Steve Keen: Why 2012 is Shaping Up to be a Particularly Ugly Year
At the high level, our global economic plight is quite simple to understand says noted Australian deflationist Steve Keen.
Banks began lending money at a faster rate than the global economy grew, and we're now at the turning point where we simply have run out of new borrowers for the ever-growing debt the system has become addicted to.
Once borrowers start eschewing rather than seeking debt, asset prices begin to fall -- which in turn makes these same people want to liquidate their holdings, which puts further downward pressure on asset prices:
The reason that we have this trauma for the asset markets is because of this whole relationship that rising debt has to the level of asset market. If you think about the best example is the demand for housing, where does it come from? It comes from new mortgages. Therefore, if you want to sustain he current price level of houses, you have to have a constant flow of new mortgages. If you want the prices to rise, you need the flow of mortgages to also be rising.
Therefore, there is a correlation between accelerating and rising asset markets. That correlation applies very directly to housing. You look at the 20-year period of the market relationship from 1990 to now; the correlation of accelerating mortgage debt with changing house prices is 0.8. It is a very high correlation.
Now, that means that when there is a period where private debt is accelerating you are generally going to see rising asset markets, which of course is what we had up to 2000 for the stock market and of course 2006 for the housing market. Now that we have decelerating debt -- so debt is slowing down more rapidly at this time rather than accelerating -- that is going to mean falling asset markets.
Because we have such a huge overhang of debt, that process of debt decelerating downwards is more likely to rule most of the time. We will therefore find the asset markets traumatizing on the way down -- which of course encourages people to get out of debt. Therefore, it is a positive feedback process on the way up and it is a positive feedback process on the way down.
He sees all of the major countries of the world grappling with deflation now, and in many cases, focusing their efforts in exactly the wrong direction to address the root cause:
Europe is imploding under its own volition and I think the Euro is probably going to collapse at some stage or contract to being a Northern Euro rather than the whole of Euro. We will probably see every government of Europe be overthrown and quite possibly have a return to fascist governments. It came very close to that in Greece with fascists getting five percent of the vote up from zero. So political turmoil in Europe and that seems to be Europe’s fate.
I can see England going into a credit crunch year, because if you think America’s debt is scary, you have not seen England’s level of debt. America has a maximum ratio of private debt to GDP adjusted over 300%; England’s is 450%. America’s financial sector debt was 120% of GDP, England’s is 250%. It is the hot money capital of the western world.
And now that we are finally seeing decelerating debt over there plus the government running on an austerity program at the same time, which means there are two factors pulling on demand out of that economy at once. I think there will be a credit crunch in England, so that is going to take place as well.
America is still caught in the deleveraging process. It tried to get out, it seemed to be working for a short while, and the government stimulus seemed to certainly help. Now, that they are going back to reducing that stimulus, they are pulling up the one thing that was keeping the demand up in the American economy and it is heading back down again. We are now seeing the assets market crashing once more. That should cause a return to decelerating debt -- for a while you were accelerating very rapidly and that's what gave you a boost in employment -- so you are falling back down again.
Australia is running out of steam because it got through the financial crisis by literally kicking the can down the road by restarting the housing bubble with a policy I call the first-time vendors boost. Where they gave first time buyers a larger amount of money from the government and they handed over times five or ten to the people they bought the house off from the leverage they got from the banking sector. Therefore, that finally ran out for them.
China got through the crisis with an enormous stimulus package. I think in that case it is increasing the money supply by 28% in one year. That is setting off a huge property bubble, which from what I have heard from colleagues of mine is also ending.
Therefore, it is a particularly ugly year for the global economy and as you say, we are still trying to get business back to usual. We are trying to rescue the creditors and restart the world that is dominated by the creditors. We have to rescue the debtors instead before we are going to see the end of this process.
In order to successfully emerge on the other side of this this painful period with a more sustainable system, he believes the moral hazard of bailing out the banks is going to have to end:
[The banks] have to suffer and suffer badly. They will have to suffer in such a way that in a decade they will be scared in order to never behave in this way again. You have to reduce the financial sector to about one third of its current size and we have to also ultimately set up financial institutions and financial instruments in such a way that it is no longer desirable from a public point of view to borrow and gamble in rising assets processes.
The real mistake we made was to let this gambling happen as it has so many times in the past, however, we let it go on for far longer than we have ever let it go on for before. Therefore, we have a far greater financial parasite and a far greater crisis.
And he offers an unconventional proposal for how this can be achieved:
I think the mistake [central banks] are going to make is to continue honoring debts that should never have been created in the first place. We really know that that the subprime lending was totally irresponsible lending. When it comes to saying "who is responsible for bad debt?" you have to really blame the lender rather than the borrower, because lenders have far greater resources to work out whether or not the borrower can actually afford the debt they are putting out there.
They were creating debt just because it was a way of getting fees, short-term profit, and they then sold the debt onto unsuspecting members of the public as well and securitized their way out of trouble. They ended up giving the hot potato to the public. So, you should not be honoring that debt, you should be abolishing it. But of course they have actually packaged a lot of that debt and sold it to the public as well, you cannot just abolish it, because you then would penalize people who actually thought they were being responsible in saving and buying assets.
Therefore, I am talking in favor of what I call a modern debt jubilee or quantitative easing for the public, where the central banks would create 'central bank money' (we cannot destroy or abolish the debt, which would also destroy the incomes of the people who own the bonds the banks have sold). We have to create the state money and give it to the public, but on condition that if you have any debt you have to pay your debt down -- no choice. Therefore, if you have debt, you can reduce the debt level, but if you do not have debt, you get a cash injection.
