The GFC and Neoclassical Economics
Steve Keen
University of Western Sydney
Debunking Economics
www.debtdeflation.com/blogs
www.debunkingeconomics.com
OECD Economic Outlook June 2007
• “the current economic situation is in many ways better
than what we have experienced in years…
• Our central forecast remains indeed quite benign:
– a soft landing in the United States,
– a strong and sustained recovery in Europe,
– a solid trajectory in Japan
– and buoyant activity in China and India.
– In line with recent trends, sustained growth in OECD
economies would be underpinned by strong job
creation and falling unemployment.” (p. 9)
• OECD Chief Economist Jean-Philippe Cotis
• Crisis began August 9 2007—just 2 months later!
– BNP closes 3 funds with strong subprime exposure…
Macroeconomic Debate 2000-2007…
• “The Great Moderation”
– Belief amongst (conventional) economists that slumps
were—thanks to them—“a thing of the past”…
• … the low-inflation era of the past two decades has seen not
only significant improvements in economic growth and
productivity
• but also a marked reduction in economic volatility…,
• a phenomenon that has been dubbed “the Great Moderation.”
• Recessions have become less frequent and milder, and …
volatility in output and employment has declined significantly…
• The sources of the Great Moderation remain somewhat
controversial, but … there is evidence for the view that
improved control of inflation has contributed in important
measure to this welcome change in the economy …
– Bernanke, 2004
How do I delude thee? Let me count the ways…
• Numerous problems in Neoclassical Economics
– See Debunking Economics for details
• Static methodology
• Equilibrium fixation
• Internal fallacies
– Demand aggregation (SMD Conditions)
– Empirically false model of production (Blinder)
– Mathematically false model of competition
(Keen)
– Empirically false model of finance (Fama &
French)
• Key GFC problem: false model of money
– Ignore nominal magnitudes based on false premise
• Friedman’s “Optimum Quantity of Money”:
How do I delude thee? Let me count the ways…
• “IT IS A COMMONPLACE of monetary theory that
nothing is so unimportant as the quantity of money
expressed in terms of the nominal monetary unit…
• let the number of dollars in existence be multiplied by
100; that, too, will have no other essential effect,
– provided that all other nominal magnitudes (prices of
goods and services, and quantities of other assets
and liabilities that are expressed in nominal terms)
are also multiplied by 100.” (Friedman 1969, p. 1)
• On what planet does this proviso apply?
– On Earth (bar Iceland!), debts are not increased
because CPI rises
• Nominal money the link between current income and past
financial commitments
– Nominal money and debt matter!
– Both ignored in neoclassical models:
Why economists didn’t see it coming…
• “One thing which has not changed over the past five
years is the philosophy underpinning the model. It
remains small, highly aggregated, empirically based, and
non-monetary in nature.”
– RBA Research Discussion Paper 2005-11, p. 1
• “The model could be described as broadly new Keynesian
in its dynamic structure but with an equilibrating long
run.
• Activity is demand determined in the short run but supply
determined in the long run…
• The model will eventually return to a supply
determined equilibrium growth path in the absence of
demand or other shocks.”
