Why is the US economy crashing?
Janszen Interview with Australian Economist Dr. Steven Keen: Part I
Dr. Keen is an economist for the University of West Sydney. He specializes in long term macro-economic trends with expertise in Debt Deflation, a rare economic and monetary process now taking place in the US, UK, Australia and other countries.
- What is debt deflation?
- Why it is occurring now?
- What impact on the financial system, economy, households and businesses?
Before we get into the interview, we start with the latest post from Dr. Keen's debtdeflation.com blog.Why Now?Janszen [J]: Thank you for granting us this interview. My first question is to get our reader’s level-set here because we’ve talked about this concept of debt deflation for a while but many readers may be new to it. First of all, you’ll agree the process that particularly the US but some other Anglo-Saxon economies are undergoing right now is a debt deflation. Would you agree?
There has been no shortage of commentators and players willing to vouch that this is the worst financial crisis they have ever seen. Equally, there has been no shortage of bailout moves by the Federal Reserve–remedies that put “the Greenspan Put” to shame in their magnitude.
And yet the market meltdown continues, and the casualties continue to mount, with Bear Stearns the latest–and surely not the last.
In all this, no one yet seems to have posed the question of “why now?”. Why is the crisis clearly more severe this time than ever before, and why are remedies that worked relatively quickly in the past (remember the fast turnaround of the market after October 1987, and the rapid recovery from the rescue of Long Term Capital Management?) failing today?
The answer is, simply, that the world has never in its history carried the level of debt that it is carrying today. The remedies that worked when America’s private debt to GDP ratio was a mere 150 percent (see Figure 1) are inadequate when that ratio is 275 percent.
Figure 1: Debt to GDP Ratios over the Long Term
Those remedies worked in the past, not because they “solved the problem”, but because they encouraged the renewal of the debt accumulation process. Each Federal Reserve rescue was followed by a renewed growth of debt relative to income–without which, the economy would have gone into a slump, rather than a boom.
The traditional cure to a financial crisis–to restart the debt accumulation engine–can’t work this time, because in America today, there’s no-one left to lend to (there is no sub-subprime borrower), and no lender willing to risk its capital in yet more debt.
So the dominoes will continue to fall. Manoeuvres like extending the range of securities that are eligible for the Federal Reserve’s repo window will provide temporary liquidity. But while that liquidity exists, the financiers then have to find someone else willing to give them the medium term credit needed to honour the other side of the repo agreement–to buy the securities back from the Fed when the repo agreement expires.
That could be when the next dose of the proverbial manure hits the proverbial fan. The repo agreements that the Fed will arrange will doubtless involve discounts to face value of the bonds being accepted as securities. The firms that take out that temporary liquidity then have to buy those bonds back–and without reserves to draw upon, that will involve further debt.
What odds that it won’t be possible to find that debt, unless the bonds can be repossessed at a higher still discount? What will the Fed do then? Bankrupt the primary dealers who can’t honour the second leg of their repo agreements? Validate the folly of sub-primes by permanently buying the toxic securities they have accepted as collateral–and at what discount? And, with what money, since the reserves of the Federal Reserve are dwarfed by the scale of outstanding private debt?
So the real fun on the markets will begin in three months time, when the credit extended by the expansion of the liquidity window yesterday by the Federal Reserve has to be repaid.
Keen [K]: It’s certainly a debt deflation in the U.S., Australia, and the UK. Whether it is occurring elsewhere in Europe is a question mark. France is an unusual example of a country that is not suffering an enormous burden of debt compared to GDP and inflation at the moment from historical standards, and compared to where we were in the 1970s where we suffered from stagflation, inflation there is quite low. So my sense is that danger is we already have one of the two debt deflation recipes there. It is possible that we can expect something as horrific as the 1930s to recur.
J: What is you definition of debt deflation?
K: Okay. A debt deflation is where you have an unsustainable level of debt in an economy, so a level that has already caused a crisis and therefore the types of affects we’re seeing with a credit crunch start to occur. And those are regarded as threefold. First of all people try to reduce their debt. Secondly, banks that were allowing a large rate of creation of new money are no longer willing to allow the creation to occur, certainly not at the same rate. And thirdly the banks are tempted to in turn reduce available funds for re-lending that in particular drops drastically. So rather than going to an airport and having to fight your way past half a dozen booths that are trying to give you a new credit card, suddenly credit cards scarce and you’ll find your credit card limits being reduced rather than expanded.
