why credit money doesn’t have to crash and why it always does
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Why credit money doesn’t have to crashAnd why it always does
Steve KeenUniversity of Western Sydney
Debunking Economicswww.debtdeflation.com/blogswww.debunkingeconomics.com
0 1 2 3 4 5 6 7 8 9 10 11 12 1325
20
15
10
5
0
5
10
15
20
25
Great Depressionincluding GovernmentGreat Recessionincluding Government
Debt-financed demand percent of aggregate demand
Years since peak rate of growth of debt (mid-1928 & Dec. 2007 resp.)
Per
cent
0
1870 1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010 20200
25
50
75
100
125
150
175
200
225
250
275
300
USAAustralia
Private debt to GDP ratios
Flow of Funds Table L1+Census Data; RBA Table D02
Yea
rs (
per
cent
of
GD
P)
The Great Moderation to The Great Recession• Everything was going SO well…
1975 1980 1985 1990 1995 2000 2005 2010 20155
0
5
10
15
UnemploymentInflation
The Great Moderation.. and Great Recession
Year
Per
cen
t
0
10
2008.5
Inflation & Unemploment Falling
Inflation & Unemploment Falling
Unem
plo
yment
Unem
plo
yment
Deflation
Deflation
What the hell happened?
• A debt bubble burst…
1920 1930 1940 1950 1960 1970 1980 1990 2000 2010 20200
20
40
60
80
100
120
140
160
180
200
220
240
260
280
300
320
USA Private Debt to GDP
Year
Per
cent
of
GD
P
175
2008.5
• Should that matter?
• Not according to conventional “neoclassical” economics…
Credit Money Myths• Neoclassical economics
– Debt not a problem because loans = savings• “Fisher’s idea was less influential in academic
circles, though, because of the counterargument that debt-deflation represented no more than a redistribution from one group (debtors) to another (creditors).” (Bernanke 2000, p. 24)
• Populist (& many non-neoclassical economists)– Inevitable problem because interest can’t be paid
• “The existence of monetary profits at the macroeconomic level has always been a conundrum … not only are firms unable to create profits, they also cannot raise sufficient funds to cover the payment of interest.” (Rochon 2005, p. 125)
Neoclassical myth: “Deposits create loans”
• Creation process:– Government creates Base Money (e.g., welfare
cheque)– Public puts BM in bank account– Bank keeps fraction (RR%: “reserve requirement”)– Lends rest: MB*(1-RR%)– Borrower deposits loan in another bank…– Iterative process generates BM/RR dollars
• Banks as– Passive amplifiers of government money creation– Mere intermediaries between savers & borrowers
• Loan transfers money from saver to borrower– Private Debt has minimal macroeconomic effect
• Only if borrower has higher propensity to spend
Reality: Endogenous money
• Banks create credit money “out of nothing”– “In the real world banks extend credit, creating
deposits in the process, and look for the reserves later” (Moore (1979, p. 539)—quoting Fed economist)
– “There is no evidence that … the monetary base … leads the cycle, although some economists still believe this monetary myth…, if anything, the monetary base lags the cycle slightly…
– The difference of M2-M1 leads the cycle by even more than M2 with the lead being about three quarters." (Kydland & Prescott 1990, p. 14)
• So credit money created “ab initio” by banks• And that doesn’t have to be a problem…
Model of credit money• Pure credit money system: bank issues own notes
– Like 19th century free banking in USA– No Central Bank
• Private bank formed by elite
• Notes “backed” by own wealth