– Australian Treasury “The Macroeconomics Of The
TRYM Model Of The Australian Economy”, p. 6
Why economists didn’t see it coming…
• Example from TRYM documentation: data and
“predictions” re unemployment
• “Predictions” forced to conform to assumption of long run
equilibrium unemployment level:
History
Projection
12.0
11.0
% of Labour Force
10.0
9.0
Average of ten year forecast
set equal to assumed long run
equilibrium unemployment rate
Unemployment Rate
Dynamic Path
• “But this long run is a
misleading guide to
current affairs. In the
long run we are all
dead. Economists set
Steady State Path
8.0
7.0
6.0
5.0
4.0
Mar-80
Mar-83
Mar-86
Mar-89
Mar-92
Mar-95
Mar-98
Mar-01
Mar-04
Mar-07
Mar-10
themselves too easy,
too useless a task if in
tempestuous seasons
they can only tell us
that when the storm is
long past the ocean is
flat again.” (Keynes)
Why economists didn’t see it coming…
• Conventional “neoclassical” economics:
– Ignores private debt completely
– Ignores money except as a factor in inflation
• Model of money has been empirically falsified
– Presumes the economy always tends to equilibrium
– Treats finance markets as inherently prescient
– Financial deregulation it promoted helped cause crisis
• US economist Hyman Minsky developed “Financial
Instability Hypothesis” as explanation for crisis
Minsky’s “Financial Instability Hypothesis”
•
•
•
•
Economy in historical time
Debt-induced recession in recent past
Firms and banks conservative re debt/equity, assets
Only conservative projects are funded
– Recovery means most projects succeed
• Firms and banks revise risk premiums
– Accepted debt/equity ratio rises
– Assets revalued upwards…
• “Stability is destabilising”
– Period of tranquility causes expectations to rise…
The Euphoric Economy
• Self-fulfilling expectations
– Decline in risk aversion causes increase in investment
• Investment expansion causes economy to grow faster
– Asset prices rise
• speculation on assets profitable
– Increased willingness to lend increases money supply
• Money supply endogenous money, not under RBA control
– Riskier investments enabled, asset speculation rises
• The emergence of “Ponzi” (Bond, Skase…) financiers
– Cash flow less than debt servicing costs
– Profit by selling assets on rising market
– Interest-rate insensitive demand for finance
The Assets Boom and Bust
• Eventually:
– Rising rates make conservative projects speculative
– Non-Ponzi investors sell assets to service debts
– Entry of new sellers floods asset markets
– Rising trend of asset prices falters or reverses
• Ponzi financiers go bankrupt:
– Can no longer sell assets for a profit
– Debt servicing on assets far exceeds cash flows
• Asset prices collapse, increasing debt/equity ratios
• Endogenous expansion of money supply reverses
• Investment evaporates; economic growth slows
• Economy enters a debt-induced recession
– Back where we started...
Crisis and Aftermath
• Modelling Minsky
– Extension of Goodwin’s Growth Cycle to include debt
• 4 “stylised facts”
– Wages share grows if wage rises exceed productivity
– Employment rises if growth exceeds productivity +
population increase
– Bank lend money to finance investment & speculation
– Speculation rises when growth rises
• Dynamics
– Borrow money to finance investment during a boom
• Repay some of it during a slump
– Debt/ Income ratio rises in series of booms/busts
– Eventually one boom where debt accumulation passes
“point of no return”…
A Minsky Model with Ponzi Finance
Capital
Output
Plot
Speculative to Productive Debt
Output
6
5
Cyclical Growth
2000
4
Package
1000
3
2
0
0
20
40
Time (Years)
60
WageShare
Output
1
0
0
10
20
30
40
Time (Years)
50
60
Cyclical Growth
Wages share of output
Employment Rate
1.0
Debt
Ratios
On
DebtInModel
1.
On
Ponzi
1.
.5
Plot
0
0
Debt to Output Ratios
20
40
Time (Years)
60
Ponzi model
3 pattern closer to
2 actual data
4
1.1
1.0
.9
.8
.7
0
Total Debt
Productive
Speculative
6
5
Cyclical Growth
Employment
• Cyclical model of
debt accumulation
and potential
breakdown…
Investment
1
.6
EmploymentRate
Wages
+
Profit
+
.8
*
1
Employment
InterestRate
TotalDebt
0
0
10
+
+
20
30
40
Time (Years)
Productive
Debt
Speculative
Debt
Profit
Investment
RateOfGrowth
50
60
What could happen?
• USA & Australia debt ratios highest in history:
Debt to GDP Ratios
300
275
250
225
USA
Australia
Start of Great
Depression
Start of Our
Depression?
Percent
200
175
150
125
Start of 1890s
Depression
100
75
50
25
0
1870 1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010
Neoclassical theory on money vs Empirical data
• Friedman (& conventional “Keynesian”) theory
– Money multiplier model:
• Central Bank creates “base money”
– Sets “money multiplier”
• Credit Money = Base Money / Money Multiplier
– “Government dog wags the credit tail”
– Economic data
• “There is no evidence that either the monetary
base … leads the cycle, although some economists
still believe this monetary myth.
• … the monetary base lags the cycle slightly…
• The difference of M2-M1 leads the cycle by …
about three quarters.” (Kydland & Prescott 1990, p.
15)
– “Credit dog wags the government tail”
The new monetary paradigm
• Money supply “endogenous”
– Credit money not under government control
• Inherent bias towards providing as much debt as can flog
• How does it work? Simple!
