The global debt bubble

Steve KeenUniversity of Western Sydney

A booming economy…

• Seventeen years of growth…

1992 1994 1996 1998 2000 2002 2004 2006 20082

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Change in Real GDPHewson LosesHoward Wins

Economic GrowthP

erce

nt

A booming economy…

• Fifteen years of falling unemployment…

1992 1994 1996 1998 2000 2002 2004 2006 20084

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UnemploymentHewson LosesHoward Wins

UnemploymentP

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A booming economy…

• And 43 years of debt rising faster than GDP…

1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 20100

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1000000

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2000000

DebtGDPMenzies 49-72Whitlam 72-75Fraser 75-83Hawke 83-96HewsonHoward 96-07?

Debt and Nominal GDP

$ M

illio

ns

Having the (borrowed) time of our lives…

• Another look at the medium term trend…

1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 20101000

10000

100000

1000000

1 107

DebtGDPMenzies 49-72Whitlam 72-75Fraser 75-83Hawke 83-96HewsonHoward 96-07?

Debt and Nominal GDP

$ M

illio

ns

• Does that look sustainable to you?

Asset Rich and Debt Poor…

• Assets are rising too…

1990 1995 2000 20050

2000000

4000000

6000000

AssetsLiabilitiesNet Position

Household Assets and Liabilities

$ M

illio

n

• But not as fast as debt has risen…

Asset Rich and Debt Poor…

1990 1995 2000 200510

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House Price IndexMortgage Debt

House Prices and Mortgage Debt

Ann

ual p

erce

ntag

e ch

ange

• And housing assets have risen only because they’ve become more expensive…

Volatile Prices & Sluggish Output

• Additions to housing stock lower in 2004 than in 1997…

1998 2000 2002 20040

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20

PriceQuantity

Changes in Housing Stock

Per

cent

• We had a borrowing boom, not a building boom…

Volatile Prices & Sluggish Output

• Which is why we’re having a rental crisis…• But even rents haven’t kept pace with debt servicing:

1980 1990 20000

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Rental IncomeInterest PaymentsGap (RHS)

Rental income versus mortgage interest

Cur

rent

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• Apparent high value of assets illusory

Volatile Prices & Sluggish Output

• Houses more expensive simply because we’ve been willing to borrow more money to buy them…– Prices up 250% since 1996; mortgage debt up 520%

2000 20050

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Value of HousingPrice of HousingMortgage Debt

Dwelling Price & Value vs Mortgage Debt

Inde

ces

(199

6=10

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Ponzi Households

• Lending for housing rose from 5-25% of GDP:

• Proportion that financed construction fell from 30% to under 10%:

1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 20080

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Aggregate New Lending for Housing

Per

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• No wonder we’re having a rental crisis…– We didn’t build (m)any

houses!• What’s driving the debt?

1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 20080

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70Owner OccupiersInvestors

Housing Construction

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end

ing

Having the (borrowed) time of our lives…• There’s something systematic going on here…

• And we’re not alone… unfortunately1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

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Debt RatioTrend from 64Menzies 49-72Whitlam 72-75Fraser 75-83Hawke 83-96HewsonHoward 96-07?

Debt and PoliticsP

erce

nt o

f no

min

al G

DP

Having the (borrowed) time of our lives…

1960 1980 20000

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USAAustralia1990+ trend 2.1%1990+ trend 6.8%

Household Debt to GDP

Date

Per

cen

t

• Not for the first time in our history either…

The Ponzi Economy

1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 20100

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160Debt RatioTrend 1964-NowTrend 1880-1892Trend 1925-1932

Debt to GDP: The Long Term View

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The Ponzi Economy

• Correlation isn’t causation, but…

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"Variable" "Credit" "Credit" "Credit"

"Compared to" "GDP" "GDP" "GDP"

"Start Date" 1880 1925 1964.5

"End Date" 1892.5 1932 2007.7

"Growth Rate" 9.2 9.5 4.2

"Correlation %" 97.9 97.6 99.1

"Doubling Period" 7.5 7.3 16.6

"Duration" 12.5 7 43.2

"Initial Value" 33.9 40.3 24.7

"Final Value" 103.9 76.2 159.5

"Increase %" 206.5 88.8 546.9

Clearly exponential processClearly exponential process

Biggest bubble in our historyBiggest bubble in our history

• Serious Depressions after previous two debt bubbles• What can we expect after this one?• According to RBA, there’s nothing to worry about!…

Efficient markets & financial democracy?

• Ric Battellino, Deputy Governor, RBA:– “Has the expansion of household credit run its

course? Will it reverse? We cannot know the answer to these questions with any certainty, but my guess is that the democratisation of finance which has underpinned this rise in household debt probably has not yet run its course...”

