The Experts

Last week I took part in a debate entitled ‘The Great Residential Housing Debate - the next Bubble or a legitimate Boom?’ at the annual conference for Perennial Investment Partners; I put the Bubble case and Chris Joye of Rismark International presented the Boom case (here is my paper and my presentation). As is well-known, Australia is one of the few countries in the OECD not to experience two quarters or more of falling GDP as a result of the GFC, and probably the only country that has not experienced a fall in its property market.

The conference was held twice, firstly in Melbourne on Wednesday, 24 February and then in Sydney on 26 Friday. There were roughly 400 people in the audience on both occasions, all of whom were customers of Perennial--with the majority (roughly 75 per cent) being financial planners. The conference employed an electronic voting mechanism that let participants answer general questions, as well as rate the speakers. In our debate, it was used to work out where people stood on the "Bubble vs Boom" spectrum both before and after the debate. A "1" indicated a complete Bear who expected property to crash and advised getting out now, while a "10" was a complete Bull who advised "Buy, Buy, Buy".

Prior to our debate in Melbourne, the average score was 4.9. This surprised me, because I expected the audience to be generally pro-property; however a score of below 5.5 indicated that overall the audience was bearish on property (since the average of the ten numbers from one to 10 is 5.5).

After our debate, the score was 5.2--a small move in favour of the bullish position, but still slightly in the bearish camp. Chris commented that this was "about even" and "too close to call" as he left the stage, which I thought was a fair enough summary of the outcome.

So I was stunned when Crikey asked me to respond to the report Chris had given them of the Melbourne debate ("Reflections on Cage Match Mk 1"), which included the statements that:

So I think I pretty comprehensively monstered Steve Keen at our debate in Melbourne yesterday. That was certainly the feedback from those who attended (there were 500)...

While I felt I was able to intellectually tear Steve apart limb-by-limb, I will say this: he is a lovely guy. Very diplomatic and humble in defeat...; and

Unfortunately, the electronic scoring in yesterday’s debate was a bit convoluted: it measured the shift in the audience sentiment from bearish (Steve) to bullish (Chris) before and after the event. On that basis, I won. But I think a simpler Chris versus Steve voting system would have made the difference much more striking...

Huh? The rest of the post was of a similar vein--though there were occasional caveats such as: "As I noted in my presentation, Steve has made some valid criticisms of conventional economics, and its neglect of debt capital market imperfections. And he deserves some kudos for anticipating a credit crisis" (gee, thanks!), even this was immediately followed by "But whatever strengths he possesses are overwhelmed by his propensity to make silly statements."

I had no intention of commenting on the debate prior to seeing this hit a national news site, but of course this couldn't be ignored--though at the same time it didn't deserve to be taken seriously. So I took a facetious approach--opening my reply with "I don’t know what Chris consumed after our talk at Perennial’s conference yesterday, but if he has any spare I’d like to try it at a party tomorrow night", and concluding with the advice to Chris that, "Next time, after a conference, don’t consume anything, just take a cold shower"  (I also pointed out the statistical fact Chris apparently missed, that the middle point in scores from one to 10 is not five, but 5.5).

Chris took this rejoinder very well--despite our fundamental differences over this issue, we get on well personally, and unlike some participants in this debate, he does have a sense of humour.

And so we proceeded to Sydney. There the audience was slightly less bearish than in Melbourne: the average score prior to the debate was 5.3, just slightly below the neutral level. But after the debate, there was a significant shift towards the Bear case. The post debate score was 4.6.

Chris had made the classic mistake of declaring victory at half-time, only to get a cold shower with the full-time result (see below).

Why Debt-Deflation Causes Depressions

"Declaring victory at half-time" is a syndrome which afflicts the entire debate over our current economic situation: optimists are of the opinion that the crisis is all over now, while pessimists think it's only just begun. On this front, as always, I regard history as the best indicator of who may be right. On this front, I can't commend highly enough the site New from 1930, which from 1 January 2009 began publishing summaries of the Wall Street Journal from 1 January 1930. The last few entries include these pearls of wisdom from February 1931:

An Old-Timer believes the market rally “will do more to restore prosperity than anything else.” Total security values have increased over $20B since start of year; barring another dive in the market, this assures a recovery since the 10M-15M US owners of stock feel richer. Bulls say the ease with which considerable profit-taking has been absorbed recently is “the surest indication of a strong healthy market.” Market has rallied very substantially; “if it runs true to form, it will have one of those 'healthy reactions' that will, according to the bulls, strengthen its 'technical position.'” “The buying power of the people and the corporations still is large ... In other words, the country never was in a better position to stage a comeback after a depression ... (25 February)

One banker cites plenty of evidence that the backlog of consuming power is largest its been in years: corp. inventories are down 20 per cent from a year ago, and even more from two years ago; corps. are holding more cash; production of many products is below requirements; products have been wearing out for 18 months of deferred buying; security values up $20B since 1 January; easy credit; record-breaking savings deposits. Last year there were few rallies on which to sell; this year there have been few dips on which to buy. Public interest has grown this year, but is still small compared to 1928 and 1929; “a market with a growing public interest is a dangerous market to sell short.” (26 Febuary)

Yeah, right: in both 1930 and 1931, the belief was widespread--at least in the financial community--that the Depression was over, and recovery was just around the corner. As Australia's Alan Kohler noted when he first discovered this blog, at least early on during the Great Depression, people didn't realise that they were in it. They too, were declaring victory at what turned out to be not even half-time.

Ultimately, the debate over whether we're in a complete recovery or merely a temporary recess from the GFC will only be resolved by time. But well-informed theory can also give a guide as to what we can expect, and here I regard Hyman Minsky's Financial Instability Hypothesis and Irving Fisher's Debt Deflation Theory of Great Depressions as the outstanding guides. However they are complex theories, especially when most economists have been mis-educated by neoclassical economics into ignoring money, debt, and disequilibrium dynamics. So the following numerical example might make it easier to understand their arguments:

• Imagine a country with a nominal GDP of $1,000 billion, which is growing at 10 per cent per annum (real output is growing at four per cent p.a. and inflation is six per cent p.a.);
• It also has an aggregate private debt level of $1,250 billion which is growing at 20 per cent p.a., so that private debt increases by $250 billion that year;
• Ignoring for the moment the contribution from government deficit spending, total spending in that economy for that year--on all markets, both commodities and assets--is therefore $1,250 billion. 80 per cent of this is financed by incomes (GDP) and 20 per cent is financed by increased debt;
• One year later, the GDP has grown by 10 per cent to $1,100 billion;
• Now imagine that debt stabilises at $1,500 billion, so that the change in debt that year is zero;
• Then total spending in the economy is $1,100 billion, consisting of $1.1 trillion of income-financed spending and no debt-financed spending;
• This is $150 billion less than the previous year;
• Stabilisation of debt levels thus causes a 12 per cent fall in nominal aggregate demand.

What about if debt doesn't actually stabilise, but instead grows at the same rate as GDP? Then we get the following situation:

• In the first year, total demand is $1,250 billion, consisting of $1,000 billion in income and $250 billion in increased debt;
• In the second year, total demand is also $1,250 billion, consisting of $1,100 billion in income and $150 billion in increased debt;
• Nominal aggregate demand is therefore constant;
• But after inflation, real aggregate demand will have contracted by six per cent.

This is the real danger posed by debt: once debt becomes a significant fraction of GDP, and its growth rate substantially exceeds that of GDP, the economy will suffer a recession even if the debt to GDP ratio merely stabilises.

A debt-dependent economy has no choice but to record rising levels of debt to GDP every year to avoid a recession. Unfortunately, this makes a debt-servicing crisis inevitable at some point, especially when a large fraction of the increase in debt is financing Ponzi-speculation on asset prices, since this adds to debt without increasing society's capacity to finance that debt.

That is why falling debt levels caused the Great Depression, as Irving Fisher argued back in 1933, and the phenomenon is obvious in the empirical data. The next few charts illustrate this argument.

Private debt and GDP levels in the USA from 1920 to 1940:

The change in private debt, added to GDP to show aggregate demand as the sum of GDP plus the change in debt:

 

Now I calculate the proportion of aggregate demand that is debt-financed, by dividing the change in debt by the sum of GDP plus the change in debt: the formula for is:

The correlation of the fraction of demand that is debt financed (lagged one year since the data is end-of-year annual) with unemployment is minus 0.77.  Roughly speaking, this tells us that when the debt-financed fraction of demand rises, unemployment falls, and the correlation of these two series accounts for 77 per cent of the change in unemployment between 1920 and 1940:

Now let's repeat the same exercise with the data from 1990 till 2010. Firstly, private debt and GDP levels in the USA from 1990 to 2010:

The change in private debt, added to GDP to show aggregate demand as the sum of GDP plus the change in debt:

Finally, the correlation of the fraction of demand that is debt financed (unlagged since we now have quarterly data on debt) with unemployment (the correlation coefficient is now minus 0.84):

This is why debt-deflation matters, and it's also why we are barely at the half-time mark in the GFC. Though government spending has countered the fall in debt-financed spending to some degree, that fall has only hit 40 per cent of the level that applied during the Great Depression, even though debt levels are substantially higher (relative to GDP) than they were back then.