So those combinations come together and you’re going to have a downturn driven by those factors of reduced credit and tightened credit plus the excessive debt level and the basic elimination of investment due to people trying to pay their debt down rather than trying to invest. That gives you a downturn, and then on top of that you have falling prices and they can come about for a range of reasons. If there is distress selling taking place people who are in debt are trying to move their product more rapidly to improve their cash flow and reduce their debts. You can bet they can actually cause a cascade over from falling asset prices into falling consumer prices with the impact of that, and very visibly this is what happened in America in the 1930s, this actually increases the ratio of debt to GDP because two factors of price declines and debt repayment occur simultaneously.
First the rate of GDP growth stops and becomes negative so GDP is actually falling and then it starts falling doubly fast because its falling in nominal terms. Therefore the debt, even though you pay down the debt in monetary terms, the actual ratio of debt to GDP rises. So with America’s debt situation at the beginnings of the Great Depression in the 1930s the ratio of debt to GDP was as shown in the chart above but that ratio rose 65% courtesy of deflation in the first two years of the Depression.
J: The US experienced in the 1930s and to a certain extent the Japanese in the 1990s a spillover effect of asset price deflation into the real economy resulting in a decline in the general price level. In the 1930s most governments were operating under a gold standard which made inflation difficult, and the Japanese experienced deflation (although it was never a runaway deflation, never more than 2% in a year) attempted to internalize their problems unlike the US which has been externalizing its economic distress by depreciating its currency.
K: Yes. That’s true.
J: So our understanding of what occurred before during commodity price deflations is that a lot of the decisions that were made that created that result were political and not mechanical or monetary. In other words, the US put a lot of emphasis on protecting the value of the dollar at a time when the policy in retrospect should have been to allow the dollar to depreciate in a way that would have benefited the US but maybe not so much foreign investors in the US. The politics was: let the deflation occur, let the dollar appreciate and let the economy and the market clear itself.
K: I think there was an internal endogenous dynamic to this as well. It isn’t just bad political decisions during a debt deflation that leads to commodity price deflation and that’s one reason why I’m trying to go back and create a model to simulate it to see whether it's something that is entirely driven by its own dynamic or whether you need some external policy mistake to make it happen. The results I see and my interpretation of Fisher’s theories and Minsky’s theories say the dynamic is endogenous. It is something which will occur in a debt deflation even if the policy makers do what looks like the right thing under the circumstances, even if they avoid trying to realign consumer prices with asset prices.
J: One of our observations from reading the history is that in 1933 when FDR called in gold and re-priced it the US had an instantaneous 40% inflation and this was done simultaneously with a bank holiday where all the banks were closed and all but 20% were reopened. Thus confidence was somewhat restored in the banking system and the inflation stimulated demand. Everyone believed that the banks that were open were actually solvent and that largely ended the credit crisis. The economy actually grew quite strongly from that period, from 1933 to 1937. It reminds us very much of the post stock market bubble period from 2001 to 2007, actually. We had a more modern approach to reflation in 2001 than in 1933 but it had a similar result, creating a temporary inflationary boom. Debt was expanded, too. A lot of people forget that the stock market in 1937 had almost risen to the same level as 1929, in nominal terms, but in real terms only increased by about half and again this was very similar to what we’ve seen over the last seven years where the DJIA is close to its nominal peak but in real terms is down about 15% - 20% or so. So it appears to us the parallels are interesting. The question is, can they be used again to manage debt deflation?
Unemployment is rising in 58 of 58 California counties as of Jan. 2008
K: This is partly where I think the Minsky analysis goes wrong. The presumption is the Fed has an intimate role in controlling the money supply and from the point of view of the research that I do that comes from the post-Keynesian perspective – and its also known as the Circuit school coming out of Europe, mainly out of Italy – the argument is the money supply is predominantly endogenous, in other words predominantly under the control of the relationship between the financial sector and household and business sectors. The government’s contribution is like a second way ‘in’ of creating additional money. So it certainly does have the capacity to create money both in fiat terms and then credit creation on top of that. But it is comparatively minor compared to the impact of the endogenous capacity of the financial system can generate credit. So when you have a downturn like we had in the 1930s – and in Japan recently too – you can have actions taken by government fail abjectly to increase the money supply by directly manipulating the components that it controls and then waiting for the flow-through effects for the rest of the system to amplify that. Policies designed to restore money can if necessary include depreciation of the currency.