• Lends to local businesses…• How did it work?• Stylised model with 5 accounts
• “Vault”—where bank stores its wealth• “Safe”—for spending, payment & receipt of
interest• “Loans”—ledger recording who owes bank how
much• “Firms”—deposit account for firms• “Workers”—deposit account for workers
• System starts with Notes (say $1 million) in Vault
19th century free banking: Stage 1 • $1 million in Vault, all other accounts zero…• Bank loans transfer notes from Vault to Firms• Bank records loans in its Loans ledger• Bank charges interest on loans• Firm pays interest which Bank deposits in its Safe• Bank records payment of interest on Loans ledger• Bank pays deposit interest to Firm• End result at this point:
• Over time, Vault emptied of Notes• Notes pass via Firms back to Banks’ Safe:
19th century free banking: Stage 1• Modelled using new software package QED
– “Quesnay Economic Dynamics”
QEDQED
19th century free banking: Stage 2• Closing the system: workers, factories & consumption• Firms pay wages to Workers• Bank pays workers interest on deposits• Workers and Bankers consume • End result at this point: System sustainable
• Firms make profits• Workers earn wages, Banks earn interest
Non-Neoclassical myth: “Interest can’t be repaid”• Common belief in Post-Keynesian economics &
populist views of money: No it isn’t– Interest can’t be repaid because loan less than
loan + interest; and firms can’t make monetary profits:• “The existence of monetary profits at the
macroeconomic level has always been a conundrum for theoreticians of the monetary circuit… not only are firms unable to create profits, they also cannot raise sufficient funds to cover the payment of interest. In other words, how can M become M`?” (Rochon 2005, p. 125)
– Wrong!– Confusion of stock (size of loan in $) with flow
(turnover of economic activity in $/year)
Non-Neoclassical myth: “Interest can’t be repaid”
• System is stable if accounts can stabilise• Vault empties over time: all bank assets Loans to Firms
• Accounts do stabilise
• What’s happening?• After the vault
empties…
Non-Neoclassical myth: “Interest can’t be repaid”• Long run dynamics in final 8 rows of table:A
dd u
p co
lum
ns
Ad
d u
p co
lum
ns
• System stable if sum of flows in each column equal zeroFlow conditions for stability of all accounts except Vault
Account Outflows Inflows
Loans Interest charged Interest paid
Firms Interest on Loans + Wages Deposit Interest + Consumption
Safe Deposit interest + Consumption
Interest on Loans
Workers Consumption Wages + Deposit Interest• Vault stabilises too if loan repayment equals rate of loans:
19th century free banking: Stage 3• Firm repays loan which Bank puts back in Vault• Bank records repayment on Loan ledger
• Sustainable system• Bank assets now unlent Notes in Vault plus Loans to
Firms • Incomes for all classes• Wages $310.47 p.a.• Net Interest $3.72• Profit? 217.33 p.a.
(shown later)• Final step: new money
• In 19th century: notes
• In 20th century: credit
QEDQED
Money creation in pure credit economy• 19th century: add new notes to vault
Money creation in pure credit economy• 20th century: simultaneously issue loan and deposit
Money creation in pure credit economy• System not inherently unstable
– Firms can pay interest & make a profit– Debt can remain low & constant relative to GDP– Rising debt also necessary for expanding economy…
• “If income is to grow, the financial markets … must generate an aggregate demand that, aside from brief intervals, is ever rising.