The numerical example given above is, by the way, not too far removed from the empirical data for both Australia and the USA prior to the GFC. In the year before the crisis, Australia's GDP was roughly A$1.1 trillion, and the increase in debt that year was A$260 billion, which was a 17 per cent increase on the previous year; for the USA the comparable figures were roughly US$14 trillion, a US$4.5 trillion increase in debt, and a peak rate of growth of debt of about 10 per cent p.a.

The example also illustrates why the rate of inflation matters, and why a low rate prior to a debt crisis is a serious danger. If inflation is high when the crisis hits (say 20 per cent p.a.) then most of the decline can be taken by a fall in the rate of consumer price inflation itself. But if the commodity inflation rate is low, then the hit will be taken by asset prices and actual output as well as by a fall in the inflation rate.

The process can be countermanded to some degree by the government running a deficit, which counteracts the fall in aggregate demand caused by private deleveraging. But the government deficit would need to be far higher than current levels to return us to prosperity if nothing is also done about the astronomical level of private debt.

With the deficits that are being contemplated today, I expect the outcome to be that the rest of the OECD will "turn Japanese" and enter a long-running, low level Depression. Actions that limit those deficits--or even worse, force countries in crisis like Greece to impose austerity measures to reduce deficits back to zero--will turn this from a drawn-out Depression into a sudden and deep one.

Of course, at the same time that economic policy makers--misled by neoclassical economics--are imposing austerity programs on national governments, they are trying to restart the private debt binge mechanism that gave us the crisis in the first place. I'll write more on this in a future Debtwatch, but in the meantime I recommend the post on this point on Vox by Peter Boone and Simon Johnson, "The doomsday cycle".

Why has Australia done so well?

I've noted previously that government policy during 2009 boosted household disposable income dramatically, and Gerard Minack of Morgan Stanley recently pointed out just how much: "household disposable income increased by 10.1 per cent over the year to the September quarter, while labour income – the biggest component of household income and traditionally the largest swing factor – increased by just 0.4 per cent." (Morgan Stanley Australia Strategy and Economics, 24 February, 2010: The Odd Expansion). The primary factors driving household disposable incomes higher were the government's stimulus package (which boosted incomes by about 4%) and the RBA's rate cuts (which added another five per cent to disposable incomes).

As Gerard commented when he first publicised this outcome (Morgan Stanley, Downunder Daily October 9, 2009: Antipodean Lessons), "If that’s recession, bring it on!": it's unheard of for household incomes to rise during a recession, and that's a major reason why Australia avoided a downturn last year.

But it's not the only reason: the other one, as my numerical example above illustrates, is what happened to debt levels. In our debt-dependent economies today, a recession almost always means a fall in debt levels relative to GDP (while a Depression results from absolutely falling debt). We began that process early in 2008, only to dramatically reverse direction in 2009 so that, once again, debt was growing faster than GDP.

The key cause of this was that other government policy, the First Home Vendors Boost, which enticed Australians back into mortgage debt in droves (both First Home Buyers who actually received the Boost, and the Vendors who sold to them who took levered the extra $15-40K The Boost added to the sale price into another $100-200K for their next house purchase). This policy gave us the fastest turnaround in debt levels in our post-WWII economic history.

Note that the period prior to 1965 had as many periods of the debt to GDP ratio falling as rising--which is the sign of a cyclical but non-Ponzi economy. Then from 1965 on, the trend was for debt ratios to rise faster than GDP except during the recessions of 1973-76 and 1990-94. The period of the Howard Government involved the longest sustained period of rising private debt ever--though notably this trend for rising debt began while Keating was still PM.

Then the GFC hit virtually as Rudd came to office, and the rate of growth of private debt plunged--a similar coincidence to the one that had done the Whitlam government in decades earlier (note that the debt bubble whose bursting brought Whitlam undone had also commenced under the preceding Liberal government of Billy McMahon).

Rudd deserves no blame for the bursting of the debt bubble--as I warned since December 2005, this was inevitable and when it happened, a serious global recession would begin (because the phenomenon was global and not merely limited to Australia). But his government does deserve whatever is deserved--credit or blame--for the rapid turnaround in debt. This wouldn't have happened without the First Home Vendors Boost, since as is illustrated below, the only source of this increase in private debt has been rising mortgage debt.

Had this trick been pulled back in the 1990s, then Rudd would have received credit for it in the long run, since it would have set off a prolonged boom as debt to GDP ratios rose for many years and gave us a strong if illusory recovery from the preceding recession.

But this is 2010: household debt has risen from under 30% to almost 100% of GDP (the RBA has recently changed its statistics on this front--two months ago the figures in D02 yielded a ratio slightly above 100%), and I simply don't believe there's capacity for it to continue rising. So I expect that the trend will rapidly reverse itself back into a falling private debt to GDP ratio, and the recovery this rising debt has helped engineer will evaporate.

That will leave government spending as the one prop to keep the Australian economy afloat, and it is a prop that shouldn't be underestimated, as the next chart illustrates: though the private debt to GDP ratio turned around from falling at five per cent p.a. to rising at two per cent p.a. courtesy of government policy, the increase in government debt added another three per cent to the mix.

The sum of changing private and government debt thus substantially boosted spending in the Australian economy in 2009--enough to stop the GFC in its tracks here. But in 2010, it is highly unlikely that the private sector will continue re-leveraging. That will leave increased government debt-financed spending as the only boost.

If the government's contribution remains at about the level of 2009--roughly a three per cent boost--and the private sector continues the deleveraging it was doing before government policy kicked in--at a rate of close to six per cent p.a.--then the net outcome will still be a falling debt to GDP ratio. While that is necessary in the long term to get us out of the Ponzi cycle we have been trapped in for the last four decades, it will still mean pain: private sector deleveraging will outweigh government sector pump-priming.

The reason is simple: so much debt has been taken on already by the Australian private sector that its capacity to take on any more is virtually exhausted. Even as households slapped on more mortgage debt under the influence of the FHVB, other personal debt was falling (until just recently) and the business sector has been rapidly deleveraging--and even so, business debt today still exceeds the peak it reached in 1990.

So the Australian gambit out of the GFC--get back into debt as fast as possible--may soon run its course. We should then find ourselves in the same situation as in the rest of the OECD--deleveraging. The fact that we are taking the "hair of the dog" approach to a debt-hangover (get drunk again on debt the next morning) is readily apparent in this comparison of Australian and US private debt levels: Australia actually began to deliver before the USA did, but just as they hit deleveraging with a vengeance, our aggregate private debt started to grow once more.

Just like the "hair of the dog" approach to getting over a hangover, it works once or twice, but not forever: the ultimate destination is DA: "Debtors Anonymous". Australia has merely delayed its entry into the club.

Further reflections on the Perennial debate

Chris in part attributed doing poorly in Sydney to a couple of personal mishaps that morning prior to the debate--and he did say that he expected not to speak as well as in Melbourne before the debate in Sydney took place. That would certainly have been a factor.

One other factor may be that I developed the numerical example used in this DebtWatch Report after the Melbourne conference. That gave the Sydney audience a clearer idea of why debt-deflation matters--and why the servicing cost of debt, which Chris insists is not high, is not the main problem with a debt-driven economy.

Of course, I dispute the argument that debt servicing costs are not particularly high today. As the next chart shows, even though the RBA's rate cuts have reduced the cost substantially from its peak, interest payments on mortgages in Australia today consume 7.5 per cent of household disposable income. This is 1.65 times the average from 1976 till now.

Yet this "average" itself is almost as high as the debt servicing costs in 1990, when mortgage rates were an astronomical 17 per cent--2.5 times as high as today's rates. The primary driver behind this extreme rise in debt servicing costs is the factor Chris loves to ignore, the ratio of mortgage debt to income. This is more than five times larger today than it was in 1990 (130 per cent of household disposable income versus 25% in 1990).

In Sydney, the audience was advised (after our debate) to make a large change to its previous number if they were persuaded one way or the other; this may have made the final swing larger in Sydney than Melbourne.

Finally, Chris later argued later that financial planners are inherently bearish on residential property, since they want to advise people to get into stocks instead. That is an argument that I would prefer to take with a grain of salt. Whether that is true or not as a general proposition, it appears that the people "Mum and Dad investors" might rely upon for advice about where to put their speculative dollars are on average telling them not to put them into residential property, which is the opposite advice to that one sees regularly in the Australian media today (sourced from commentators who clearly have no pecuniary interest in whether house prices rise or fall...).