Of course, this would then feed into the financial sector would have to reduce the value of the debts that it currently owns, which means income from debt instruments would also fall. So, people who had bought bonds for their retirement and so on would find that their income would go down, but on the other hand, they would be compensated by a cash injection.
The one part of the system that would be reduced in size is the financial sector itself. That is the part we have to reduce and we have to make smaller. That is the one that I am putting forward and I think there is a very little chance of implementing it in America for the next few years not all my home country [Australia] because we still think we are doing brilliantly and all that. But, I think at some stage in Europe, and possibly in a very short time frame, that idea might be considered.
Click the play button below to listen to Chris' interview with Steve Keen (48m:50s)
Chris Martenson: Welcome to another PeakProsperity.com podcast. I am your host, of course, Chris Martenson, and today we have the good fortune of speaking with Steve Keen, Professor of Economics and Finance at the University of Western Sydney and author of the popular book Debunking Economics and website Steve Keen’s Debtwatch.
I have long been an avid reader and follower of Steve’s work over the years, because it is logical and starts with the data. Steve’s research focus is on the dynamics of debt and leads him to believe that debt deflation is the key issue that will continue to dictate what happens in the global economy. I am really looking forward to discussing deflation, his new book, maybe something of his recent debate with Paul Krugman, and whether the global markets are rolling over as we are speaking today. Steve, it is a pleasure to have you as your guest.
Steve Keen: It is great to be back on again, Chris.
Chris Martenson: Fantastic. So let us start right at the outset, if you could give a summary for those who are not familiar with your work. You say debt deflation is the key issue. Can you give us a summary of your views?
Steve Keen: Well, a capitalist economy necessarily has banks. That is news to conventional economists, but banks create spending power by creating debt. So you can actually have a boom being driven by banks lending money at a faster rate than the economy itself is growing, which gives you an accumulation of debt that is getting to be a higher and higher ratio of debt to the GDP.
You get to the point where that cannot continue any longer, where you cannot get new borrowers. And when you reach that point, you go through a turning point, then, where people who have normally been enticed into debt to borrow money to gamble money on rising asset prices. Instead, finance prices are falling and trying to liquidate, you then have a period where debt levels are reduced, and rather than rising debt, adding to the demand as it does during the boom phase.
During the depression phase – it is not a slump, its a depression – people are spending less than they earn. And therefore the aggregate demand is less than income, and you have a declining level of demand all the way through, as asset prices collapse and debts gradually paid back down.
That is what gave us the 1930s, and we began the 1930s process with an American debt-to-GDP ratio of roughly 175%, and thanks to Greenspan and Co., we began this particular downturn with a peak level of debt of 303% of GDP. Just as it took about 15 years to get out of the last Great Depression, this one which Americans are still calling a “lesser depression” now, I noticed, it could last even longer than Great Depression I did.
Chris Martenson: This time with 50% more extra debt. In this story, then, there is a math problem, and the math problem is that you cannot borrow more than your income. If you debts are growing at a faster rate than your income, eventually you have a math problem. You are saying we reached that math problem in 2008, I guess. Do you agree with that?
In addition, secondarily, was there a trigger in events that precipitated that, or did these things just somewhat happen randomly?
Steve Keen: It is an endogenous thing. It does not require an external event, because to continue having more and more debt being taken on, you have a ton of people who are willing to acquire that debt. Initially, the level of debt the household had back in the 1990s was relatively low, about 40% of GDP. They were then enticed by the subprime bubble, and the debt levels for the household was about 100% of GDP. To keep the bubble going, you would need not just for people to keep raising their debt, but accelerating debt.
This is why it always has to break down, because for debt to accelerate indefinitely, you have to get to the stage where debt-to-income ratios were infinite. Now, of course that can’t happen. So, as soon as you start to exhaust the supply of people who are willing to go into debt, as we have more and more of society becoming indebted, a simple slow-down of the rate of growth of that is enough to turn the acceleration negative. That is what drives the whole economy down.
So, we take a look at the data. I think you have to look at three factors of debt, the absolute level, the rate of growth of debt, and whether that rate of growth of debt is accelerating or decelerating. In fact, the process begins as soon as the rate of acceleration consistently decelerates and goes from getting faster to growing more slowly. That is what sets the process off.
It actually began pretty much at the beginning of 2008, but of course, part of the other triggers as well was that a large part of the debt that was created was then put into ventures, which themselves were losing money. Therefore, you had the subprime crisis, where we know people were borrowing amounts of money they could never pay. They were unnecessarily going bankrupt, there were losses being made by speculative ventures elsewhere as well, but those losses accumulate and have to be serviced or they have to go bankrupt and write the debts off. Therefore, those triggers were all sitting there, but they were truly internal. It does not take a meteor from Mars to create this crisis.
Chris Martenson: I plant the seeds of this stretching back a long ways. I am the most familiar with U.S. debt. At this point, I know that starting in the 1970s through the next four decades, over those four decades total credit market debt, which includes financial and non-financial, doubled five complete times in that period of time – and, of course, the economy did not double anywhere close to five complete times.
So, that rolled over around 2008, so just to get back on that trajectory, to get back to what people would call normal for budgets to operate like we expect them to – capital markets, and the whole shebang – I would estimate that we would have to double again over a decade. Therefore, from 2008 to 2018, the U.S. has to figure out how to accumulate $50 some-odd trillion of new incremental debt. I do not know what we would even possibly lend to ourselves; the total housing bubble was still only a $10 or $11 trillion market. Do you see any opportunities out there for us to take on the kinds of debt that seem to be required to rescue this system?