• For real aggregate demand to be increasing, … it is necessary that current spending plans, summed over all sectors, be greater than current received income…
• It follows that over a period during which economic growth takes place, at least some sectors finance a part of their spending by emitting debt or selling assets.” (Minsky 1982, p. 6; emphasis added)
Money creation in pure credit economy
• Schumpeter on same issue: growing debt adds demand beyond that generated by sales of goods & services
• Debt essential for entrepreneurial function– Entrepreneur often has idea but no money– Needs purchasing power before has goods to sell– Gets purchasing power via loan from bank– Entrepreneurial demand thus not financed by “circular
flow of commodities” but by new bank credit– Since entrepreneurial activities essential feature of
growing economy, in real life “total credit must be greater than it could be if there were only fully covered credit. The credit structure projects not only beyond the existing gold basis, but also beyond the existing commodity basis.” (Schumpeter 1934, p. 101)
Money creation in pure credit economy• But incentive to instability exists:
– Bank income rises if• New money issued more rapidly• Debt repaid more slowly (or not at all)
Money creation in pure credit economy• Same result in modern banking; bank income rises if
– Bank reserves circulated more rapidly– Loans paid off more slowly– New loans created more rapidly
Money creation in our real economy• Banks have inherent bias to create debt• Borrowers control whether that bias is expressed• Income based borrowing—inherently limited• The “Solution”: lend to finance Ponzi Schemes
– Potential borrower expects asset price to rise– Borrows money to buy asset– Drives price of asset up– Rise entices other borrowers into market
• Positive feedback from leverage to prices causes asset price bubble
• Scheme “works until it fails”:– Rising debt-financed spending boosts economy– Requires acceleration in debt to continue forever…
The Facts on Debt
• 2 obvious US debt bubbles in last century
1920 1930 1940 1950 1960 1970 1980 1990 2000 2010 20200
20
40
60
80
100
120
140
160
180
200
220
240
260
280
300
320
USA Private Debt to GDP
Year
Per
cent
of
GD
P
175
2008.5
Debt and Aggregate Demand
• Conventional “exogenous money” economics– Debt has minor macroeconomic effects
• Redistributes money from lender to borrower• “Absent implausibly large differences in marginal
spending propensities among the groups, it was suggested, pure redistributions should have no significant macroeconomic effects.” (Bernanke 2000, p. 24)
• Realistic “endogenous money” economics– Increasing debt expands aggregate spending– Aggregate demand equals GDP plus change in
debt• Spent on all markets—goods + existing assets
– Volatile “change in Debt” component dominates economy as debt grows relative to income
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 214 10
6
6 106
8 106
1 107
1.2 107
1.4 107
1.6 107
1.8 107
2 107
GDP aloneGDP+Change in Debt+ Government
US Aggregate Demand GDP 1990-2010
Years since 1990
$ m
illio
n
18
Crisis by Crisis by de-de-
leveragingleveraging
Debt and Aggregate Demand• Crisis manifestation of deleveraging
But notice But notice recent recent
turnaroundturnaround
1975 1979 1983 1987 1991 1995 1999 2003 2007 2011 201536
30
24
18
12
6
0
6
12
18
24
30
36 0
11
10
9
8
7
6
5
4
3
2
1
0
Debt-financedInc. GovUnemployment
Correlation US debt-financed demand & unemployment
Year
Per
cent
cha
nge
p.a.
Per
cent
une
mpl
oyed
(in
vert
ed)
0
Debt and Aggregate Demand• Correlation with unemployment
Crisis by Crisis by de-de-
leveragingleveraging
But notice But notice recent recent
turnaroundturnaround
Acceleration in Debt & Change in Employment
• Since AD = GDP +D– AD = GDP +D– Changes in aggregate demand
• & hence changes in employment– Correlated not with change in debt (D)
• But with acceleration/deceleration in debt (D)• Defining “credit impulse” (Biggs, Meyer & Pick) as
ChangeI nChangeI nDebtGDP
• Empirically, credit—ignored by neoclassical economics—is the key driver of the economy...
1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 201530
25
20
15
10
5
0
5
10
Acceleration of private debtChange in Private Employment
Acceleration of private debt & change in employment, USA
Year
Per
cent
p.a
.
0
2008
Change in Debt & Change in Employment
• Correlation with change in employment
USA stalled crisis by USA stalled crisis by slowdown in slowdown in deleveragingdeleveraging
Crisis Crisis beginsbegins
Change in Debt & Change in Employment
• Summing up: Credit drives the economy• Acceleration in debt precedes change in GDP
20 10 0 10 20 300.2
0
0.2
0.4
0.6
0.8
EmploymentGDP
Credit Impulse Correlations in the USA
Lag in months
Cor
rela
tion
0 • Doesn’t have to drive it “over the cliff”
• But always does• Why?• The temptation
of Ponzi Finance• Putting it all
together...