Important information: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.

So I'm walking to Kosciusko--now that the ABS Established House Price Index has cracked its September 2008 peak of 131 to reach an all-time high of 134.4 (as of September one year later). This renewed bubble reversed the trend of falling nominal house prices that had dropped the index to a low of 123.8 in March 2009.

This level of price volatility--down 5.5 per cent in six months, only to rise 8.5 per cent in the subsequent six months-- almost matches the stock market's manic-depressive performance.

Though you'd see no mention of it if it you only read Chris Joye ("Keen concedes defeat"), the main factor behind the revival of the bubble is what is formally known as the First Home Owners Boost (FHOB), but what is more accurately described as the First Home Vendors Boost. As at the end of September--the date of the latest ABS house price data--171,000 applicants had received this $7,000 bribe. Since many are couples, more than one per cent of Australia's population has leapt into the property market pool at the behest of a government stimulus.

So how has a mere $1.2 billion injection of government money driven the average house price up by eight per cent in six months? By the "magic" of leverage: the typical First Home Buyer (FHB) took that $7,000 to the bank and leveraged it up to another $40-50,000, which then was handed over to the First Home Vendor (FHV) as cold, hard cash.

The FHV then took that extra $40-50,000 and leveraged it to an additional $200,000-$250,000, which meant that that new place which had been just out of reach prior to the FHOB was now well within range. Competing with other lucky recipients of government and bank largesse, he drove up the price of that middle to upper tier house by an additional $100,000 or more.

The aggregate impact of this government enticement into private debt was that Australian households reversed the deleveraging process that had begun in late 2008, and as a result the mortgage debt to GDP ratio, which had been falling, began to rise once more. The FHOB has led to Australians taking on an additional $50 billion of mortgage debt. That "demand" factor, far more than any other, is why I've lost the second half of Rory's bet with me.

Normally I regard the "ceteris paribus" assumption of conventional economic theory as a copout--in a market economy everything is connected to everything else, and you can't assume that, for example, a firm's output can change without affecting the market price. But I think I'm entitled to ask the "ceteris paribus" question here: what would have happened to house prices had the government not spiked the market with the FHVB? I somehow doubt that Rory would be crowing today had that irresponsible policy move not been made.

In fact, there's a good argument that we wouldn't be having a property bubble here at all, were it not for the First Home Buyers policy. I'm not one for making arguments solely on statistical correlations--I'm only too aware of the "correlation isn't causation" argument--but I think I can also spot a smoking gun when I see one.

Prior to the FHB, though real house prices were rising, so was real household disposable income. Then add two dollops of the FHB--one its introduction as a "temporary" measure to get us over the shock of the GST in 2000, the other its doubling to boost the economy during the brief 2001 recession--and off go real house prices relative to real household disposable income.

Last year, as the market starts to head back towards parity between house prices and incomes again, Rudd throws in another temporary doubling (of this temporary measure that is now almost a decade old), and off goes the house price bubble once more.

In the main, I've been a critic of banking practices as the underlying cause of the Global Financial Crisis. But I also believe that the crisis would have occurred long ago (in 1987) and been far less severe if governments and Central Banks hadn't attempted to rescue the system from its own follies. The First Home Owners is a classic government folly, and its doubling last year is the main reason I'll be walking to Kosciusko some time in April 2010.

Important information: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice. 

I’m off to join the rest of the country is losing bets on the Melbourne Cup today, and since it coincides with an important personal event I won’t have time to comment on why I lost part two of Rory Robertson’s two part bet with me on house prices (the main part, a peak to trough fall of 40 per cent over 10 to 15 years, is still alive and well, as Rory graciously acknowledged).

But I can’t let the event pass without some comment, so I can do no better than to reproduce the commentary I made over a year ago when the First Home Vendors Boost was announced with the suitably deceptive name of the First Home Buyers Boost—a bit like the way that “accept what the boss wants or lose your job” was called “Work Choices”.

Many elements of the recently announced package are justified. When the economy is about to go into a debt-induced recession, government spending both boosts demand, and provides the private sector with cash flow needed to meet its debt repayment commitments.

Equally vital was the guarantee of all bank deposits. A run on the banks would be disastrous, and this guarantee ensures that this will not happen.

But yet another increase to the First Home Buyers Grant???

Is this because, um, house prices are, like, maybe too low?

Oh please, some reality here: the root cause of this crisis is excessive debt that drove house and share prices to unsustainable levels. Times appeared rosy as the house (and stock market) bubble continued, but this was only because borrowed money was adding to demand.

No one worried about this when it was easy to flog a house for a higher price. But unfortunately, this game had to come to an end, because debt servicing became prohibitive as house prices rapidly outstripped incomes. The bubble burst first in the USA, and the carnage it has wreaked there should warn us all that asset price bubbles are dangerous.

And how does the Australian government respond? By providing yet another stimulus on the demand side.

A collapsing housing bubble may be a scary prospect, but the more it is inflated, the scarier the final bust. And Australia's, on any measure, is bigger than America's.

A simple comparison of the ABS Established House Price Index (ABS 641601 and 641603) to the CPI shows just how large the Australian house price bubble is (see figure one).

Since 1987 – hardly a time when Australian house prices were low by historical standards – house prices have increased two and a half times as fast as consumer prices (see figure two). Median incomes have fared little better than the CPI, so that houses are 60 per cent less affordable now than in 1987.

Figure two: ratio of house prices to the CPI

That's also true even when we take into account lower interest rates. Yes, rates are about half what they were in 1987 (see figure three); but debt is six times larger as a percentage of household disposable income than it was then (see figure four) – so that merely paying the interest on outstanding mortgage debt consumes 13 cents in the household dollar, versus a mere 3.5 cents back in 1987.

Figure three: mortgage rates and payments

Figure four: mortgage debt to disposable income

Increasing the amount of money that first home buyers can slap down on a home may help those who can't afford to get into the market do so – great. It will also increase competition for houses, and potentially sustain the Great Australian Housing Price Bubble. 

As the USA shows us, the pain of a bursting house price bubble can be pretty immense – especially since it's fuelled by excessive levels of debt.

But that pain will only get worse if the bubble is driven any higher. The higher up you are when you fall off a mountain, the more it hurts when you hit the ground. The Australian house price mountain, on any measure, is substantially higher than the USA's was when it began its long, painful descent (see figure five).

Boosting the First Home Buyers Grant is a mistake, just as it was when Howard did it. It will merely delay the day of reckoning.

Figure five: Australian vs US housing bubble

Important information: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.

If I was asked to nominate the wisest aphorism of all time, Mark Twain’s “History doesn’t repeat, but it sure does rhyme” would definitely be one of my top two candidates.

On song, today Wall Street is replaying the 1930s, but to a slightly different meter. With the 80th anniversary of the Great Crash of 1929 falling on 29 October of this year, Wall Street is celebrating in characteristic style – with a euphoria-led bubble that now appears to be crashing up against economic reality.

Of course, our time is not a mirror image of that momentous period 80 years ago. It’s closer to a mirror image of the days roughly a year later, when the first two bear market rallies that followed the crash finally petered out, and the long slow grind of the Great Depression gradually took hold on the economy and the minds of America.

But in 1930, though on our reckoning the Depression had well and truly begun, the mindset that prevailed was very similar to today’s—that the worst of the crisis is behind us, and economic recovery is underway.

This mindset is on show at the wonderful blog News from 1930, which in honour of this week’s anniversary is publishing news summaries from the Wall Street Journal of 1929 as well as from 1930. Reading newspaper stories from 1930 is remarkable enough on a day-by-day basis, as comments made about the recovery that was then in place (and the return of the bull market) could easily have been lifted from today’s—or last week’s—newspapers. But to see these juxtaposed with the actual coverage of the Crash of 1929 is all the more startling.

The most obvious chord in the historical song is that very few people realise when they are participants in an event of historic proportions. Even though the Dow had never fallen by anything like what it did in the five days of the Great Crash, the belief that this would nonetheless turn out to be a rather ordinary event was the dominant perspective, as this excerpt from the Wall Street Journal’s Editorial for Saturday 26 October 1929 indicates:

“The market will find itself, for Wall Street does its own liquidation and always with a remarkable absence of anything like financial catastrophe ... Suggestions that the wiping out of paper profits will reduce the country's real purchasing power seem rather far-fetched.”

It seems that only in retrospect was it realised that 1929 was a watershed in world history: few living at the time actually understood that—and none of them had their prognostications published by the Wall Street Journal.