– “Eventually, household debt will reach a point where it is in some form of equilibrium relative to GDP or income, but the evidence suggests that this point is higher than current levels.”• (Battellino, “Some Observations on Financial

Trends”, 25 September 2007)

Another interpretation: limitless lending

• Who’s in control of the money supply and debt?– Economics textbooks

• The Government/Central Bank– Central Bank creates “base money”– Sets “money multiplier”– Credit Money = Base Money * Credit Money

– 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)

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<―>firmInterest flows: bank<―>firmWage flows: firm―>workersWage flows: firm―>workers

Interest flows: bank―>workersInterest flows: bank―>workersConsumption flows: bank & workers―>firmsConsumption flows: bank & workers―>firms

New Money/Debt flows: bank<―>firmsNew Money/Debt flows: bank<―>firmsDebt repayment flows: firmsDebt repayment flows: firms―>bank―>bankReserve relending flows: Reserve relending flows: bank―>firmsbank―>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!• Bank income rises if

– Loans are repaid slowly (or not at all)

– Repaid money is recycled more quickly; and

– More new money is created

0 2 4 6 8 102

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StandardNew MoneyLoan RepaymentRecycling Loans

Bank Net Income and Bank Parameters

• Lenders profits by extending more credit…– Structural reason for lenders creating rising

debt– What if they decide to change direction?

“Money from nothing, but your cheques ain’t free”• “Credit Crunch”: the rate of money creation drops

– & repayment of loans increases– & relending drops…

0 5 10 150

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Firm LoanBank ReserveFirm DepositWorker DepositBank Deposit

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Firm LoanBank ReserveFirm DepositWorker DepositBank Deposit

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AssetsBank ReservesFirm Loan

• Loans—Assets in circulation fall even without bankruptcy• Credit-driven economic reversal…

Why do borrowers accept debt in the first place?• Hyman Minsky’s “Financial Instability Hypothesis”

– An explanation for debt-driven booms & depressions• Economy in historical time• Debt-induced recession in recent past• Firms and banks conservative re debt/equity

ratios, asset valuation• Only conservative projects are funded• Recovery means conservative projects succeed• Firms and banks revise risk premiums

– Accepted debt/equity ratio rises– Assets revalued upwards

The Euphoric Economy

• Self-fulfilling expectations– Decline in risk aversion causes increase in

investment• Investment causes economy to grow faster

– Asset prices rise• Speculation on assets becomes profitable

– Increased willingness to lend increases money supply• Credit money endogenous

– Riskier investments enabled, more asset speculation• Emergence of “Ponzi” financiers

– Cash flow always less than debt servicing costs– Profits made by selling assets on a rising market– Interest-rate insensitive demand for finance

The Assets Boom and Bust

• Initial profitability of asset speculation:– reduces debt and interest rate sensitivity– drives up supply of and demand for finance– market interest rates rise

• But eventually:– rising interest rates make many once conservative

projects speculative– forces non-Ponzi investors to attempt to sell assets

to service debts– entry of new sellers floods asset markets– rising trend of asset prices falters or reverses

Crisis and Aftermath

• Ponzi financiers go bankrupt:– can no longer sell assets for a profit– debt servicing on assets far exceeds cash flows

• Asset prices collapse, drastically increasing debt/equity ratios

• Endogenous expansion of money supply reverses• Investment evaporates; economic growth slows or

reverses• Economy enters a debt-induced recession ...• High Inflation?

– Debts repaid by rising price level– Economic growth remains low: Stagflation– Renewal of cycle once debt levels reduced

Crisis and Aftermath

• Low Inflation?– Debts cannot be repaid– Chain of bankruptcy affects even non-speculative

businesses– Economic activity remains suppressed: a

Depression• Big Government?

– Anti-cyclical spending and taxation of government enables debts to be repaid

– Renewal of cycle once debt levels reduced• Sounds like history lesson rather than economic

theory…

Meanwhile, in the real world…

• Combination of record Debt/GDP, high nominal interest rates and low inflation means huge real interest burden:

1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 201010

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Inflation-adjusted interest payment burden

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• Debt servicing pressure will constrain debt growth at some point– Borrowers

cease borrowing

– Lenders cause credit crunch…

The Ponzi Economy

• Rising debt in the economic driver’s seat– No influence on unemployment in the 60s– Accounts for 90% of unemployment now

• What happens next?...

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11Debt ChangeWhitlam 72-75Fraser 75-83Hawke 83-96HewsonHoward 96-07?Unemployment

Change in Debt, Politics, & Unemployment

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CorrelationWhitlamFraserHawke

Unemployment & Debt Contribution to Demand

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Back in the USA…

• USA Housing Bubble has clearly burst:

1990 1995 2000 200550

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IndexMonthly Change

Case-Schiller US Housing Index

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House prices falling by more than 1% House prices falling by more than 1% per month!per month!

In China we trust…

• Macroeconomic link:– Aggregate demand = GDP + change in debt– As debt rises, dependence on change in debt has

risen• Now accounts for 18% of aggregate demand

• Even stabilising debt/GDP ratio will cause 5%+ cut in spending

• Serious downturn inevitable• Counter forces

– Possible global warming/peak oil inflation• Inflation reduces debt burden

– China boom…• We are entering stormy economic waters…

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