– Consider bank loan of $L to Firm
– Simultaneously creates Deposit $L and Loan $L
– Charges rL% p.a. on loan
– Pays rD% p.a. on deposit
– And so on…
• Put together flows & you can understand credit creation
– Starting from the beginning
• Loan by bank created both money and debt…
“Money from nothing, but your cheques ain’t free”
• Loan an asset of bank
• Simultaneously creates liability of money in firm’s deposit
account:
• Sets off series of obligations:
– Interest charged on loan at rL% p.a.
– Interest paid on deposit at rD% p.a. where rL > rD
– Third account needed to record this: Bank Deposit BD
“Money from nothing, but your cheques ain’t free”
• Full system is:
Interest flows: bank<―>firm
Wage flows: firm―>workers
Interest flows: bank―>workers
Consumption flows: bank & workers―>firms
New Money/Debt flows: bank<―>firms
Debt repayment flows: firms―>bank
Reserve relending flows: bank―>firms
• Table describes self-sustaining pure credit economy
• Can now ask “What happens to bank income if…”
– New money created more quickly
– Loans repaid more quickly
– Reserves re-lent more quickly?
“Would you like a credit card with that?”
• Surprise surprise!
12
• Bank income rises if
– Loans are repaid slowly10
(or not at all)
8
– Repaid money is
recycled more quickly;
and
6
– More new money is
4
created
2
Bank Net Income and Bank Parameters
Standard
New Money
Loan Repayment
Recycling Loans
0
2
4
6
8
• Lenders profits by extending more credit…
– Structural reason for lenders creating rising debt
– What if they decide to change direction?
10
“Money from nothing, but your cheques ain’t free”
• “Credit Crunch”:
– Rate of money creation drops
– Repayment of loans increases
– Relending drops…
300
15
Firm Loan
Bank Reserve
Firm Deposit
Worker Deposit
Bank Deposit
Assets
Bank Reserves
Firm Loan
300
200
10
200
100
5
100
0
0
5
10
15
0
0
0
5
10
15
• Loans—Assets in circulation fall even without bankruptcy
• Credit-driven economic reversal…
“Money from nothing, but your cheques ain’t free”
• Economic downturn caused by credit crunch alone
• Debt-deflation adds to impact shown here…
Unemployment Rate
Real Output and Employment
Rise in “equilibrium”
unemployment due
to fall in credit
turnover parameters
1000
800
2000
600
1000
400
0
20
Price Level
40
0.15
Percent
3000
Number of Workers
Units
Output
Employment
0.05
200
60
0
40
0
20
Wages
40
60
Money Wages ($)
30
$ per unit output
0.1
20
2.5
2
40
1.5
20
1
10
0
60
0
20
40
60
20
40
0.5
60
Real Wages (Units of Output)
4000
The Crisis in Perspective
• Apparent economic success post-1987 illusory
• “Ponzi Economy” booms driven by debt finance
• Decline in spending inevitable given collapse of debtfinanced spending
– Aggregate demand sum of GDP plus change in debt
– At peak, change in debt accounted for
• 23% of demand in USA, 20% in Australia
• Asset bubbles built on leverage
– Must collapse as leverage unwinds
The Scale: Biggest Bubbles in History
Deflating US Asset Prices
250
Lagging 10 Year Price-Earnings Ratio
Shiller Lagging PE Ratio
Case-Shiller Housing
40
200
30
150
20
100
10
0
1910
1920
1930
1940
1950
1960
1970
1980
1990
2000
50
2010
CPI Deflated Housing Index (Average 103)
50
The Housing Issue
• Our housing bubble dwarfs America’s…
There's no house price bubble in Australia...
CPI Deflated Indices 1890=100
400
Australia
USA
300
200
100
0
1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010
The Scale: Deleveraging Driving Collapse
25
0
20
3
15
6
10
9
5
12
Debt Contribution
0
15
Unemployment (RHS, inverted)
−5
1970
1980
1990
2000
2010
Unemployment (Inverted)
Debt Contribution to Demand Percent
Debt Contribution and Unemployment, USA
Conclusions
• Sustainable economy a long way away
• Vital to restrain tendency to speculate on asset prices
– Limit appeal of leveraged speculation
• Time-limited Shares
• Rent-based house valuation and security limits
• Sustainable economic theory needed too
– Neoclassical economics contributed directly to crisis
• Post-1987 rescues of “efficient” markets made
debt bubble twice natural size
• Deregulation, “post-industrial service economy”
nonsense…
• Need realistic growth-aware dynamic economic models