One year later, though the far-fetched had become somewhat harder to dismiss, the general tenor of economic and business commentary was that the worst of the crisis was over, and that 1931 would be a bumper year for the market and the wider economy. This observation in a radio address by General Motors executive and Democratic Party National Committee Chair J. Raskob is indicative of business attitudes in 1930:

In closing, let me say that no country in the world, not even our own, was ever in as splendid position to go forward and enjoy a period of prosperity as our own country is today. Everything has been thoroughly deflated and business is now turning upward. The momentum is necessarily slow at first, but within three months ... we will quickly leave depression behind.” (WSJ Tuesday October 1930)

The second chord is that the causes and effects of momentous events can be misunderstood both at the time and in retrospect—which leads humanity to repeat its mistakes all over again. Reading the commentary in the 1930, it is clear that the government of the time was doing all it thought possible to prevent the Crash turning into an economic crisis, and it appeared to believe that it had been successful.

The statistics certainly imply that Hoover wasn’t sitting on his hands doing nothing as Wall Street burned, which is the modern mythology. Government debt was equivalent to 30 per cent of GDP when the crisis began; just three years later it was 70 per cent of GDP—and that was when the so-called “automatic stabilisers” were a lot smaller than they are today (because the government sector was much smaller back then).

Yet today, the view that dominates conventional economic thinking today is that the Depression was caused by a disengaged government and bad monetary policy—if only the Fed hadn’t tightened in 1930, everything would have been fine. In fact, if the Fed did tighten—and the evidence on that is mixed—it was because they, like today’s Fed, believed they had already done enough to avert catastrophe.

Bollocks to that: the problem in 1930 wasn’t the tightening of fiat money, but the preceding failure to constrain the private debt bubble that financed Wall Street’s speculative excess of the 1920s. Yet armed with the misguided belief that there wouldn’t have been a Great Depression had the Fed not tightened in 1930, the Fed of the 1980s-2007 ignored an even bigger bubble in private debt than its predecessor ignored in the 1920s.

By the time Ben Bernanke made his fawning paean to Milton Friedman at his 90th birthday—“Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton and Anna: regarding the Great Depression. You're right, we did it. We're very sorry. But thanks to you, we won't do it again”—the Fed had already caused a far bigger crisis by ignoring private debt and the asset bubble it financed.

I’ll finish with my other favourite aphorism: Max Planck’s observation that “science progresses one funeral at a time”. It will take a lot of funerals before the economics profession abandons the follies that led it to describe the decade leading up to today’s crisis as “The Great Moderation”.

Important information: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.

If the economy does in fact recover from the Global Financial Crisis—without private debt levels once again rising relative to GDP—then my approach to economics will be proven wrong.

But this won't prove conventional neoclassical economic theory right, because, for very different reasons to those that I put forward, modern neoclassical economics argues that the government policy to improve the economy is ineffective. The success of a government rescue would thus contradict neoclassical economics just as much—or maybe even more—than it would contradict my analysis.

The actual reasons for this belief are arcane, but this choice quote from leading neoclassicals Thomas Sargent and Neil Wallace puts the dominant neoclassical case in a nutshell:

“In this system, there is no sense in which the authority has the option to conduct countercyclical policy. To exploit the Phillips Curve [a relationship between unemployment and inflation], it must somehow trick the public. But by virtue of the assumption that expectations are rational, there is no feedback rule that the authority can employ and expect to be able systematically to fool the public. This means that the authority cannot expect to exploit the Phillips Curve even for one period. Thus, combining the natural rate hypothesis with the assumption that expectations are rational transforms the former from a curiosity with perhaps remote policy implications into an hypothesis with immediate and drastic implications about the feasibility of pursuing countercyclical policy.’” (Rational Expectations And The Theory Of Economic Policy, Journal of Monetary Economics, Vol. 2 (1976) pp. 177-78; emphases added)

The neoclassical confidence that the government can’t beneficially affect the economy is thus based on the insane assumption of “rational agents” who live in a world that is permanently in equilibrium, and whose expectations about the future are accurate—something that Ross Gittins’s recent column did a good job of critiquing. The real world is inhabited by real, fallible human beings, who are prone to bouts of irrational exuberance, susceptible to Ponzi Schemes disguised as investment, and who live in a world in permanent disequilibrium and with an uncertain future, in which their expectations are almost always wrong. They are therefore incapable of predicting and therefore neutralising the impact of government policy, as neoclassical theory assumes that “rational agents” do.

There are other strands in neoclassical theory that argue there is some role for the government in controlling the economy—notably the so-called Taylor Rule which argues that the Central Bank can control the economy by fine tuning the interest rate. Taylor himself is arguing that deviation from his rule—when the Federal Reserve under Greenspan held interest rates at near zero after the burst of the DotCom bubble in 2000 – is what caused the crisis. I disagree, but that’s a topic for a later day.

The general proposition remains that in its overall bias, neoclassical theory argues that the government can’t beneficially influence the economy—and therefore that if there is a genuine, sustainable recovery as a consequence of the government stimulus packages, that contradicts neoclassical economics even more than it would contradict my approach.

That means that if there is a “winning” economic theory out there, then it must be one that argues that government action alone can help an economy recover from a crisis, and indeed maintain output growth at a level that will maintain full employment.

There is one “neoclassical” theory that argues this, which most economists—reflecting their non-existent training in the history of their own discipline—actually think is Keynesian. This is the so-called “IS-LM” model, which argues that the government can manipulate employment via fiscal policy. Neoclassicals are likely to retreat to this model—and declare themselves “Born Again Keynesians” in the process—without realising that the originator of this model, John Hicks, rejected it on very sound grounds almost 30 years ago.

Hicks realised that his model attempts to represent the economy using just two markets—goods and money—when there is of course another important market: that for labour. He omitted the labour market from his model on the basis of what neoclassical economists call “Walras’ Law”. This is the proposition that, if all but one market in an economy are in equilibrium, then that final market must also be in equilibrium.[1]

Writing in 1979 in the non-orthodox Journal of Post Keynesian Economics, Hicks realised this flaw (and several others) in this logic: it can apply only when the economy is in equilibrium—when both the goods market AND the money market are in balance. That, in terms of the model, is where the two curves cross. But the model is used to simulate what is supposed to happen when one or both markets are not in equilibrium, or when one curve—normally the IS curve—is shifted by deliberate government policy, such as running a deficit during an economic crisis. Therefore it is used to try to describe what happens in disequilibrium.

But in disequilibrium—anywhere on the diagram apart from where the two curves cross—Walras’ Law can’t be used to ignore what’s happening in the labour market. So even working from Hicks’s model, neoclassical economists would need to consider disequilibrium dynamics of three or more markets. Hicks damningly concluded that:

“the only way in which IS-LM analysis usefully survives – as anything more than a classroom gadget, to be superseded, later on, by something better – is in application to a particular kind of causal analysis, where the use of equilibrium methods, even a drastic use of equilibrium methods, is not inappropriate”. (Hicks, J. 1981, 'IS-LM: An Explanation', Journal of Post Keynesian Economics, vol. 3, no. 2, p. 152; my emphasis)

Yet as Gittins pointed out, and as Paul Krugman himself recently confirmed, neoclassical economists are so obsessed with equilibrium methods that they will shy away from thinking in disequilibrium terms. As Krugman put it, right after critiquing neoclassical economics for being braindead, “I, for one, am not going to banish maximisation-and-equilibrium from my toolbox”.

I'm sorry Paul, but stick with those tools and you'll never come to grips with Minsky's Financial Instability Hypothesis, let alone the actual disequilibrium dynamics of the real economy.

So there is no coherent neoclassical theory that can take solace from the success of the government stimulus packages, should they avert a deep recession and cause a sustained recovery without a rise in the private debt to GDP ratio.[2] If there is to be a winner in this debate, it has to be a non-neoclassical school of thought.

There is such a school of thought, which has developed in Post Keynesian literature recently. Known as Chartalism, it argues that the government can and should maintain deficits to ensure full employment.

Chartalism rejects neoclassical economics, as I do. However it takes a very different approach to analysing the monetary system, putting the emphasis upon government money creation whereas I focus upon private credit creation. It is therefore in one sense a rival approach to the “Circuitist” School, which I see myself as part of. But it could also be that both groups are right, as in the parable of the blind men and the elephant: we’ve got hold of the same animal, but since one of us has a leg and the other a trunk, we think we’re holding on to vastly different creatures.

That said, I do have numerous issues with the Chartalist approach, but I haven’t studied its literature closely enough yet to write a critique.[3] I also could have distorted their arguments if I had attempted a summary of their views. So what I decided instead to do is to ask a leading Chartalist, Professor Bill Mitchell from the University of Newcastle, to write a précis of the Chartalist argument (Bill also has a blog on this approach to economics).

This précis follows. I emphasise in closing my own comments that, if there is a genuine recovery not involving rising private debt to GDP levels, then Chartalism is the only theory left standing. Neoclassical economics is dead.

The fundamental principles of modern monetary economics

By Bill Mitchell, Professor of Economics, University of Newcastle

The following discussion outlines the macroeconomic principles underpinning modern monetary theory (sometimes referred to as Chartalism).