Steve Keen: No. You cannot go back to business as usual. This is the real trap of the debt bubble, because the thing that actually entices people into that much debt is the expectation that asset markets are going to continue rising. If you look at the debt that people have with respect to their income – you know, personal lines [of credit] and stuff like that – despite all the enticements to charge up credit cards, would you like an increase in your credit limit with that? Like if you are going to McDonald’s and getting extra fries.
Banks are trying to pump out higher credit limits all the time. Deals on buying cars – you know, buy now and pay later, etc. Despite all of that, the ratio of unsecured personal debt-to-income has not been flatlined, but it certainly has not gone on an exponential rise. The only form of debt that rises exponentially compared to income is debt, which is being used by an asset, where you believe that the asset is going to increase in price and you can sell it for a higher amount of money than what you paid to buy it in the first place.
If you can get a capital gain, which really is a Ponzi game, you do not do anything, but you get money for it. That is what drives prices up. You have the biggest bubble in stock market history and the biggest bubble in housing market industry simultaneously having reached that peak because you can longer have accelerating debt driving up those processes further. They are now falling, and that it is going encourage people out of debt. Therefore, far from saying, in a way, it will get people back in again, the asset market bubble being over is going to drive people out of debt rather than getting enticed to take on more. So, what was usual over the last 40 years cannot be restored.
Chris Martenson: Very interesting in that I note that – one of the places that I did sort of a recent stumble in all of this – yes, it is a four-decade-long credit bubble, but in 1994, we had a real issue in the credit market, particularly corporate bonds. Greenspan took that moment to implement something called the Sweep Programs, which enabled banks to effectively dodge the reserve requirements, as minimal as they were, entirely.
That enabled a brand new gigantic round of liquidity to take off, so they had the stock bubble – and, of course, that met its fate, and then that led to another round of ultra-cheap money. Ultimately, that led to a housing bubble. Therefore, my view of this is that we started with a relatively small crisis, but with the application of more sugar, monetary heroin, or whatever metaphor we are using here, that beget an even larger problem that required an even larger stimulus.
Therefore, here we are now, globally looking at coordinated central-bank interventions, where in the past six years the balance sheets of just the six largest central banks have expanded by $10 trillion. Do you think that they can realistically keep this game going much longer?
Steve Keen: Well, they can prevent people from going insolvent by giving somebody who is bankrupt cash. That is pretty much what they have been doing. They have been bailing out the banks and bailing out the bondholders. Just as banks can create money, the commercial banks can create money by double-entry book-keeping. So can central banks, so they do not face very many limits at all.
There is not a limit to their profitability, of course. So, they can keep on doing this indefinitely, but what they are hoping to have happen – and this is what is going to fail – is by doing it, the system will suddenly kick-start itself. It will be like a lawnmower in which you continue pulling on the cable to try to get it to start, pull it a few more times, put a bit more fuel in, and it will finally fire up and then it will go off of it’s own.
That is what is not going to happen. They are going to have to continue pumping money back in again…
Chris Martenson: So, spell it out for me. Why exactly is it that this engine will not sputter back to life?
Steve Keen: Because too much debt is already in there, and because people no longer see a way of rising debt – meaning a gain on the asset markets for themselves. They are going to be trying to reduce their debt, particularly if asset markets are in fact falling. They are going to be reducing their gearing, reducing their leverage, and every time, you kick-start-to-go the system with a lot of extra money and hope to get it started once more.
Once you stop injecting that government-created money into the system, the system will then go to this stage where it takes money out, because to pay your debt down you have to take money out of circulation. Therefore, the economy will fall again, and rather than booming, it will go back to faltering once more.
Chris Martenson: So, perhaps in a microcosm, if we look at what is happening in Spain today, where we note that they have an extraordinary debt-to-GDP ratio, they have really dismal economic prospects, they have a banking system that is really weak if not mortally wounded, and they have just nationalized Bankia. Is Spain a good metaphor here for what maybe the larger world is going to experience?
Steve Keen: I think Americans can still apply to this metaphor, because at a point, I think metaphorically we are talking about the actual story. Because Spain is part of the euro, and the euro is another catastrophe on top of all the overall catastrophe of private-banking-funding Ponzi schemes. Therefore, the real story is the commercial banks generating money and making profit for themselves by creating debt and persuading us to go into far too much debt by the asset bubbles that actually caused the prices to rise.
In addition, of course, Greenspan’s rescue is making this process go on for far longer than it would have without that particular government intervention. But, Spain is caught up with the euro, where just as neoclassical economists are responsible for the scale of the crisis by making us turn a blind eye to rising debt. They also drafted the economic component of the treaty to bring about European Union.
That treaty embodied the neoclassical fantasy that a market economy works best if there is no government intervention and no government policy. Therefore, they set up a system in which the governments could not do an exchange-rate policy, because they are all part of the one currency. Therefore, they cannot devalue against each other.
You cannot do a monetary policy, because the European Central Bank is in control of that and sets an interest rate for the entire continent of Europe. You cannot do a fiscal policy either, because the master treaty said the maximum deficit that you can run is 3% of GDP and the maximum accumulative deficit that you can have is 60% of GDP. They are talking about public debt there.