Finance and Economic Breakdown
• Economy is– Inherently cyclical
• Waves of innovation/destruction (Schumpeter)• Struggles over income distribution (Marx, Goodwin)• Complex & aperiodic (Lorenz, Mandelbrot,
Prigogine)– Inherently monetary
• Moore, Graziani– Inherently afflicted by uncertainty
• Keynes (not IS-LM!)• Given nature of capital assets
– Banks’ desire to create debt leads to financial crises• The Financial Instability Hypothesis: Minsky
Minsky’s “Financial Instability Hypothesis”
• Economy in historical time– Both ignored by conventional “neoclassical”
economics)• 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…
• Self-fulfilling expectations– Decline in risk aversion causes increase in investment– Investment expansion causes economy to grow faster
The Euphoric Economy
• Asset prices rise: speculation on assets profitable• Increased willingness to lend increases money supply
– Money supply endogenous , 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
• Rising debt levels & interest rates lead to crisis– 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
The Assets Boom and Bust
• 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...• Process repeats once debt levels fall
– But starts from higher debt to GDP level• Eventually final crisis where debt burden overwhelms
economy
Modelling Minsky
• Modelled by– Introducing nonlinear functions
• Capitalist desire to invest• Debt repayment rate• Money relending rate
– Endogenous money creation via “line of credit”• Firm investment desire funded by increased
deposit• Simultaneous increase in debt
– Modelling production & price formation• Also growth in population & labor productivity
Modelling Minsky: Financial side• New Godley Table
““Line of Line of credit”: credit”:
money & money & debt created debt created
at same at same timetime
• Exponential functions for expectations under uncertainty:• Given uncertain future, investors assume that “the
present is a much more serviceable guide to the future than a candid examination of past experience would show it to have been hitherto” (Keynes 1936, p. 214)
Modelling Minsky: behavioural components• Functions for wage setting (workers), investment (firms),
loan repayment (firms) and money relending (banks)
90 92 94 96 98 1005
0
5
10
15
20
Wages and Employment Rate
Employment Rate
Per
cent
cha
nge
in m
oney
wag
es
5 0 5 100
10
20
30
40
50
Investment & Profit Rate
Profit Rate %
Perc
ent o
f GD
P
10 5 0 5 100
5
10
15
20
Loan repaymentMoney relending
Loan Repayment and Money relending
Rate of Profit
Yea
rs
• Purpose of functions not to generate cycles• System already inherently cyclical (Goodwin)
• But to constrain cycles to realistic levels
Modelling Minsky: Production Relations
• Capital K determines output Y via the accelerator:
Y/
lr1
Labour Productivitya
L
• Y determines employment L via productivity a:
• L determines employment rate l via population N:
• l determines rate of change of wages w via Phillips Curve
• Integral of w determines W (given initial value)
• Y-W determines profits P and thus Investment I…dw/dt 1/S
Integrator
w++
1Initial Wage
*L
W
WY +
-Pi I dK/dt
• Closes the loop:
1Initial Capital +
+1/SIntegrator
dK/dt
K 1/3Accelerator
Y
L/
lr100
PopulationN
l
PhillipsCurve dw/dt+- *
10WageResponse
.96"NAIRU"
• (Linear Phillips curve for (Linear Phillips curve for now)now)
Modelling Minsky: Inherent cycles
• Model generates cycles (but no growth since no population growth or technical change yet)…:
K 1/3Accelerator
Y
/lr1
Labour Productivitya
L
/lr
1Population
Nl
PhillipsCurve dw/dt
1/SIntegrator
w++
1Initial Wage *
LW
Y +-
Pi I dK/dt
3Initial Capital +
+1/SIntegrator
+- *10
WageResponse
.96"NAIRU"
Goodwin's cyclical growth model
Time (Years)0 2 4 6 8 10
.50
.75
1.00
1.25
1.50Employment
Wages
Goodwin's cyclical growth model
Employment.9 .95 1 1.05
Wa
ge
s
.7
.8
.9
1.0
1.1
1.2
1.3
Goodwin01B.vsm
• Cycles caused by essential nonlinearity:
• Wage rate times employment
• Behavioural nonlinearities not needed for cycles;
• Instead, restrain values to realistic levels
Modelling Minsky: Wage dynamics
• Phillips curve much maligned in economics– But used by almost all schools of thought
• Also misunderstood: three factors, not just one:– 1. Level of unemployment (highly nonlinear
relationship)– 2. Rate of change of unemployment– 3. Rate of change of retail prices “operating through
cost of living adjustments in wage rates.” (Phillips 1958 p. 283-4)
• All 3 factors included in this model:
1 1
h
d dW P g P
W dt P dt
EmployEmploymentment
Rate of change of Rate of change of employmentemployment
InflationInflationRate of Rate of change of change of
wages wages depends depends
on…on…
Modelling Minsky: Price dynamics
• Physical Output (Q) = Labor times L labor productivity a• Labor = Money flow of wages divided by money wage W• Flow of wages = worker share of output during turnover
period S (time from outlays to receipts)
• Money Demand = Annual flow of wages plus profits
– = Money in Firms divided by turnover S .