The modern monetary system is characterised by a floating exchange rate (so monetary policy is freed from the need to defend foreign exchange reserves) and the monopoly provision of fiat currency. The monopolist is the national government. Most countries now operate monetary systems that have these characteristics.

Under a fiat currency system, the monetary unit defined by the government has no intrinsic worth. It cannot be legally converted by government, for example, into gold as it was under the gold standard. The viability of the fiat currency is ensured by the fact that it is the only unit which is acceptable for payment of taxes and other financial demands of the government.

The analogy that mainstream macroeconomics draws between private household budgets and the national government budget is thus false. Households, the users of the currency, must finance their spending prior to the fact. However, government, as the issuer of the currency, must spend first (credit private bank accounts) before it can subsequently tax (debit private accounts). Government spending is therefore the source of the funds the private sector requires to pay its taxes and to net save, and it is not inherently revenue constrained.

So statements such as “the federal government is spending taxpayers’ funds” are totally inapplicable to operational reality of our monetary system. Taxation acts to withdraw spending power from the private sector but does not provide any extra financial capacity for public spending.

As a matter of national accounting, the federal government deficit (surplus) equals the non-government surplus (deficit). In aggregate, there can be no net savings of financial assets of the non-government sector without cumulative government deficit spending. The federal government via net spending (deficits) is the only entity that can provide the non-government sector with net financial assets (net savings) and thereby simultaneously accommodate any net desire to save and hence eliminate unemployment. Additionally, and contrary to mainstream economic rhetoric, the systematic pursuit of government budget surpluses is necessarily manifested as systematic declines in private sector savings.

We often read that the appropriate fiscal stance is to balance the federal budget over the business cycle. Some economists claim the goals should be to run a surplus on average over the cycle allowing for deficits in extreme downturns. Both goals would be fiscally irresponsible in Australia’s situation where our current account is typically in deficit. If the government balanced the budget on average and the current account deficit was in deficit over the business cycle then the private domestic sector would on average be in deficit (dis-saving) over that cycle. The decreasing levels of net private savings financing the government surplus increasingly leverage the private sector. The deteriorating debt to income ratios which result will eventually see the system succumb to ongoing demand-draining fiscal drag through a slow-down in real activity.

In other words, adopting a growth strategy that relies on increasingly leveraging the private sector is unsustainable. The only way the private domestic sector can save if there is a current account deficit is for the government sector to run deficits up to the desired private saving. Government deficits “finance” private saving by ensuring that aggregate spending is sufficient to generate the level of output and income that will bring forth the private desired saving levels.

Unemployment occurs when net government spending is too low. As a matter of accounting, for aggregate output to be sold, total spending must equal total income (whether actual income generated in production is fully spent or not each period). Involuntary unemployment is idle labour unable to find a buyer at the current money wage. In the absence of government spending, unemployment arises when the private sector, in aggregate, desires to spend less of the monetary unit of account than it earns. Nominal (or real) wage cuts per se do not clear the labour market, unless they somehow eliminate the private sector desire to net save and increase spending. Thus, unemployment occurs when net government spending is too low to accommodate the need to pay taxes and the desire to net save.

How large should the deficit be? To achieve full employment net government spending has to be equal to the non-government desire to net save to ensure there is no aggregate demand gap. Unlike the mainstream rhetoric, insolvency is never an issue with deficits. The only danger with fiscal policy is inflation which would arise if the government pushed nominal spending growth above the real capacity of the economy to absorb it.

If governments are not revenue constrained why do they borrow? We have to differentiate voluntary constraints governments impose on themselves (which reflect ideological dispositions) from the underlying mechanics of the banking system in a fiat monetary system.

In terms of the latter, while the federal government is not financially constrained it still might issue debt to control its liquidity impacts on the private sector. Government spending and purchases of government bonds by the central bank add liquidity, while taxation and sales of government securities drain private liquidity. These transactions influence the cash position of the system on a daily basis and on any one day, they can result in a system surplus (deficit) due to the outflow of funds from the official sector being above (below) the funds inflow to the official sector. The system cash position has crucial implications for the central bank, which targets the level of short-term interest rates as its monetary policy position. Budget deficits result in system-wide surpluses (excess bank reserves).

Competition between the commercial banks to create better earning opportunities on the surplus reserves then puts downward pressure on the cash rate (as they try to off-load the excess reserves in the overnight interbank market). So budget deficits actually put downward pressure on short-term interest rates, which is contrary to all the claims made by mainstream economics.

If the central bank desires to maintain the current positive target cash rate then it must drain this surplus liquidity by selling government debt. In other words, government debt functions as interest rate support via the maintenance of desired reserve levels in the commercial banking system and not as a source of funds to finance government spending.

However, the central bank could equally just pay the commercial banks the target rate of interest on all overnight reserves, which would achieve the same end without the need to issue debt. So there is no intrinsic reason for a sovereign government to borrow to “finance” its net spending.

The reality is, however, that the neo-liberal era has forced the governments to adopt voluntary constraints on its fiscal activity, which are tantamount to those that operated during the gold standard period.

So the federal government now issues debt to the private markets via an auction system dollar-for-dollar with net government spending (deficits). This allegedly imposes “fiscal discipline” on the government (it is totally unnecessary from a financial perspective) because the rising debt becomes a political issue. In conclusion, much of the deficit-debt hysteria that defines the current macroeconomic debate is based on false premises about the way the monetary system operates and the financial constraints on government spending.

Modern monetary theory provides a sound basis for understanding the intrinsic opportunities available to governments in a fiat monetary system and exposes most of the constraints that are imposed on the conduct of fiscal policy as being of an ideological origin.

Important information:This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.

I’m happy to admit that I underestimated how strongly governments would respond to this financial crisis. Dramatic reductions in interest rates, huge fiscal stimuli and—in the USA and UK—expansion of government-created money, have all had a positive impact on the economy and asset markets (both shares and houses).

In his recent essay, Australian Prime Minister Kevin Rudd estimated that the rescues were the equivalent of roughly 18 percent of global GDP over a three-year period, which is an unprecedented level of expenditure by governments.

Eichengreen and O’Rourke’s comparison of today to the Great Depression gives the most balanced assessment of how effective these policies have been at the global level.

They have clearly turned around stock markets. Six months ago, world stock markets were 50 per cent below their peak, a far worse performance than during the Great Depression when, at the same time after the peak, they had only fallen 10 per cent. By the beginning of September, markets had recovered to be only a couple of per cent below the comparable 1930 position of a 30 per cent fall.

Industrial output has also turned around. Six months ago this was 13 per cent below the peak level, worse than the 1930s position of an 11 per cent decline. Since then it has risen to be only 10 per cent below, while at the equivalent time in the 1930s, industrial output had fallen 20 per cent from its 1929 high.

So has the government cavalry ridden to the rescue? If the crisis were one simply of liquidity, the answer would be yes. A government stimulus can overwhelm the impact of a credit crunch, and the innate dynamic of a productive economy can re-assert itself after such a crisis, leading to renewed growth.

But this not merely a crisis of liquidity. It is one of excessive private debt, on a scale that is also unprecedented: the USA is carrying US$41.5 trillion in debt on the back of a US$14 trillion economy, proportionately 70 per cent more debt than it had at the start of the Great Depression. In December 2007, the private sector swung from ramping up debt levels as it chased speculative gains on asset markets, to retreating from debt as the asset bubbles burst.

In the space of a year, private debt went from adding US$4 trillion to aggregate demand, to subtracting US$165 billion from it. Private debt had ceased being the economy’s turbocharger and had instead become its flooded engine.

While economic outsiders like myself, Michael Hudson, Niall Ferguson and Nassim Taleb argue that the only way to restart the economic engine is to clear it of debt, the government response, has been to attempt to replace the now defunct private debt economic turbocharger with a public one.

In the immediate term, the stupendous size of the stimulus has worked, so that debt in total is still boosting aggregate demand. But what will happen when the government stops turbocharging the economy, and waits anxiously for the private system to once again splutter into life?

This is especially so since, following the advice of neoclassical economists, Obama has got not a bang but a whimper out of the many bucks he has thrown at the financial system.

In explaining his recovery program in April, President Obama noted that:

“There are a lot of Americans who understandably think that government money would be better spent going directly to families and businesses instead of banks – ‘where's our bailout?,’ they ask”.

He justified giving the money to the lenders, rather than to the debtors, on the basis of “the multiplier effect” from bank lending:

“The truth is that a dollar of capital in a bank can actually result in eight or ten dollars of loans to families and businesses, a multiplier effect that can ultimately lead to a faster pace of economic growth”. (page 3 of the speech)

This argument comes straight out of the neoclassical economics textbook. Fortunately, due to the clear manner in which Obama enunciates it, the flaw in this textbook argument is vividly apparent in his speech.