So, they pushed Europe together and said you can have neither the fiscal, monetary, nor exchange-rate policy, and we are going to have the most wonderful world. Well, look at what has happened. It is the greatest catastrophe on the planet. Therefore, Spain is an additional catastrophe. Like, in some ways, it is America squared.
Chris Martenson: America squared. However, America is maybe the better metaphor; because it is not a metaphor, we can talk about it directly.
Steve Keen: Yeah, it is the real story. America is big enough even though it is being industrialized massively through the last 30 to 40 years under the cover of the financialization of this economy and even though it has a much larger import bill than it used to have because of that, it is still pretty much a self-contained economy. What is going on there is an entirely endogenous process of the banks creating too much debt, funding an asset market bubble, and now we are caught up in the deleveraging from that and we are back in another Great Depression.
Chris Martenson: So, start to spin over in the great debate that has brewing with the neoclassical economists, who, by the way, have been just spectacularly wrong. I have yet to hear a qualified reasonable mea culpa from that crew. If I could summarize, they seem to be saying, any failures in policy and traction that we are not seeing so far is simply because we did not do enough. Enough of what?
You have mentioned that some of the strategy here was sort of delay-and-pray, so we just kick the can long enough and pray, and maybe the economy sputters back to life all on its own. However, there have been a number of other dynamics driving this, with taking what were private debts and pushing them over on to the public side of the balance sheet with direct monetization of government debt by central banks, in particular the Federal Reserve; very large quantities. What exactly is the strategy here?
Steve Keen: Well, this is the intriguing thing, because the strategy is “panic.” The neoclassical economists believe that the economy is self-equilibrating, that it will return to the equilibrium after the minor shock, and they really regard the global financial process as just a big shock. However, for some reason, they continue remaining negative and they cannot work out why.
In fact, if they have had their ‘druthers, they would have driven on nothing back at the time of the 2007 crisis. Except that, according to their theories, that crisis should not have happened. So, what happened when the crisis hit? You had people who were neoclassical and vehemently anti-government spending who suddenly became born-again Keynesians. They threw as much money as they could at the system, hoping that would get it over this temporary process.
Then, when they did that and they got a bit of a recovery for a while, the scale of the government spending was far greater than the Great Depression. Therefore, you had a boost of aggregate demand coming out of the government’s behavior. Then they thought they could sit back and watch it start booming once more – and rather than booming of course, we have had an economy, which splatters.
Normally, after a standard post-second-World-War recession, where you know growth is negative for a couple of quarters, you normally get a rebound where it bounces up between five and six percent on an annual basis per quarter for a few quarters, at least after the slump. The best they have managed so far is about three; of course, we are falling back to the stage where one may even hit negative again.
Their response was to abandon their principles – so called – and go for government spending, and then pray that would be enough to get the system started again. They are basically flummoxed as to why it has not worked.
Chris Martenson: I am going to note that I think Keynes is getting a bad rap in this.
Steve Keen: He is getting a bad rap; yeah.
Chris Martenson: I have read some of his works, and he is clearly a very intelligent person. I am going to go out on a fat limb and suggest that he would not ever support the idea of trying to exponentially grow and increase your debts faster than your income. He was clearly too smart for that.
Steve Keen: No, Keynes was aware of the dangers there. I often said – people like Paul Krugman call themselves new Keynesians, him and Woodford and so forth – as I read Development of Economics, if they can call themselves Keynesians, then I can call myself a duck, because I can say the word quack.
There is no way in which they reflect what Keynes actually wrote. Ironically, you read them and they do not care what Keynes actually wrote. They call it “research.” I am sorry, but knowing what somebody said is essential before you can use their name as a label of what you do. However, in fact, they do not do that, they simply think oh, this looks like what I think Keynes said according to a textbook I read a few years ago and I will call myself the Keynesian. I am sorry, but they are better off calling themselves ducks, because they really are quacks.
Chris Martenson: Way to bring it all together. If we could, just for a minute here, there was a very public debate with a New York Times “economist” – I am putting your quotes up here on this; I guess he is an economist – Paul Krugman. I was reading his blog, and he was defending the idea that banks cannot create money out of thin air. He may have backtracked a bit on that, but it was a very odd debate. I did not quite understand ultimately what was being argued there. Can you help us out?
Steve Keen: Yeah. Well, the basic neoclassical attitude is that banks do not matter. Banks are simply intermediaries between savers and borrowers. All the bank does is act as a conduit; it does not actually create money. Now, you then argue, of course, it does create money, and the money multiples then. So, the government gives a unemployed person a check, they go bank the money at the bank, the bank holds onto a bit of it, and lends out a bit.
There is the money multiplier process that they ultimately get to the stage where they finally have a ratio between their deposits and their reserves, which is the maximum level they can get to, and then they cannot lend anymore until the government creates more reserves. That is the sort of money-creation model that Krugman believes, that neoclassical economists in general believe the banking sector is capable of. However, they argue that the bank cannot simply create money beyond what the reserve systems allow it to do. I think that is the conventional belief they have.
Now, the position that I come from is to say that banks are unconstrained by the reserve system. There are a number of reasons behind that. One of the simplest – and the European Central Bank actually states this – the way the reserves are calculated is as a lagged response to what has happened in the lending market. So, the reserves are based on the deposits that were credited two weeks earlier, in some cases. In America’s case, it is 30 days earlier.
Therefore, in other words it is after the banks have created new money, then the reserves they need to match the new money they have created are determined. Therefore, rather than reserves creating it first and deposits coming later, it is precisely the reverse way around. That is the big mistake; it means that banks can create money by double-entry bookkeeping.