And I say abjectly because the scale of what the government does is like trying the raise the level of the river by putting a hose into it. The amount you’re contributing to raise the water level is tiny compared to the impact of the volume of water draining out. With all that endogenous capacity it’s very hard for the government sector to do anything to counter the impact of what that financial and industrial component is doing.
J: So you’re point is it’s a scale issue. I guess our interpretation of Keynes’ contribution to all this is to say that when the endogenous credit system breaks down the government can temporarily step in, stimulate demand and get the endogenous credit system restarted. The government doesn’t substitute for the endogenous credit system but steps in to prevent it from completely spiraling down to the level of dysfunction that we saw in the 1930s. That’s why the Fed is making loans to non-bank institutions that are part of the endogenous credit system.
K: Yes but I think Keynes underestimated how big a problem that was, and I think also other aspects of reflation besides manipulating the money supply. Ben Bernanke famously said that, “If we do actually find ourselves in a deflation we can take comfort in the fact that the logic of the printing press will restore inflation.” Returning to the hose in the river analogy the most recent instance to refute that is what happened in Japan in 2001 or 2002, the Japanese monetary authorities increased base money by over 25% in one year. Now you’d expect that to restart the endogenous credit system and create some inflation and have solved the problem. In fact a year after that 25% growth in broad money the rate of inflation in Japan was negative once more. The rate of deflation actually rose from minus 0.5% to minus 1% in wholesale price terms, so this isn’t something that can be addressed merely by growing the money supply. That’s what scares me because that’s the policy that monetary authorities have committed themselves to.
J: Here’s our observation from reading a lot of Bernanke’s writing going back to 1983, snd if you may remember that here in the United States when he was brought on board he was sold to the public as a keen student of the Great Depression. That tells you a lot about what they were expecting when they hired him. And what he wrote in a lot of his papers was that the big mistake that the US made in the Depression and that the Japanese also made in the early 90s was not shifting from interest rate to inflation targeting and maintaining inflation to prevent real interest rates to turn negative. Priority #1 in a debt defation is to even if they hit the zero bound they must keep inflation above zero because once they hit the zero-bound that there was nothing much more that they can do to stimulate demand. The moral they took away from past was target inflation and in so doing prevent asset price deflation from evolving into a deflationary economic crisis. So far they seem to be sticking to the program.
K: In fact though if you just saw the most recent figures for the CPI in America the rate of increase in February was zero. Now from the point of view of the very conventional economists who dominate Australian policy that would be just fine here because managing inflation is all they obsess about. At least Bernanke realizes debt deflation is a risk over there but I also agree there are plenty of inflationary forces taking place in the US and that the zero CPI number may be a misleading one month figure. That’s my other great fear, that the circumstances on the planet, generally speaking in favor of inflation, are being created by global warming and peak oil and are causing a rise in the cost base worldwide. But it’s feasible that a sudden collapse in the utilization of capacity due to the debt deflation can lead to a whole chain reaction effect of people having to liquidate to meet debt payments leading to a potentially deflationary effect and a much lower cost level. The combination of cost push inflation and debt deflation could lead to a demand crash and deflation spiral and once that happens I don’t believe there’s any effective monetary means of fighting it.
J: Friends who run public and private tell me they have experience cost push inflation for a number of years because of the depreciated dollar and high input costs for many traded good,s especially energy, and anything else they have to bring in or that competes with materials they bring into the country. This is now started to feed into the prices they have to charge for their finished products. Price in creases at restaurants are the most obvious symptom. The net effect this is quite extraordinary because we also have very low savings rate here and people have a lot of debt. So as we go into recession and unemployment begins to rise we have this perverse situation here where wage-earners don’t have any pricing power in the market so they can’t demand higher wages. On the other hand many businesses they encounter, whether a restaurant or any business that is producing a product that is not coming from a country that manages its currency the way China can, prices are going up. So what’s occurring the worst of both worlds: businesses in order to stay in business to maintain profits have to raise prices (or use cheaper ingredients or smaller portions) as their input prices go up. Wage earners can’t pay more so they either buy items less frequently or will consume cheaper versions of the same kind of product. That’s the process we are in right now.