This “multiplier effect” will only work if American families and businesses are willing to take on yet more debt:

“A dollar of capital in a bank can actually result in eight or ten dollars of loans”.

So, the only way the roughly US$1 trillion of money that the Federal Reserve has injected into the banks will result in additional spending is if American families and businesses take out another US$8-10 trillion in loans.

What are the odds that this will happen, when they already owe more than they have ever owed in the history of America? The next chart inverts the usual portrayal of America’s debt to GDP ratio by inverting it: the top of the graph represents zero debt, the bottom, a debt to GDP ratio of 300 per cent—which is just shy of the current ratio of 292 per cent.

If the money multiplier was going to “ride to the rescue”, private debt would need to rise from its current level of US$41.5 trillion to about US$50 trillion, and this ratio would rise to about 375 per cent—more than twice the level that ushered in the Great Depression.

This is a rescue? It’s a “hair of the dog” cure: having booze for breakfast to overcome the feelings of a hangover from last night’s binge. It is the road to debt alcoholism, not the road to teetotalism and recovery.

Fortunately, it’s a “cure” that is also highly unlikely to work, because the model of money creation that Obama’s economic advisers have sold him was shown to be empirically false over three decades ago.

The first economist to establish this was the American Post Keynesian economist Basil Moore, but similar results were found by two of the staunchest neoclassical economists, Nobel Prize winners Kydland and Prescott in a 1990 paper Real Facts and a Monetary Myth.

Looking at the timing of economic variables, they found that credit money was created about four periods before government money. However, the “money multiplier” model argues that government money is created first to bolster bank reserves, and then credit money is created afterwards by the process of banks lending out their increased reserves.

Introducing money and credit into growth theory in a way that accounts for the cyclical behavior of monetary as well as real aggregates is an important open problem in economics.

I couldn’t agree more, but unfortunately they—and neoclassical economists in general—did bugger all about it. On the other hand, the Post Keynesian group, of whom I am one, have continued to try to construct models of the economy in which credit plays an essential role.

I’ve recently developed a genuinely monetary, credit-driven model of the economy, and one of its first insights is that Obama has been sold a pup on the right way to stimulate the economy: he would have got far more bang for his buck by giving the stimulus to the debtors rather than the creditors.

The following figure shows three simulations of this model in which a change in the willingness of lenders to lend and borrowers to borrow causes a “credit crunch” in year 25. In year 26, the government injects $100 billion into the economy—which at that stage has output of about $1,000 billion, so it’s a pretty huge injection, in two different ways: it injects $100 million into bank reserves, or it puts $100 billion into the bank accounts of firms, who are the debtors in this model.

The model shows that you get far more “bang for your buck” by giving the money to firms, rather than banks. Unemployment falls in both case below the level that would have applied in the absence of the stimulus, but the reduction in unemployment is far greater when the firms get the stimulus, not the banks: unemployment peaks at over 18 percent without the stimulus, just over 13 per cent with the stimulus going to the banks, but under 11 per cent with the stimulus being given to the firms.

The time path of the recession is also greatly altered. The recession is shorter with the stimulus, but there’s actually a mini-boom in the middle of it with the firm-directed stimulus, versus a simply lower peak to unemployment with the bank-directed stimulus.

Why does this model show that it’s better to give the money to the debtors than the lenders, in contrast to the case that Obama was sold, that it’s better to give it to the bankers?

Because the “money multiplier” model is effectively a mechanical, static, equilibrium model of the economy. Give the banks excess reserves, and they will lend them to the public, which will happily take on the debt. Once the reserves are fully lent out, the economy is back to equilibrium again.

In contrast, my model is a dynamic, non-equilibrium one, where the “circular flow” of money and goods is properly accounted for. In this system, you can think of the different bank accounts in the system as like dams with pipes connecting them of vastly different diameters.

When a credit crunch strikes, the pipes pumping the bank reserves to the firms shrink dramatically, while the pipe going in the opposite direction expands, and all other pipes remain the same size.

If you then fill up the bank reserves reservoir—by the government pumping the extra $100 billion into it—that money will only trickle into the economy slowly. If however you put that money into the firms’ bank accounts, it would flow at an unchanged rate to the rest of the economy—the workers—while flowing more quickly to the banks as well, reducing debt levels.

So giving the stimulus to the debtors is a more potent way of reducing the impact of a credit crunch—the opposite of the advice given to Obama by his neoclassical advisers.

This could also be one reason that the Australian experience has been better than the USA’s: the stimulus in Australia has emphasised funding the public rather than the banks (and the model shows the same impact from giving money to the workers as from giving it to the firms—and for the same reason, that workers have to spend, so that the money injected into the economy circulates more rapidly.

This model can explain some aspects of the current US data that are inexplicable from the conventional, neoclassical point of view—the key paradox being that while base money (“M0”) has been increased dramatically, there has been almost no movement in broader measures of money (“M1” and “M2”). If the money multiplier argument were correct, the increases in M1 and M2 would have been multiples of the increase in M0, as Obama was led to expect.

In fact, the expansion in M0 has been met by a fall in the credit-generated component of the money supply: since M2 includes all of M1 and M1 includes all of M0, this is clearer when we subtract the double-counting out. M1 has actually contracted almost as much as M0 has expanded, while the expansion in M2 has been less than a third the size of the growth in M0.

The “money multiplier” has also collapsed—a mystery from a neoclassical point of view, but entirely predictable from the “endogenous money” perspective.

Obama has been sold a pup by neoclassical economics: not only did neoclassical theory help cause the crisis, by championing the growth of private debt and the asset bubbles it financed; it also is undermining efforts to reduce the severity of the crisis.

This is unfortunately the good news: the bad news is that this model only considers an economy undergoing a “credit crunch”, and not also one suffering from a serious debt overhang that only a direct reduction in debt can tackle. That is our actual problem, and while a stimulus will work for a while, the drag from debt-deleveraging is still present. The economy will therefore lapse back into recession soon after the stimulus is removed.

Important information:This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.

You have just come from your annual medical checkup, where your doctor assures you that you are in robust health.

Walking jauntily down the street, you bump into a practitioner of alternative medicine. He takes one look at you and declares: “You have a serious tumour! It must be removed or you will die”.

You ignore him as you always have, and continue your merry way down the street. One day later, a stabbing pain suddenly cripples you, and you collapse to the pavement.

In agony, your call your doctor, who initially refuses to send an ambulance because he knows you are well.

When you lapse into a coma and stop talking mid-sentence, your doctor concludes that perhaps something is wrong, and sends an ambulance to take you to hospital.

Initially, the doctor waits for you to revive spontaneously, because he still knows there's nothing really wrong with you. But as your pulse starts to weaken, he reluctantly calls a retired doctor who had experience of a similar inexplicable malady in the distant past.

She prescribes massive doses of tranquilisers, painkillers, vitamins, and oxygen—all substances that had been removed from the medical panoply due to recent advances in medical theory. Reluctantly, your doctor follows his retired colleague's advice—and miraculously, you start to revive.

After a year of expensive medical treatment, you return to the same robust health you displayed before your inexplicable illness. Triumphant, if somewhat puzzled, your doctor declares you well once more, and releases you from intensive care.

As you stride confidently away from the hospital, you have the misfortune to once again bump into the practitioner of alternative medicine.

“But they haven't removed the tumour!” he declares.

...

One shouldn't have to spell out the details of such an analogy, but in times of widespread denial, one has to:

• You are the economy.
• The tumour is a massive accumulation of private debt.
• Your doctor is Neoclassical Economics, and the retired colleague is a so-called "Keynesian" Economist (who doesn’t know it— since his medical textbooks were poorly written—but he’s actually following another economist called Paul Samuelson, not Keynes).
• The alternative medicine practitioner follows Hyman Minsky's Financial Instability Hypothesis (which is based on what Keynes actually did say—as well as the wisdom of Joseph Schumpeter and, in whispers, Karl Marx).
• The moment you hit the pavement is the beginning of the Subprime Crisis.
• The collapse of Lehman Brothers is the moment when you slip into a coma.
• And the day the doctor takes you off life support and declares all is well … is next month.

The final reason for me being a bear is that I am that practitioner of alternative medicine. Minsky’s Financial Instability Hypothesis has been ignored by conventional economists for reasons that are both ideological and delusional. A small band of “Post-Keynesian” economists, of whom I am one, have kept this theory alive.

According to Minsky’s theory:

• Capitalist economies can and do periodically experience financial crises (something that believers in the dominant “Neoclassical” approach to economics vehemently denied until reality—in the form of the Global Financial Crisis—slapped them in the face last year).
• These financial crises are caused by debt-financed speculation on asset prices, which leads to bubbles in asset prices.
• These bubbles must eventually burst, because they add nothing to the economy’s productive capacity while simultaneously increasing the debt-servicing burden the economy faces.
• When they burst, asset prices collapse but the debt remains.
• The attempts by both borrowers and lenders to reduce leverage reduces aggregate demand, causing a recession,
• If the economy survives such a crisis, it can go through the same process again, with another boom driving debt up even higher, followed by yet another crash,
• But ultimately, this process has to lead to a level of debt that is so great that another revival becomes impossible since no one is willing to take on any more debt. Then a Depression ensues.