If you go to a bank and ask for a loan, the bank asks you what the money is for. I have this idea for this new hydrogen-powered iPad; the bank says that is a great idea; here is one hundred million dollars, and by the way, you owe us one hundred million dollars. They simultaneously create a loan and a deposit without having to take the money out of the account of any other savers. Therefore, that means you get to spend one hundred million dollars building this new hydrogen-powered iPad, but it does not reduce the spending power of other people in society, it adds to it.
Therefore, banks play an essential role in the real economy and in the models that I build of it, as well. They are actually adding to aggregate demand. What they add to aggregate demand generally goes on two things. First, investment, which would be a good thing if indeed a hydrogen-powered iPad was a good idea – which it is not, but nonetheless, that would be a good investment.
However, it also goes on speculation, which means buying existing assets and using the borrowed money to bid up the prices. That role of banks is an essential element of why we got into the crisis in the first place. But Krugman is quite amazing at having said this; he is all for putting in banks where they matter. But why do banks matter in a story about debt and leverage? To me, that was a bit like saying I am for it with considering wings on birds, but why do I need to worry about wings and why birds fly?
Chris Martenson: It is mysterious. It is just mysterious to me that there can be such a disconnect between what appear to be obvious conclusions from lots of data. You do not have to dig hard; it is all right there.
Help me understand something, then. I do something very arcane, I look at the monetary aggregates, because I think that there is still some information in that. My prediction is that someday the velocity of money will turn around like it always does, and that will be a moment to behold.
I am watching, say, M2 or MZM – it does not matter; they are still trending up at an almost unbroken clip throughout this entire crisis. In fact, they even have some sharper up-sloping periods during part of this crisis. On that basis, it looks like there is still plenty of money entering the system by hook or by crook, even as credit is declining; mostly it is financial credit that has declined. How do we explain that?
Steve Keen: I have to plead ignorance there. But first I tend to look at the debt levels. To me, the central act in creating new money is the creation of debt, because debt and money are created as a bonded pair when they begin, and then after the creation process they are separated. So I am looking at the level of new debt being created, and that is still declining. The level of debt in the economy is still falling very slowly; it was falling very rapidly when the crisis first began. That is the main metric I look at.
The monetary aggregates, on the other hand – I tend to regard them as being caught up in the whole shadow banking sector and what is being done by the government in its rescue attempts. I think there are so many black ops going on there that I just do not find the data reliable enough to worry about too much.
Chris Martenson: Yeah, I understand that.
Steve Keen: It does puzzle me; I have to defer to you on that one.
Chris Martenson: All right, well, back to your earlier point, then. One of the other things about this double-entry bookkeeping and credit expansion really does enable as well: If I am looking at the inflation adjusted expenditures of all the major OECD governments, they are all upwardly sloping lines for the past decade. Therefore, the other enabling feature of creating all of this money is to allow governments to not really have to figure out how to balance their books all that carefully. So, everybody’s got to participate in this party I assume?
Steve Keen: Well, it is a bit different. There is a reason why debt should rise over time, but it should rise roughly at the same pace as income, faster sometimes and slower at other times. I was talking about private debt there, because when you have a growing economy because the growth is financed largely by the increasing debt financing investment, which then gives you technological improvements, new products, and so on. That is a reason to continue borrowing money.
We should normally expect the banks to be creating new debt most of the time, and only when the economy is actually in a recession is when we should see the level of debt falling. That would be a healthy economy if we did not have [debt] financing Ponzi schemes and therefore rising exponentially faster than income.
The same thing applies for the government. If you have a mixed economy, you have a combination of private-sector spending and government spending, private-sector created money and government-created money, you have to have the government creating additional money over time as well. The major way it does that is by running a deficit. Therefore, the normal situation for a growing economy should be a deficit that means the level of government money in the system remains roughly comparable to the level of private money.
Instead, what we have with this fixation on balancing of the books – which would be the right thing to do if you had a static economy – that has actually led to the level of government money plunging over time. If you go back to the 1960s – and I have some memory of the levels of aggregates back then – back in the 1960s, M Zero was about 15% of the total money supply. If you fast-forward to just before the crisis, we were down to about 3%.
That was the government, actually, because of the obsession with running surpluses during the boom times and even during some slump times. Reducing the amount of government money in circulation, letting the credit system go crazy, and then when the crisis hit, what does Bernanke do? He doubles the base money supply in four months from the previous doubling, which took 13 years. We got back to pretty much the same ratios as 1960 by the time we finished the pumping into the system, but it actually helped stabilize it in the period before that.
Chris Martenson: Interesting. So, let us imagine, then, when you see what is going on right now, you say credit is slowly falling and it is not growing at all. If credit is falling slowly at this point, would you say then the pressures on the global financial system, on markets and the larger economy, are those pressures still growing at this point?
Steve Keen: Yeah, the reason that we have this trauma for the asset markets is because of this whole relationship that rising debt has to the level of asset markets. If you think about it, the best example is the demand for housing; where does it come from? It comes from new mortgages. If you want to sustain the current price level of houses, you have to have a constant flow of new mortgages. If you want the price level to rise, you need the flow of mortgages to also be rising.
Therefore, there is a correlation between accelerating and rising asset markets. That correlation applies very directly to housing. You look at the 20-year period of the market relationship from 1990 to now; the correlation of accelerating mortgage debt with changing house prices is 0.8. It is a very high correlation.