K: You’ve made a good point because here in Australia, in our case we haven’t been suffering a depreciating currency whereas America does have this massive impact of a depreciating currency and it is only going to get lower, too, and that will continue to cause inflation and rising cost levels which is a complication that I do not have to factor into my thinking about my own country. But to me the dilemma goes one step further and that is that your wage earners are not in a position to push up their wages but in fact that really means that the cash flow that businesses are getting is being constrained on two sides. This is different from the situation like you did in the 1930s when there was very little need to worry about America importing inflation from a depreciating currency because it was so much a more self-sufficient economy in the 1930s than it is now. That prospect could lead to rising wages and the whole thing could cause inflation that would erode the outstanding value of the debts.
Real incomes needed to repay debts started to decline rapidly at the end of 2007,
fueling debt deflation, falling demand and rapid descent into recession
J: Bingo. Currency depreciation driven cost-push inflation is good in a debt deflation and asset price deflation, right? Isn’t that the question, how to create inflation when the endogenous credit system is on the fritz? The cycle of currency depreciation and traded-goods price inflation is a natural brake on the deflationary impact of falling assets prices. Eventually, as you say, it will lead to wage inflation. That will be the next problem to solve, politically.
K: The process is in effect conscripting the cash flow that companies have available to pay their debts and at the same time of households who are facing high rising costs are having a restricted ability to repay their own debts so they’re both much more likely to go bankrupt. So you’re getting like a super-inflation coming out of that or a super-stagflation. It’s actually in a sense a completely new phenomenon.
J: Yes, we are very inventive here. I want to explore that point more. The only experience we’ve had with stagflation was in the 1970s and I think the way everyone remembers as a long period of recession and inflation throughout the 1970s. In fact we had two recessions and inflation was very volatile throughout the period. We’d have one month when inflation would be 9% and then the next month it would be 0%. Inflation was all over the place. This is when commodity prices, and particularly precious metals, were going way up because it was very difficult for the market to design wage and other fixed price contracts that required a steady expectation of inflation. This is a point I’ve made to readers over the years, that societies can function with seemingly absurd levels of inflation for many years as long as the inflation rate is fairly constant. What does the yield on a 10 year US Treasury bond mean when inflation is 0% on month and 6% the next? That’s what we are seeing again today. But in order to get money out of hard assets and back into the financial sector, out of the commodity sector, the US Central Bank in the early 1980s had to raise interest rates all the way to 20% until the spread between CPI inflation and the yield on the thirty-year bond was 9%.
K: Huge. That is what it takes once inflation expectations become embedded.
J: That’s what was necessary in order to convince capital to move out of commodities back into financial assets. The way most people remember the period was a lot of unemployment and prices declining as the transmission of wage inflation into prices was broken. So most people assume that what really got rid of the inflation in the early 1980s was busting up the unions and the break in the wage inflation. I’d like to hear your comments on this, but my understanding is that that was part of it but it wasn’t by any means the whole story. Stopping wage inflation was only part of the story.
K: A large part of the story was an enormous debt bubble. Most people look back on the 1970s don’t realize that a debt bubble back then had burst. And that happened both in Australia and America and so to give you a very rough idea of it we’re talking about a much smaller scale than what we’re going through now of course. The private debt-to-GDP ratio in America peaked at 97% in the mid 1970s and then fell down to 91% in the aftermath of 1980s Fed policy actions. And that decline in debt finance expenditure was actually a large part of the recession that occurred at that time. It was a speculative bubble. It burst but it was not nearly as obvious as when the 90s speculative stock bubble burst. The bursting of the 1970s credit bubble was a large part of why we had a major downturn in the economy. Inflation was overlaid on top of that courtesy of the momentum of the economy beforehand and the Vietnam war effect as well. You had a booming economy, high wage demands with workers driving up their wages in an attempt to get ahead of price inflation. And of course those high real wages did occur for a while, certainly in Australia they did, and to some extent also in America. But that was then eroded by subsequent stagflation, high rates of inflation in a stagflationary period.
If we hadn’t had that inflation then if OPEC hadn’t come along after the stock market bust in the early 1970s and after the downturn began, then we could have had a deflation back then and that would have been a damn sight worse then what we went through. It’s amazing but we don’t realize how bad the period could have been, the alternative could have been a 1930s style deflation.
J: That’s a very interesting point. It’s long been the iTulip hypothesis – we came up with theory called the Ka-Poom Theory which presumes the US government will eventually have to inflate fiscal and household debt away, that is, both the private sector and public sector debt, and the mechanism of this would be depreciating the currency which would be self reinforcing with respect to the response of US creditors.
K: I’m not so certain they’ll do that. That’s a policy guess.
J: Yes. That’s a policy guess, of course. But doesn’t it appear that is exactly what they are doing?
