fell faster than it did in 1928 and 1929. On five of these occasions there was a recession, but nothing resembling the scale of what happened at the end of the 1920s. In some cases, unemployment rose when the rate of M0 growth was high and fell when it was low: results that defy Bernanke’s explanation.
Professor Keen argues that it’s not changes in M0 that drive unemployment, but unemployment that triggers changes in M0: governments issue more cash when the economy runs into trouble.
He proposes an entirely different explanation for the Great Depression and the current crisis. Both events, he says, were triggered by a collapse in debt-financed demand.
Aggregate demand in an economy like ours is composed of gross domestic product (GDP) plus the change in the level of debt. It is the sudden and extreme change in debt levels that makes demand so volatile and triggers recessions. The higher the level of private debt relative to GDP the more unstable the system becomes. And the more of this debt that takes the form of Ponzi finance—borrowing money to fund financial speculation—the worse the impact will be.
Keen shows how, from the late 1960s onwards, private-sector debt in the US began to exceed GDP. It built up to wildly unstable levels from the late 1990s, peaking in 2008. The inevitable collapse in this rate of lending pulled aggregate demand down 14%, triggering recession.
This should be easy enough to see with the benefit of hindsight, but what lends weight to Keen’s analysis is that he saw it with the benefit of foresight. In December 2005, while drafting an expert witness report for a court case, he looked up the ratio of private debt to GDP in his native Australia to see how it had changed since the 1960s. He was astonished to discover that it had risen exponentially. He then did the same for the US, with similar results. He immediately raised the alarm: here, he warned, were the conditions for an economic crisis far greater than those of the mid-1970s and early 1990s. A massive speculative bubble was close to bursting point. Needless to say, he was ignored by policymakers.
Now, he tells us, a failure to address these problems will ensure that this crisis will run and run. The “debt-deflationary forces” unleashed today “are far larger than those that caused the Great Depression”. In the 1920s, private debt rose 50%. Between 1999 and 2009, it rose 140%.
The debt-to-GDP ratio in the US is still much higher than it was when the Great Depression began.
If Keen is right, the crippling sums spent on both sides of the Atlantic on refinancing the banks are a complete waste. They have not and will not kickstart the economy, because M0 money supply is not the determining factor.
President Barack Obama justified the bank bailout on the grounds that “a dollar of capital in a bank can actually result in eight or $10 of loans to families and businesses. So that’s a multiplier effect”. But the money multiplier didn’t happen. The $1.3-trillion that Bernanke injected scarcely raised the amount of money in circulation: the 110% increase in M0 money led not to the 800% or 1 000% increase in M1 money that Obama predicted, but a rise of just 20%.
The bailouts failed because M0 was not the cause of the crisis. The money would have achieved far more had it simply been given to the public. But, as Angela Merkel and Nicolas Sarkozy demonstrated over the weekend, governments have learned nothing from this failure, and seek only to repeat it. Instead, Keen says, the key to averting or curtailing a second Great Depression is to reduce the levels of private debt, through a unilateral write-off, or jubilee. The irresponsible loans the banks made should not be honoured. This will mean taking many banks into receivership. Otherwise private debt will sort itself out by traditional means: mass bankruptcy, which will generate an even greater crisis.
These are short-term measures. I would like to see them leading to a radical reappraisal of our economic aims and moves to develop a steady-state economy, of the kind proposed by economists Herman Daly and Tim Jackson. Governments and central bankers now have an unprecedented opportunity to learn from the catastrophic mistakes they’ve made. It is an opportunity they seem determined not to take.—
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