Last week I pointed out the fundamental, systemic flaw in our current monetary system:
The money supply can only expand through an increase in private debt. If debt is paid off, the money supply will contract, so private debt needs to keep expanding to ever greater levels to keep the money supply increasing in line with productivity. But households and businesses can only sustain so much debt, so a crash becomes inevitable.
So is the next crash inevitable? Well by coincidence, Professor Steve Keen just had a new book published in April, titled “Can we avoid another financial crisis?”, so it seems worth taking a little detour to see what he says. (This is a very brief summary, with a few of my own interpretations mixed in – I hope I do him justice. But basically, buy the book – it’s very short and clear.)
Keen’s book starts by reviewing the state of macroeconomics before the 2008 financial crisis. The dominant models, used by economists and governments everywhere, were ‘Dynamic Stochastic General Equilibrium’ (DSGE) models. Keen describes briefly how these models evolved from earlier theories, but the key point for you to know is that they are rooted in the dominant neoclassical theory, which predicts that free-markets will lead to equilibrium. And from the ‘80s onwards peaks and troughs in the economy became less pronounced and less frequent – each crash was less severe than the one before. This was known as the ‘Great Moderation’, with the likes of Gordon Brown hailing the end of boom and bust.
So everything was looking great, and DSGE models predicted that 2008 was going to be a bumper year…
Meanwhile, Keen’s own models were predicting a crash, based on the work of Hyman Minsky and his ‘Financial Instability Hypothesis’. Minsky worked outside the mainstream of neolassical economics, and had the great insight that to be able to explain the Great Depression of the ‘30s you had to have an economic model that can generate a depression. Equilibrium models can neither explain nor predict crashes or crises because these models assume that the economy is heading towards equilibrium – the assumptions of these models are set so that the models will predict equilibrium (thereby justifying unregulated free markets) and no-one ever seems to mind how ridiculous these assumptions are.
Minsky developed a theory of why markets are actually unstable, and will tend towards a crisis (there’s not time to explain his theory properly now – we will look at Minsky in more detail when we consider financial markets).
Keen describes how he developed his own models from Minsky’s work, and in 1992 his model predicted a crisis preceded by a long-period of moderation with the market peak and troughs decreasing in size before the crash came. The seeming period of calm merely hides continued growth in private debt.
Keen raises the importance of the ratio of wages to Gross Domestic Product (GDP – the value of the goods produced by a nation in a year – we will look at this in more detail in the next section of the blog). Over the last 15 years this ratio has fallen markedly, which means that a greater proportion of business income is going to profit and less is going to wages. This is a very significant phenomenon that has transformed financial markets in ways that are not widely understood (Keen doesn’t actually look at this, it’s the subject of recent work by Zoltan Pozsar and Perry Mehrling). We will look at these effects in detail in a future series of posts. In several places in his book Keen emphasises the importance of income distribution in influencing the path the economy takes, a point I made in this post.
But Keen’s main focus is in on the ratio of private debt to GDP, the topic of last week’s post. Remember, I argue that the root, systemic flaw in our current monetary system is that it requires ever increasing levels of private debt. Because Keen’s understanding of the economy told him that this was the most important indicator of a crash, he watched with concern as it rose rapidly in the early part of this century – if his model was accurate (and it had accurately predicted the ‘Great Moderation’) a crash was on the way, and from 2005 he began to warn in earnest of this.
Once private debt has risen to 150% of GDP you are in a danger zone. Minsky’s theory would predict a crash starting with a slow-down in private debt, which is what happened in 2008. The simplest way to think of it is as the private sector not being able to sustain its level of debt, therefore reducing that level and credit correspondingly slowing down. However, a more accurate summary of the technical detail of 2008 is that lenders lost confidence (rightly) in the value of specific morgage-back securities (the famous CDOs) that were being used widely as collateral in financial markets (a dynamic I briefly explain in this post). Credit lines dried up, and the resulting collapse in Lehman Brothers demonstrated that all the institutions in the market were so interconnected they could all bring each other down. With credit not flowing, the economy choked, and governments had to step in.
Some economies were worse hit than others and some were better able to weather the storm (Keen’s description of the reasons for this is very insightful, but would take too long to discuss here). But these economies have since seen their credit continue to rise, and the likes of Ireland, China, Hong Kong, Australia and Canada are likely to be hit worse by the next crash. Keen suggests a severe economic crisis is likely in the latter two countries by 2020. The current prime ministers will get blamed, but it is nothing to do with their policies – this is the result of processes unfolding since the ‘80s.
But can we avoid it? Keen does suggest some policies that could possibly avert or mitigate it, and there are other proposals by economists and campaigning organisations with a similar analysis of the economy. Yet the answer is no, and the reason is largely politics, not economics.
To accept any of the suggestions being made you have to reject the orthodoxy of mainstream economics. And can you see thousands of economics professors across the world accepting that they have been, crudely speaking, wrong for most of their careers, and now backing such proposals? Rather, they are more likely to defend the theories they have spent their professional lives advocating. And these theories justify the dominant political ideology that underpins all of Western civilisation – free markets, individual choice and limited government. There is just no chance of generating the political will to stop the next crash happening.
However, in all this there is hope – I will get to the hopeful bit eventually…