The boom and bust is obviously, too. It is not quite so clear for the stock market, but it is about 0.35. And then given how volatile the stock market is, I find that to be a remarkably high correlation, anyway, of aggregate debt to the change in the stock market.
Now, that means that when there is a period where private debt is accelerating, you are generally going to see rising asset markets, which, of course, are what we had right up to 2000 for the stock market and through 2006 for the housing market. Now that we have deceleration debts, debt is slowing down more rapidly over time rather than accelerating. That is going to mean falling asset markets.
Because, we have such a huge overhang of debt, that process of debt acceleration downwards and decelerating negative is more likely to rule most of the time rather than going positive. We will therefore find the asset markets traumatizing on the way down, which of course encourages people to get out of debt. It is a positive feedback process on the way up and it is a positive feedback process on the way down.
Chris Martenson: Do we also have something else contributing here, where any market, whether it is an asset market or a fish market, if you have more buyers than sellers prices tend to go up in the reverse more sellers than buyers and prices tend to go down? When I look at the demographics of the United States and of Europe, people enter their peak earning years between the ages of 30 and 50, and then you have more retirees that people behind them. If you have some sort of a demographic bulge ,you generally will find, well, whom are they going to sell their assets to, as they want to fund their retirement?
Japan in many respects is almost exactly 10, maybe 11 years ahead of the United States in terms of its population demographics. They have been experiencing just horrible asset markets for a very sustained period. Bernanke certainly studied that and promised we would not turn Japanese. Have we just turned Japanese?
Steve Keen: Oh, well, I am sure. That sort of work is the sort of stuff that Harry Dingey entertained. It is a genuine product of the whole dynamic that I tend not to include in my modeling. If I include the demographics, it would pretty much swamp everything else. I want to focus on the contribution the financial sectors made to it is own suicide.
But, yes, when you have a demographic bulge – such as the Baby Boom and so on – passing through the system, and they are trying to liquidate their assets and get their retirement funded, all doing it at once and then having finding asset markets driven up through high levels of debt, now they are trying to capitalize that and come out with an income for the future. They are going down again.
Now of course, when you have a declining population, you do not need to have more houses being built and you can therefore have houses becoming empty. That, of course, is going to have a downward pressure on housing prices. Which maybe a reason why Japan’s house prices have fallen now more than 70% from their peak in nominal terms. So, an enormous decline over time.
We may face a similar thing in America, such as the demographic bulge of the Baby Boom. That is a secular trend in addition to the cyclical phenomenon and bubble phenomenon of the stock market of the financial sector funding a Ponzi scheme. That is something we have never had to cope with before. As well as cross-global warming and Peak Oil. All these things coming together at once is an incredible cacophony of problems that makes me wonder whether I am actually on Planet Earth or am I caught on an episode of Star Trek.
Chris Martenson: Well, it certainly explains why the strategy is “panic.” If we cast into that cauldron of things that you just put out there, what I see is that we are trying to preserve the status quotes, we have dumped trillions and trillions of dollars, and it does not seem to be working.
As I read the current economic statistics, so here we are, it is June 4, 2012; I am looking across the global landscape this last, horrible week. So, China is decelerating strongly. Japan is in a recession. Europe is in a recession. And the PMI statistics are down horribly and in contractionary territory. The United States is at stall speed, and against that backdrop we have to sort of conclude maybe that printing efforts one and two, and LTRO one and two, and all those other things have not worked.
If you put on your prediction hat, where are we in this story right now, and what are the chances of rescue at this stage? Well, let me start here: What do you see going on in the global economic landscape right now?
Steve Keen: Well, Europe is imploding under its own volition, and I think the euro is probably going to collapse at some stage or contract to being a northern euro rather than the whole of euro. Again, we will probably see every government of Europe be overthrown and quite possibly have a return to fascist governments. It came very close to that with Greece and fascists getting five percent of the vote from zero. Maybe left-wing groups as well. So political turmoil in Europe; that seems to be Europe’s fate.
I can see England going into a credit crunch this year, because if you think America’s level of debt is scary, you have not seen England’s level of debt. America has a maximum ratio of private debt-to-GDP adjusted over 300%; England’s is 450%. America’s financial sector debt was 120% of GDP, England’s is 250%. It is the hot-money capital of the western world.
Now that we are finally seeing decelerating debt that is turning up over there, plus the government running an austerity program at the same time, which means there are two factors pulling on the demand of that economy at once, I think there will be a credit crunch in England, so that is going to take place as well.
America is still caught in the deleveraging process. It tried to get out; it seemed to be working for a short while, and the government stimulus seemed to certainly help. Now that they are going back to reducing that stimulus, they are pulling up the one thing that was keeping the demand up in the American economy, and it is heading back down again. We are now seeing the assets market crashing once more. That should cause a return to decelerating debt. For a while, you were accelerating very rapidly. That gave you a boost in employment, so you are falling back down again.
Australia is running out of steam, because it got through the financial crisis by literally kicking the can down the road by restarting the housing bubble with a housing policy of what I call the “first-time buyers boost,” where they gave first-time buyers a larger amount of money from the government.
China got through the crisis with an enormous stimulus package. I think in that case, it is increasing the money supply by 28% in one year. That is setting off a huge property bubble, which I have heard from colleagues of mine. A friend of mine, Craig Tindale, is publishing a little piece of that on my blog this week. That is also coming to an end.
