“Economics is too important to leave to the economists.”
- Steve Keen
Hedgeye’s Macro Team hosted a call today with Steve Keen, renowned professor of economics and finance. at Australia’s University of Western Sydney. Keen calls himself a “post-Keynesian” and is critical of today’s dominant neoclassical economics, which he calls inconsistent and unscientific. Keen was hailed as “the economist who most cogently warned of the crisis” of 2007. Alas, this recognition came in 2011. The Real-World Economics Review said Keen’s work “is most likely to prevent future crises.” Professor Keen may not be at the top of the list of candidates likely to replace Tim Geithner, but he graciously made himself available to our clients in an exclusive presentation.
Debt: The Real Thing
Professor Keen says contemporary economic theory rests on a misunderstanding of the roles that banks, debt and money play in an economy. Economists didn’t see the financial crisis coming because they don’t understand that banks create leverage within the economy. Neoclassical economists view banks as intermediaries who loan deposited cash. Superstar neoclassical economist Paul Krugman says that when banks loan out savings deposits, it does not lead to an increase in demand. This is because he assumes increases in debt automatically are offset by increases in the assets within an economy.
But the balance between assets and liabilities is an accounting definition, not an economic truth, and Keen says debt is added to income to dynamically increase the money supply, spurring demand. Keen defines “effective demand” as income, plus the change in debt. When this debt-inflated money supply is invested, it leads to growth in an economy. When it is used instead for speculation, it can lead to disaster.
Keen says private sector debt is completely ignored in policy debates, in the press, and in the work of most academic economists. In a healthy and growing economy, private sector debt stokes growth by fueling demand in excess of the cash income in an economy.
When private sector debt flows from economic goods to speculative investments – when the capitalist stops building factories to employ workers and starts building time-share developments on abandoned farmland – it causes prices of speculative goods to inflate. Price inflation in speculative assets attracts more investment, which creates profits that are used to leverage and create more debt, which is further re-invested in the speculative goods. This is the bizarre economic concept of a “Giffen good,” an item that is in more demand the higher the price goes, and becomes unattractive as the price goes down. If you think this makes no sense, you’re right: just look at the stock market, where rising prices climax in a “melt-up” of panic buying, while price drops precipitate a flush-out as investors sell their losers in despair.
Work by Hedgeye Financial sector head Josh Steiner indicates that housing may behave like a Giffen good. Steiner’s analysis implies that rising house prices cause increases in demand, which meshes with Professor Keen’s observation that increases in mortgage debt have an 85% correlation to increases in house prices.
Keen also finds a close positive correlation between increases in margin debt, and increases in stock prices. The higher the price of a stock goes, the more investors can borrow against it. The more they borrow, the more stock they buy. It should be obvious that this is a vicious cycle that invites disaster.
Keen says the economic crisis can be explained simply by comparing private sector debt with public sector debt. Private sector debt rose steadily as a percentage of GDP from 1993, then started to decelerate after 2007. Professor Keen’s charts show clearly that public sector debt starts to increase at an accelerated rate in 2008-2009, as private sector debt is decreasing. The annual change of private sector debt peaked at well above $4 trillion, dropping to an annual decline of $3 trillion in two years, a huge decline that chopped some $7 trillion out of the economy.
Rising private sector debt is good for the economy until it isn’t, and then it can be disastrous. There is a very high .94 negative correlation between private sector debt and unemployment. Meanwhile, rising unemployment is .82 positively correlated with increases in public sector debt. In short: rising unemployment causes governments to borrow, rising government debt creates economic activity, which creates jobs. When there are enough jobs, there is excess income in the private sector, which makes them comfortable enough to start borrowing again. Which creates jobs. The definition of a virtuous cycle. I think you have the causality backwards here: Normal debt levels affect the prices of goods and services. Abnormal debt levels spill over into the prices of speculative goods. Left to spiral out of control, increases in debt create instability which ultimately leads asset prices to crash. When that happens, private sector debt retrenches quickly and severely.
Meanwhile, government debt expands naturally to fill the void when private sector debt retracts. Keen says politicians who harp on debt reduction are wrong on two counts: they don’t recognize that government debt is reactive, and that the government is not so much in control of levels of debt in the economy. Worse, says Keen, despite Professor Bernanke’s fame as a scholar of the Great Depression, politicians and economists alike have not learned the lessons of history. Efforts in the late 1930s to control the deficit sparked massive private sector deleveraging, which caused unemployment to nearly double, to 20%. Says Keen, the only thing that bailed out the economy was WW II. He fears the stage has been set for a repeat of the scenario, as policy makers try to rush to deleverage our economy.
Keen says we are in the midst of a massive private sector deleveraging which could stretch out for twenty painful years, because policy makers refuse to take bold steps. Excess debt will not be eliminated efficiently because the ways to accomplish this are politically dicey.
The simple answer is for the US to admit we made a whopper of a mistake by financing massive Ponzi schemes in the housing and stock markets. The government could neutralize those mistakes by giving large quantities of cash to people in debt. They would then pay down their debts and spend whatever was left over. (You may recall, this was the original intent of the TARP program, to bail out troubled mortgages.) Keen says our economy can’t get back to sensible levels of debt because timid policies will keep us locked in for the next 20 years.
Keen says it is not possible to clean up excess debt with a policy of 2% inflation – inflation has to approach ten per cent in order for it to take a meaningful bite out of public sector debt. But no one can propose such a policy because it violates government and academic economists’ theories, because people fear inflation, and because Democrats and Republicans alike are caught in the shared fallacy of deficit reduction.
Keen says the only way we will avoid a “lost 20 years” of deleveraging is if we are confronted with a phenomenon that hits us the way the Second World War stimulated our economy. Keen muses that perhaps a major climate change event could scare the bejesus out of Americans and get us moving, but he is not very sanguine on the prospects of anything radical happening.
Until, and unless, such a galvanizing event comes around, Keen says policy steps that could grapple head on with our economic woes are too scary – politicians perceive the risk to their own careers as greater than the risks to the nation. The situation will not change until that perception reverses.