That is where we were … in 1987. The great tragedy of today is that naïve Neoclassical economists like Alan Greenspan and Ben Bernanke allowed this process to continue for another three or more cycles than would have occurred without their rescues.

In 2008, they did it again—only with methods they would have disparaged a mere year earlier (‘Rational Expectations Macroeconomics’, a modern neoclassical fad, preaches that government intervention can’t influence the level of economic activity at all—yet another belief that reality has recently crucified). This time, while the rescue has worked, the recovery they expect afterwards can’t happen—because there’s almost no one left who will willingly take on any more debt.

This time, there’s no re-leveraging way out. The tumour of debt has to be removed.

Important information:This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.

“Green shoots” are appearing everywhere—just read the newspapers, and you can be assured that we’ve turned the corner. Bar the latest rise in US unemployment—up 0.3 per cent to 9.7 per cent, after falling 0.1 per cent the previous month—there’s nothing but good news as far as the eye can see.

Unless, that is, you take a look at a wider range of data, as economic historians Barry Eichengreen and Kevin O’Rourke have been doing in their series A Tale of Two Depressions.

They have now published three installments of this study, which collates data from a number of countries and compares it to the same information in the 1930s—taking June 1929 as the starting point for the Great Depression, and April 2008 as the same for our current “Great Recession”.

Their latest installment was published on 1 September, and it does indeed show some signs of a turnaround—“green shoots” perhaps. But their comparison of today with the 1930s still reaches the conclusion that “today’s crisis remains dramatic by the standards of the Great Depression”.

The key improvement they see in the current data over that for the 1930s is an uptick in world industrial production, which has risen by about two per cent (compared to peak output in April 2008) in the last four months from its low of 88 per cent. This now puts it substantially above the comparable period in the 1930s, when by this stage industrial output had fallen to 81 per cent of its peak.

However, they express the concern that this turnaround reflects the gigantic government stimuli that have been applied in the last year, and the continuance of a positive trend now relies upon the private sector taking over:

“The question now is whether final demand for this increased production will materialise or whether consumer spending, especially in the US, will remain weak, causing the increase in production to go into inventories, leading firms to cut back subsequently, and resulting in a double dip recession.”

There are signs of good news elsewhere too—notably in stock markets and world trade. However, these aren’t as robust as a focus solely on the US indices and Japan’s exports might imply. Though world stock markets have rebounded, they are still slightly below their comparable levels in the 1930s.

The world trade figure is more telling. Neoclassical economists have often pointed at restrictions to world trade as one reason the Great Depression was as bad as it was—citing in particular the Smoot-Hawley Tariff Act in the United States. In fact, this Act was signed into law in June 1930, one year after Eichengreen & O’Rourke’s reference date for the start of the Great Depression. By that time, world trade had already fallen about eight per cent below its peak level; three months later had fallen a further two per cent.

15 months into our modern-day crisis, and with no such protectionist legislation even being contemplated, world trade had fallen 20 per cent below its peak.

The recent one per cent uptick in world trade volumes is welcome, but it still puts us well below the 1930s.

This in itself is a reflection of how much world industrial output has been globalised in the last thirty years, which is in part why the crisis spread very rapidly from the USA to the rest of the world. In the 1930s, the vast majority of the USA’s industrial needs were met by its own factories, so the downturn hit its own industries and workers first and hardest. Today, the heavy blows also fell on the world’s industrial exporters—notably Japan and Germany.

One obvious statistic that Eichengreen and O’Rourke don’t use is the unemployment rate. I suspect this might reflect justified skepticism about the comparability of the modern measure to the old; the current ILO definition is so tight that recorded unemployment today is far lower than it would be were the 1930s standard applied (conversely, there were many swagmen in the 1930s who would be classified as fully employed on the current standard).

A more comparable statistic for the USA is the U-6 measure, which includes most (but not all) discouraged workers. That now stands at 16.8 per cent, up from 16.3 per cent last month—versus the official rate of 9.7 per cent. And though recorded unemployment is worsening much more slowly than in the 1930s, the U-6 measure is deteriorating more quickly now than it did in the 1930s, and it started at a far worse position.

A similar pattern applies in Australia. Roy Morgan Research prepares a U-6 like-measure that now stands at 16.6 per cent—and their survey also disputes the ABS’s measure of formal unemployment rate, which they put at 7.8 per cent, two per cent higher than the ABS.

So “green shoots”, or selective reporting? There is no doubt that the immense government stimulus packages across the world have slowed the rush into Depression. But the force that caused the crisis in the first place—excessive private debt accumulated in a Ponzi Scheme laundered through share and house-price bubbles—is still with us. Until that debt is addressed, the downward rush of deleveraging is likely to resume as soon as governments wind back their spending in the false hope that the crisis is over.

I’ll finish with an extract from what has become one of my favourite daily reads—the News from 1930 blog. On Thursday 4 September 1930, the Wall Street Journal reported that the Harvard Economic Society said there is “every prospect that the [business] recovery … will not long be delayed.”

Important information:This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.

“The Marxian view is that capitalistic economies are inherently unstable and that excessive accumulation of capital will lead to increasingly severe economic crises. Growth theory, which has proved to be empirically successful, says this is not true.

“The capitalistic economy is stable, and absent some change in technology or the rules of the economic game, the economy converges to a constant growth path with the standard of living doubling every 40 years.

“In the 1930s, there was an important change in the rules of the economic game. This change lowered the steady-state market hours. The Keynesians had it all wrong.

“In the Great Depression, employment was not low because investment was low. Employment and investment were low because labor market institutions and industrial policies changed in a way that lowered normal employment.”

Obviously, I did not write the above. The author was instead Edward C. Prescott, who shared the 2004 Nobel Prize in Economics for the development of real business cycle theory, in his 1999 paper Some Observations on the Great Depression (Federal Reserve Bank of Minneapolis Quarterly Review, Winter 1999, vol. 23, no. 1, pp. 25– 31).

This statement is remarkable for a number of reasons I'll discuss below. But though it is extreme, it does express a belief that is endemic in neoclassical economics, that a market economy is inherently stable and will always return to a stable growth path after a shock.

That common belief lies behind the expectations of economists that, now that the GFC has played itself out, the economy will return to trend growth and the emergency measures that attenuated its impact can be withdrawn.

From this perspective, the GFC was a “pothole in the road” caused by the subprime crisis, a “change in the rules of the economic game” which is now behind us. With the damage caused by the crisis largely contained, normal economic growth can resume. Over time, the unemployment rate will return to pre-crisis levels as the economic car resumes its steady speed along the highway of history.

The alternative perspective is that the GFC was more akin to an abrupt change in the terrain. The “economic car” had been coasting downhill with the gravity of ever-increasing private debt adding to the speed of the car. With the GFC we reached the bottom of the hill, and the car now has to drive uphill as it attempts to maintain its previous debt-enhanced speed while also reducing debt.

Visually at least, the “change in terrain” analogy stands up better than the pothole. I normally show the debt to GDP ratio as a rising function, but the economy's speed gets a boost as the increase in debt makes a positive contribution to aggregate demand, and is slowed down when deleveraging reduces demand. So turning the ratio upside down may give a better idea of the depth of the “Valley of Debt” into which we have fallen:

When Australia began its most recent descent into debt in mid-1964, the average annual increase of 4.2 per cent in the ratio added only a trivial amount to aggregate demand—since at the time debt was a mere 25 per cent of GDP. But at the end of the debt bubble in 2008, when debt had become 165 per cent of GDP, that same rate of debt growth added a huge amount to demand—the economic “car” gained speed as the slope of the debt mountain increased.

We hit the bottom of that mountain in March 2008, and now we're starting to climb out of the valley—though not yet in absolute terms, since thanks to the First Home Vendors Boost, mortgage debt is still growing as business busily delivers (see comments on the data, below). But once deleveraging takes hold, the acceleration caused by racing down Debt Mountain will be replaced by an economic car straining up the Mount Debt Reduction. This change in the terrain will constrain private economic performance until debt has fallen significantly, as it did after the 1890s and the 1930s.

A similar, if more extreme, picture applies in the USA, where private debt is now 300 per cent of GDP. In contrast to Australia, the USA's debt ratio began to rise as soon as WWII ended: on average, US private debt rose 2.9 per cent faster than GDP every year until 2008, taking the debt ratio from 45 per cent at the end of the war to 300 per cent now. Deleveraging from this level of debt must exert a substantial break on economic performance, by diverting income from expenditure to debt reduction.