• Physical Demand = Money demand divided by Price level• In equilibrium, flow of physical supply = physical demand
1 1
e eD D
e eS S e
F FsQ a D
W P
• Solving for equilibrium price:
1
1e
WP
as
• As a dynamic process:
1 1
1P
d WP P
dt as
Convergence over timeConvergence over time
PhysicaPhysical l
demandemandd
Physical Physical supplysupply
Modelling Minsky: The full system
•In
scary
equatio
ns…
Financial Sector
tBC t( )d
d
FL t( )
RL r t( ) BC t( )
LC r t( ) BC 0( ) BC0
tBPL t( )d
drL FL t( ) rD FD t( ) rD WD t( )
BPL t( )
B BPL 0( ) BPL0
tFL t( )d
d
BC t( )
LC r t( ) FL t( )
RL r t( ) PC t( ) Yr t( ) Inv r t( ) FL 0( ) FL0
tFD t( )d
drD FD t( ) rL FL t( )
BC t( )
LC r t( ) FL t( )
RL r t( ) BPL t( )
B
WD t( )
W PC t( ) Yr t( ) Inv r t( )
W t( ) Yr t( )
a t( ) FD 0( ) FD0
tWD t( )d
drD WD t( )
WD t( )
W
W t( ) Yr t( )
a t( ) WD 0( ) WD0
Physical output, labour and price systems
Level of output Yr 0( ) Yr0Yr t( )Kr t( )
v
Employment L t( )Yr t( )
a t( )L 0( ) L0
Rate of Profit r t( )PC t( ) Yr t( ) W t( ) L t( ) rL FL t( ) rD FD t( )
v PC t( ) Yr t( ) r 0( ) r0
Rate of employmentt t( )d
d t( ) g t( ) ( )[ ] 0( ) 0
Rate of real economic growth g t( )Inv r t( )
v g 0( ) g0
tW t( )d
dW t( )( ) Ph t( )( ) g t( ) ( )[ ][ ]
1Pc
1W t( )
a t( ) 1 s( ) PC t( )
Rate of change of wages W 0( ) W0
Rate of change of prices PC 0( ) PC0tPC t( )d
d
1Pc
PC t( )W t( )
a t( ) 1 s( )
Rate of change of capital stocktKr t( )d
dKr t( ) g t( ) Kr 0( ) Kr0
Rates of growth of population and productivityta t( )d
d a t( )
tN t( )d
d N t( ) N 0( ) N0 a 0( ) a0
Modelling Minsky: The full system
•In
less sca
ry Q
ED
form
at:
QEDQED
Modelling Minsky: The outcome• Model generates Great Moderation & Great Recession
– Not yet calibrated on data yet qualitatively similar…
70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 100 102 104 106 108 1102
0
2
4
6
8
10
12
14
16
InflationUnemploymentU-6 Measure
US Inflation and Unemployment since 1970
Year
Per
cent
70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 100 102 104 106 108 1102
0
2
4
6
8
10
12
14
16
InflationUnemploymentU-6 Measure
US Inflation and Unemployment since 1970
Year
Per
cent
0 10 20 30 40 50 60 70 80 90 100 1105
0
5
10
15
InflationUnemployment
Great Moderation to Great Recession
Year
Per
cen
t p.a
.