Therefore, it is a particular ugly year for the global economy, and as you say, we are still trying to get business back to usual. We are trying to rescue the creditors and restart the world that is dominated by the creditors. We have to rescue the debtors instead, before we are going to see the end of this crisis.
Chris Martenson: What does deflation really look like? I remember in 2008, Hank Paulson marched in to Congress, closed the door, and said, If we do not fix this Lehman crisis what we are going to have is Martial Law and Mad Max. He was really using scare terms. And then I think it was a year after that or more. Mervin King came out and said, oh, yeah, by the way, we were just a few hours away from a really major banking snafu over here in England. It was a dicey touch-and-go, again, with the implication that would be the systemic failure. Everybody seems to be afraid of systemic failure, and I do not know if that just means just all on their own, the banking system sort of dominos its way down and we have a lot of institutional failures, or some larger cataclysm involving derivatives create some sort of black hole of finance. In your mind, if deflation really takes control and the central banks are impotent to really do any thing next, what happens?
Steve Keen: Well, the deflation is lower. We have certainly had deflation, but it is lower than the last time around. In the 1930s, we had deflation running at 10% per annum for a couple of years there. The major reason for that, I believe, is that in the 1930s, the nonfinancial business sectors were largely in debt. Its debt ratio when the crisis began was 125% of GDP, and therefore businesses were the ones who were insolvent when the crisis hit. Their reaction was to cut their prices to try to drag customers in through their doors rather than their neighbor’s doors, because they all did it, and therefore there was this dramatic falling of prices. That debt was paid down, but the prices fell faster than the debt fell. Therefore, you had serious deflation.
This time around, the nonfinancial business sectors peaked in America to about 70% of GDP. Large, but far less than the Great Depression, and sustainable. The household sector is deleveraging from a much higher level of debt than they had in the Great Depression. Roughly 25% of GDP was the household level of debt back in the 1930s; it rose because of deflation, but it did not get too high.
This time we are starting at four times that level. And the trouble for households is, they cannot de-lever anywhere near as rapidly as businesses can, because businesses can get out of debt three ways. They can go bankrupt, they can stop investing, and they can sack the workers. Households find it very embarrassing to go bankrupt, it is very hard to stop consuming, and they cannot sack the kids. Therefore, consequently, it is a very slow-grinding deflation.
When it comes to what the central banks and the governments are doing about that whole process, they are afraid of a systemic breakdown in what you can pretty much call the repo market. They repurchase agreements that are a major part of how banks fund themselves by selling a bond or a financial instrument of some sort to another bank and agreeing to buy it back at a higher price and at a later period. That is such a fundamental part of the whole chain in the payments between banks.
The scare that all the central banks have is that the chain breaks down, and it breaks down when a bank says I am not going to buy a bond off somebody and expect to sell it back to them for a higher price in 30 days time, because I know my bonds are shonky, and therefore their bonds are likely to be shonky. Therefore, the whole repayment scheme that existed at that level stops, and suddenly the whole banking system freezes.
That is the real fear that they have. And the other fear, which we accessed at the time of the Lehman Bros.’ collapse, was that the Lehman Bros. had cornered the commercial paper market. And these days, unfortunately, because the banks have been seen so derelict in their duty, that is how nonfinancial corporations mainly fund themselves – by issuing very short-term paper to pay the wage builds and to pay for the material inputs and so on.
When Lehman’s failed because they cornered the market, the commercial paper market failed, and that meant they literally did not have the money to pay wages that week. Now, that is what really put the bejesus up at Hank Paulson. They are afraid of a repeat of that. It is quite possible that we would see a repeat if you had a series of banks folding, courtesy of what happens with the euro or what is happening with unsuccessful plays on asset markets, which we saw with J.P. Morgan recently.
Chris Martenson: To continue this on, then, if the repo market falls apart, it is really a sort of domino theory. The BBC put out this extraordinarily beautiful and very helpful graphic where they had a big circle, and the countries were arrayed around and occupying portions of the circle, and the fatness of the arrows going from one side of the circle to the other showed the amount that each country owed to the next country. Everybody owes everybody in one giant circular piece. If everybody owes everybody and one person cannot pay, it sort of knocks the whole thing off.
I like to study bubbles, and there are many historical examples, such as railroad bubbles, tulip bubbles, and all kinds of wonderful bubbles. They have a remarkable set of symmetries to them. One is a time symmetry; about as much time as they take to develop, that may be just a little quicker than they unravel. The second is, they tend to sort of return from whence they came in terms of price levels.
If we just nominally said, okay, we are just going to pick a number and say this credit bubble started just even ten years ago. Let us start it in 2000. In the U.S., that means that we would have roughly $20 to $25 trillion of debts that would have to be unwound. We have done, I don’t know, maybe $3 trillion of that, maybe something like that. Is it possible that in this unwinding we are talking about a wholesale destruction? There must be something that central banks can do that they have not done. I have not yet received a time-sensitive check for $100,000 in my mailbox.
Steve Keen: Well, that is actually what you want them to do. I think the mistake they are trying to make is to continue honoring debts that should never have been created in the first place. We really know that that the sub-prime lending was totally an irresponsible lending. When it comes to saying who is responsible for bad debt, you have to really blame the lender rather than the borrower, because lenders have far greater resources to work out, whether or not the borrower can actually afford the debt they are putting out there.
They were creating debt just because it was a way of getting fees, short-term profit, and they then sold the debt onto unsuspecting members of the public, as well, and securitized their way out of trouble. Then they gave the hot potato to the public. So, you should not be honoring that debt; you should be abolishing it. However, of course, they have actually packaged a lot of that debt and sold it to the public as well. You cannot just abolish it, because you then would penalize people who thought they were being responsible in saving and buying assets.