I am therefore one of a minority of economic commentators who regard “deflation and deleveraging” as the main dangers facing the global economy in the near future (curiously, this minority might include Australian Prime Minister Kevin Rudd). From my perspective, the Global Financial Crisis marks “a change in the terrain”: for decades, rising debt has turbocharged economic performance; now falling debt will be a drag on economic activity.

The vast majority of economists who perceive the GFC as a pothole on the road that is now behind us do not consider debt and deleveraging in their analysis. Their models have neither credit nor money nor private debt in them, so from their point of view, there is no terrain at all beneath the car—merely a long flat highway of history along which the economic car drives at the speed it is underlying “real” economic performance.

This failure to even consider the role of private credit in a capitalist economy is an endemic weakness in conventional “neoclassical” economics, which ignores the dynamics of credit for a variety of reasons that are both ideological and illogical.

The ideology is apparent in Prescott's comments on the Great Depression, quoted above. The lack of logic is evident when you compare a key statement in that paper—that “Growth theory, which has proved to be empirically successful, says this is not true”—with the results of some very careful empirical research by the very same author just ten years earlier. There he (and co-author and Nobel Prize recipient Finn Kydland) concluded that the empirical data contradicted neoclassical growth theory:

“The purpose of this article is to present the business cycle facts in light of established neoclassical growth theory, which we use as the organising framework for our presentation of business cycle facts. We emphasise that the statistics reported here are not measures of anything; rather, they are statistics that display interesting patterns, given the established neoclassical growth theory.

“In discussions of business cycle models, a natural question is, Do the corresponding statistics for the model economy display these patterns? We find these features interesting because the patterns they seem to display are inconsistent with the theory.” (Finn E. Kydland & Edward C. Prescott, “Business Cycles: Real Facts and a Monetary Myth”, Federal Reserve Bank of Minneapolis Quarterly Review, vol. 14, no. 2, pp 3-18, p. 4).

One key pattern in actual economic data that went against the predictions of neoclassical economic theory was the relationship between broad measures of the money supply and government-created “Base Money”. The standard “money multiplier” view is that:

1. The government creates “Base Money” via deficit spending, and credits that money to private individuals via social security, goods purchases etc.

2. These private individuals then deposit that money in bank accounts.

3. The banks then retain a proportion of these deposits and lend out the rest, creating credit money (and debt).

If this view were empirically correct, then an analysis of money over time would show that “Base Money” was created first and “Credit Money” was created later, with a time lag.

In fact, what Kydland and Prescott found was that the empirical data was the opposite of this: credit money was created first, and Base Money was created later, with a lag of up to a year:

“There is no evidence that either the monetary base or M1 leads the cycle, although some economists still believe this monetary myth. Both the monetary base and M 1 series are generally pro-cyclical and, if anything, the monetary base lags the cycle slightly.

“The difference in the behavior of M1 and M2 suggests that the difference of these aggregates (M2 minus M1) should be considered. ... The difference of M2-M1 leads the cycle by even more than M2, with the lead being about three quarters.

“The fact that the transaction component of real cash balances (M 1) moves contemporaneously with the cycle while the much larger non-transaction component (M2) leads the cycle suggests that credit arrangements could play a significant role in future business cycle theory. Introducing money and credit into growth theory in a way that accounts for the cyclical behavior of monetary as well as real aggregates is an important open problem in economics.”

I couldn't agree more, but this is not what neoclassical economists did. Instead they continued to develop models in which money and debt played no role.

Despite his excellent empirical work on monetary dynamics in Real Facts and a Monetary Myth, Prescott's Great Depression paper made no reference to credit at all as an explanatory factor in the Great Depression. Instead—I'm not joking—he blamed the Depression on a “change in labor market institutions and industrial policies that lowered steady-state, or normal, market hours”.

Except for this bizarre argument that the Great Depression was the result of the voluntary response of workers to unspecified changes in labour market conditions that made labour less desirable, this lengthy quote from Prescott is representative of standard neoclassical thinking about crises like the GFC:

“Essentially, business cycles are responses to persistent changes, or shocks, that shift the constant growth path of the economy up or down. This constant growth path is the path to which the economy would converge if there were no subsequent shocks. If a shock shifts the constant growth path down, the economy responds as follows. Market hours fall, reducing output; a bigger share of output is allocated to consumption and a smaller share to investment; and more time is allocated to leisure. Over time, market hours return to normal, as do investment and consumption shares of output, as the economy converges to its new lower constant growth path. The level of the new path is lower, not the growth rate along the path.

“I’ve just described the response of the economy to a single shock. In fact, the economy is continually hit by shocks, and what economists observe in business cycles is the effects of past and current shocks. A bust occurs if a number of negative shocks are bunched in time. A boom occurs if a number of positive shocks are bunched in time. Business cycles are, in the language of Slutzky (1937), the “sum of random causes.”

“The fundamental difference between the Great Depression and business cycles is that market hours did not return to normal during the Great Depression. Rather, market hours fell and stayed low. In the 1930s, labor market institutions and industrial policy actions changed normal market hours. I think these institutions and actions are what caused the Great Depression.”

So the Great Depression was a conscious choice by American workers to enjoy more leisure, in response to unspecified changes in the labour market (Later in the same essay, he states: “Exactly what changes in market institutions and industrial policies gave rise to the large decline in normal market hours is not clear....”).

It would be bad enough if Prescott were merely an obscure academic economist, but he is far from obscure: he and Kydland shared the Nobel Prize in Economics for the development of neoclassical growth theory. As ridiculous as his argument is, it does accurately state the conclusions of the neoclassical “real business cycle” model. As is often the case, you find a much clearer—and therefore far more obviously absurd—statement of neoclassical economic theory when you go to the source, rather than relying on a second-hand account from a textbook or run-of-the-mill practitioner.

So the confidence that the vast majority of economists have that the GFC is now behind us, and the “normal” trend rate of growth will resume, is fundamentally based on the belief that credit and debt dynamics do not matter.

I beg to differ. Though the enormous government stimulus has attenuated the immediate impact of debt deleveraging, it has done nothing to reduce the outstanding level of private debt. Instead even sub-par growth has become dependent on continuing government stimuli, and whenever those stimuli are removed, the economy will falter.

Total private debt rose by a mere A$1 billion last month, versus as much as A$30 billion during the height of the debt bubble. But were it not for the First Home Vendors Boost (let's call it what it is), Australia would now be firmly in the grips of deleveraging. 

Total private debt rose by a mere A$1 billion last month, versus as much as A$30 billion during the height of the debt bubble. But were it not for the First Home Vendors Boost (let's call it what it is), Australia would now be firmly in the grips of deleveraging.

Nonetheless the debt to GDP ratio fell yet again, because the rate of growth of debt is now substantially below the rate of growth of GDP—even though that is now also anaemic.

The breakdown of debt shows that the business sector is rapidly deleveraging, while mortgage and government debt is escalating—and both those are the result of government policy.

Without the First Home Vendors Boost, it is highly unlikely that mortgage debt would still be rising today. Mortgage debt peaked as a percentage of GDP in March 2008, and fell for the remainder of the year until the First Home Vendors Boost.

The quarterly change in mortgage debt was also trending down from the 2005 peak, and that downward trend has clearly been reversed by the impact of the Boost.

The Boost has certainly had the impact the government desired, of arresting the fall in Australian house prices.

It will also almost certainly guarantee that I'll be walking (and running) to Kosciuszko under the first half of the bet with Rory Robertson.[1] The second half of the bet, that the fall from peak to trough will be of the order of 40 per cent, may still see Rory also walking some years hence—and the withdrawal of the Boost may make this occur sooner rather than later.

The reason is twofold. Firstly, the Boost has obviously brought forward some buying by first homebuyers that would have occurred anyway, as well as enticing in others who might not have considered it otherwise. The withdrawal of that demand will have a strong impact on the sub-$500,000 price range.

But the withdrawal will also affect houses in the $1 million to $1.5 million range as well, because the Boost did far more than merely boost sub-$500,000 prices.

First homebuyers who were enticed into the market by the additional $7,000 geared that up with additional debt by at least a factor of four, to result in something like a $35,000 price jump for sub-$500K houses. But the sellers of those houses—the real beneficiaries of the Boost—then received an extra $35,000 in cold hard cash. They then used this as a boost to their own deposits on their purchases of houses further up the chain—and if they also geared by a factor of four (that is, a 80 per cent marginal level of gearing, which is well within current lending practice), then the prices they paid for houses in the $750K-1.5M range would have risen by $140,000.

This works in reverse as well. When the Boost is withdrawn, not only will sellers of sub-$500K houses find that buyers have $35K less to spend than during the boost, the sellers of $750K to $1.5 million abodes will find their buyers short about $150K compared to during the boost.

Important information:This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.