Why credit money doesn’t have to crash And why it always does

1. Why credit money doesn’t have to crashAnd why it always does Steve Keen University of Western Sydney Debunking Economics www.debtdeflation.com/blogs www.debunkingeconomics.com

2. The Great Moderation to The Great Recession • Everything was going SO well… Unemployment Inflation & Unemploment Falling Deflation

3. What the hell happened? • A debt bubble burst… • Should that matter? • Not according to conventional “neoclassical” economics…

4. 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)

5. 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

6. 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…

7. 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

8. 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:

9. 19th century free banking: Stage 1 • Modelled using new software package QED • “Quesnay Economic Dynamics” QED

10. 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 Is this even possible?

11. 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)

12. 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 dostabilise • What’s happening? • After the vault empties…

13. Non-Neoclassical myth: “Interest can’t be repaid” • Long run dynamics in final 8 rows of table: Add up columns • System stable if sum of flows in each column equal zero • Vault stabilises too if loan repayment equals rate of loans:

14. 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 QED

15. Money creation in pure credit economy • 19th century: add new notes to vault

16. Money creation in pure credit economy • 20th century: simultaneously issue loan and deposit

17. 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)

18. 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)

19. 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)

20. 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

21. 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…

22. The Facts on Debt • 2 obvious US debt bubbles in last century

23. 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

24. Debt and Aggregate Demand • Crisis manifestation of deleveraging Crisis by de-leveraging But notice recent turnaround

25. Debt and Aggregate Demand • Correlation with unemployment Crisis by de-leveraging R2=-.7 But notice recent turnaround

26. Acceleration in Debt & Change in Employment • Since AD = GDP +DD • DAD = DGDP +DDD • Changes in aggregate demand • & hence changes in employment • Correlated not with change in debt (DD) • But with acceleration/deceleration in debt (DDD) • Defining “credit impulse” (Biggs, Meyer & Pick) as • Empirically, credit—ignored by neoclassical economics—is the key driver of the economy...

27. Change in Debt & Change in Employment • Correlation with change in employment Crisis begins R2=.67 USA stalled crisis by slowdown in deleveraging

28. Change in Debt & Change in Employment • Summing up: Credit drives the economy • Acceleration in debt precedes change in GDP • Doesn’t have to drive it “over the cliff” • But always does • Why? • The temptation of PonziFinance • Putting it all together...

29. 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

30. 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

31. 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

32. 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

33. 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

34. Modelling Minsky: Financial side • New Godley Table “Line of credit”: money & debt created at same time • 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)

35. Modelling Minsky: behavioural components • Functions for wage setting (workers), investment (firms), loan repayment (firms) and money relending (banks) • Purpose of functions not to generate cycles • System already inherently cyclical (Goodwin) • But to constrain cycles to realistic levels

36. Modelling Minsky: Production Relations • Capital K determines output Y via the accelerator: • 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 • (Linear Phillips curve for now) • Integral of w determines W (given initial value) • Y-W determines profits P and thus Investment I… • Closes the loop:

37. Modelling Minsky: Inherent cycles • Model generates cycles (but no growth since no population growth or technical change yet)…: • Cycles caused by essential nonlinearity: • Wage rate times employment • Behavioural nonlinearities not needed for cycles; • Instead, restrain values to realistic levels

38. 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: Rate of change of wages depends on… Employment Rate of change of employment Inflation

39. 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 tS (time from outlays to receipts) • Money Demand = Annual flow of wages plus profits • = Money in Firms divided by turnover tS . • Physical Demand = Money demand divided by Price level • In equilibrium, flow of physical supply = physical demand Physical supply Physical demand • Solving for equilibrium price: Convergence over time • As a dynamic process:

40. Modelling Minsky: The full system • In scary equations…

41. Modelling Minsky: The full system • In less scary QED format: QED

42. Modelling Minsky: The outcome • Model generates Great Moderation & Great Recession • Not yet calibrated on data yet qualitatively similar…

43. Modelling Minsky: The outcome • The full picture from QED

44. Modelling Minsky: The outcome • The full picture from QED

45. Modelling Minsky: The insights • Private debt causes both boom and crisis • Workers pay for debt through reduced share of income: • Reduced volatility with rising debt a sign of • Not increased stability (“The Great Moderation”—Bernanke 2004) • But “Calm before the storm” (Keen 1995)

46. How does “Now” compare to “Then”? • Debt-financed proportion of aggregate demand: Scale of downturn 2.5 years in 2000s Scale of government response 1930s 1930s 2000s Notice current turnaround in debt contribution

47. 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?

48. Where to from here?: Level • It’s a long way from the top if you’ve sold your soul... • 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 recession ended here!

49. Where to from here?: Rate of change • Deleveraging impact equivalent to Great Depression level • Debt reducing at Great Depression rate • Levelling out implies sustained slump • “Turning Japanese”

50. Where to from here?: Acceleration • We’re slowing down... The acceleration effect might be why the NBER thinks the recession ended here! • 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