So I am talking in favor of what I call a modern debt jubilee or quantitative easing for the public, where the central banks would create central bank money. We cannot destroy or do the abolition of debt, which would also destroy the incomes of people who own the bonds banks have sold. We have to create state money and give it to the public, but on conditions that if you have any debt, you have to pay your debt down, with no choice. Therefore, if you have debt, you can reduce the debt level, but if you do not have debt, you get a cash injection.
Of course, this would then feed into the financial system, the financial sector, which would have to reduce the value of the debts that it currently owns, which means income from debt instruments would also fall. So, people who had bought bonds for their retirement and so on would find that their income would go down, but on the other hand, they would be compensated by a cash injection.
The one part in which the system would be reduced in size is the financial sector itself. That is the part we have to reduce, and we have to make it smaller. That is the proposal that I am putting forward, and I think there is a very little chance of implementing it in America for the next few years – moreover, in my home country, because we still think we are doing brilliantly down under.
But, I think at some stage in Europe, and possibly in a very short time frame, that idea might be considered, because the crisis in Europe, as we know, is giving countries like Spain with unemployment rates of 25%. Social cohesion cannot hold with unemployment at that level. Particularly when the other policies the government is trying are battening on the poor people that never benefited from the bubble in the first place.
Chris Martenson: Right. No, I completely understand your proposal. It makes more sense to me on a number of levels, including the whole moral hazard level of basically making whole banks that never learned their lesson in all of this. One thing that we know about banks is, if they do not learn their lesson, they will not learn their lesson. I see J.P. Morgan’s recent activities just demonstrating that business as usual be returned to as soon as possible without some sort of corrective event of some kind.
Steve Keen: Yeah. They have to suffer and suffer badly. They will have to suffer in such a way that in a decade or so they will be scared from never behaving in this way again. You have to reduce the financial sector to about one third of its current size, and we have to also ultimately set up financial institutions and financial instruments in such a way that it is no longer desirable from a public point of view to borrow and gamble in rising assets processes.
The real mistake we made was to let this gambling happen as it has so many times in the past. However, we let it go on for far longer than we have ever let it go on for before. Therefore, we have a far greater financial parasite and a far greater process.
Chris Martenson: Understood. So, let us imagine, for private individuals, how would you recommend protecting ones assets, wealth, purchasing power, or one’s future?
Steve Keen: Well, in a situation like this I think dealing in cash is the safest way to survive. If you are dealing with cash, you are not going to be hit by debt problems, and you can be a vulture shopper, so to speak, if assets come on shapely. Being in cash is the best idea, but of course you can also make money by gambling on assets like gold. But the great danger is, I really do not trust that there is as much gold out there that people have bought. There are people who will find plenty of fraud there, too.
Bill Black keeps on reminding us that we have to concern ourselves about fraud, and I think people who thought they had gold and gold certificates actually might find they have gold fraud on their hands. I think the safest option is to be in cash in your national currency. Of course, the great trouble about that is, if you liquidate or you are in debt and go into cash instead by selling assets, you help cause the process that brought the overall system down.
So we cannot just do it at the individual level. We have to get together, we have to campaign, and change society to stop the thing dominated by the finance sector. I think that means collectively, which is a rare event for Americans, but I think it is about time they try it.
Chris Martenson: Well, we are going to try everything else first, but I am with you. Therefore, I understand you are finishing up a new book. Can you give us its title and a quick overview of what is in there?
Steve Keen: I am actually thinking about writing a new one. I know Paul Krugman has got a book called End This Depression Now, and I think he has the naïve belief that you can end the financial crisis with a big enough government deficit. He is ignoring the impact that private sector deleveraging has, because he ignores all of the debt.
I am thinking of writing a book, and I have not quite thought of the title yet, but it will be going from the way that I model endogenous money creation and simulate the financial system. And so let’s try a few different options here and see which one works best in the hypothetical economy, while also talking about the real levels of debt and the impact of private sector deleveraging. I am hoping to have that book started in about August and finished by the beginning of next year.
Chris Martenson: All right. Maybe a working title could be It’s the Banks, Stupid.
Steve Keen: That is not bad, Chris. I might even owe you for one on the copyrights to that. Yeah.
Chris Martenson: That will sell well in America, anyway. Well, fantastic. So, how can people follow your work, and where are they going to find your book when it comes out?
Steve Keen: Okay. Well, because Debunking Economics, the second edition, is around and alive right now, they can buy that on Amazon if they felt like it, and on Kindle, and of course at the local bookshop. I have a blog called www.debtdeflation.com/blogs, and I am about to rationalize those websites by the way and change the way I interact with the public a bit. It get’s a bit rather complicated with my current system, but that is the main blog that they can go to, www.debtdeflation.com/blogs. You might listen to the broadcast of the BBC radio for analysis program, which is going to air in about ten minutes. When we are recording, it will be up on the podcast site for BBC radio for this week.
Chris Martenson: Fantastic. We will put a link to that, as well, at the bottom of this when this loads up at ChrisMartenson.com [now PeakProsperity.com]. Thank you so much, first for the work you are doing, and second for taking as much time as you do to explain it and make sure that you spread the word as widely as you can. It is such an important dialogue and debate to be having, and thank you for coming on this program.
Steve Keen: You are welcome, and I am glad you are there.
Chris Martenson: Thank you.