0
Modelling Minsky: The outcome
• The full picture from QED
Modelling Minsky: The outcome
• The full picture from QED
Modelling Minsky: The insights
• Private debt causes both boom and crisis• Workers pay for debt through reduced share of income:
0 20 40 6010
0
10
20
30
40
50
60
70
80
90
100
110
WorkersCapitalistsBankers
Income Distribution
Year
Per
cent
of
GD
P
• Reduced volatility with rising debt a sign of• Not increased
stability (“The Great Moderation”—Bernanke 2004)
• But “Calm before the storm” (Keen 1995)
0 1 2 3 4 5 6 7 8 9 10 11 12 1325
20
15
10
5
0
5
10
15
20
25
Great Depressionincluding GovernmentGreat Recessionincluding Government
Debt-financed demand percent of aggregate demand
Years since peak rate of growth of debt (mid-1928 & Dec. 2007 resp.)
Per
cent
0
How does “Now” compare to “Then”?
• Debt-financed proportion of aggregate demand:Debt
GDP Debt
Where to from here?
• 3 factors determine debt impact on economy– Level (relative to GDP)
• Like distance between start and destination• How long before journey is over
– Rate of change• Like speed of travel to destination• Affects aggregate demand
– Rate of change of rate of change• Like acceleration/deceleration• Whether you’re getting there more quickly or not• Affects rate of change of aggregate demand
– Are things improving or getting worse right now?
Where to from here?: Level• It’s a long way from the top if you’ve sold your soul...
1920 1930 1940 1950 1960 1970 1980 1990 2000 2010 20200
20
40
60
80
100
120
140
160
180
200
220
240
260
280
300
320
USA Private Debt to GDP
Year
Per
cent
of
GD
P
75
175
2009.5• Almost 100% of
GDP reduction to get to pre-Great Depression level• Speculative
debt still present
• 200% to get back to 50s level• Only
productive debt
• Decade with aggregate demand below GDP
The NBER thinks The NBER thinks the recession the recession ended here!ended here!
Where to from here?: Rate of change
• Deleveraging impact equivalent to Great Depression level
1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 201230
25
20
15
10
5
0
5
10
15
20
25
30 0
5
0
Debt-financed demandUnemployment (inverted)
Velocity of debt & unemployment
Year
Perc
en
t o
f ag
gre
gate
dem
and
U-3
measu
re o
f un
em
plo
ym
en
t
0
2009.5
• Debt reducing at Great Depression rate• Levelling out implies sustained slump
• “Turning Japanese”
Where to from here?: Acceleration• We’re slowing down...
1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 201530
25
20
15
10
5
0
5
10
30
20
10
0
10
Acceleration of debtRate of change of employment
Acceleration of debt & change in employment
Year
Rate
of
ch
an
ge o
f n
ew
deb
t p.a
.
Rate
of
ch
an
ge o
f p
riv
ate
em
plo
ym
en
t p
.a.
0
2009.5
• Less scary than accelerating fall (rising on quarterly data)
• But still not enough to increase employment• Susceptible to future acceleration in fall
• Much of rise driven by return to Ponzi investing
The acceleration effect The acceleration effect might be why the NBER might be why the NBER thinks the recession thinks the recession ended here!ended here!
Where to from here?
• 2 most persistent debt metrics remain negative– Level of debt to GDP– Rate of change
• Most volatile currently positive– Deceleration of deleveraging
has boosted economy• Learning complicated
dynamics of debt the hard way• History implies crisis has many
years to run…
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