K: I definitely agree with the idea of the “Greenspan Put” and that’s obviously been a deliberate policy throughout the past 20 years, that whenever the financial system, the Wall Street system, gets itself in dire trouble the Fed will come in and effectively negate the mistakes it’s made at whatever cost that might involve. But it also simultaneously been on top of consumer price inflation; when they come in and validate what Wall Street’s doing, they’re validating asset price inflation and in fact as a result, they’ve driven the gap between asset prices and consumer prices to historically unprecedented levels and that, from a Minskian point of view, means that realignment of those prices is going to also be historically unprecedented in scale.
NASDAQ Bubble: $7 trillion in fictitious value
Housing Bubble: $12 trillion in fictitious value
Technology and housing bubbles created trillions in fictitious value that must be dissipated
J: Are you familiar with Dr. Michael Hudson over at the University of Missouri?
K: Yes. In fact Michael and I correspond occasionally but not often enough.
J: He’s a very smart and a very original thinker in my opinion with unique historical depth to his thinking. I particularly appreciate his observations of the construction of the US economy as really two economies: the FIRE Economy composed of the finance, insurance, and real estate sectors and the production-consumption economy. In his view the Federal Reserve has policies which are intended to maintain low all-goods price inflation, particularly the wage inflation to prevent the transmission of wage inflation into the price complex, but at the same time has as its mandate to continuously inflate asset prices.
K: That’s right. I agree with that. In fact you can see if you take a look at Robert Shiller’s housing data in particular you get a very good view as to just how ‘extreme’ that policy has been because when you take a look at the ratio of the DJIA compared to the Consumer Price Index over the long term, I’m talking from 1915 through to 1995, Shiller has done his work in his second edition of Irrational Exuberance: Second Edition you see the ratio of the Dow to the CPI at 100 in 1915, which is when the Dow series begins, and over the entire eighty years period from 1915 to 1995 the average ratio is 255. Recently the value peaked during the 2000 stock market boom and almost returned to it in 2007 at 1,240, in other words pretty close to five times the long-term average.
There can be no relationship between asset prices and consumer prices like that again. This ratio is always mean reverting. Even in housing that almost in some ways is even more extreme the ratio is lower. Doing the same thing, again with Shiller’s data, starting back in 1892 concerning the ratio of home prices to the CPI the ratio is 100 in 1890. The average made in 1890 right through to 1995, so we’re talking 105 years, the average was 103. It peaks in 2004 at around 228. And it rose to that level in from roughly 1997 at 115 to 228 just in the last twelve years. The scale of the bubble, and the scale of the evaluation of asset prices relative to other prices that the Fed has allowed to happen is utterly unprecedented.
J: Professor Shiller, by the way, he gave the keynote last week at the 22nd Annual Conference of the Boston Security Analyst’s Association that I attended. His basic thesis, as you know, is that home prices nationally in the US tend to track the rate of inflation and that’s about it. Any delta between home prices in aggregate across the US and the rate of inflation over the same period is asset price inflation.
K: I don’t think that Shiller necessarily understands the dynamics as well as he understands the empirical side.
J: He does understand the empirical process but not so much the political and financial system dynamics. I wrote a Harper's Magazine article The Next Bubble (cover article, February 2008) to help explain those dynamics, the interaction of the US political system, Wall Street, the press and so on interact with the economy in the context of Fed policy to produce asset price inflations.
K: He’s done a very good job there from a neoclassical standpoint but that approach makes it hard to understand these developments the way you can if you analyze from the point of view of Minsky and Keynes.
Interview with Australian Economist Steve Keen: Part II
"...under a floating exchange rate system, an initial disturbance (either domestic or foreign) can create an exchange rate inflation spiral. That is, the disturbance can set into motion a cumulative process of inflation and exchange rate depreciation, through which exchange rate effect is rapidly translated into domestic prices and costs and back to the exchange rate."
- Is stagflation always a transitory state for an economy or is structural stagflation possible?
- A stunning rate of economic decline due to the impact of debt deflation on aggregate demand
- Wage inflation: the only way out? And other economic heresy
- Source: IMF, Onis and Ozmucar, 1990: 137
The quotation above and image to the left lead us to the second part of our interview with Dr. Steven Keen.
Can you imagine the Fed pursuing a policy of wage inflation now to end a debt deflation spiral the way the Fed did in 1933? Probably not until the financial and economic crisis becomes as politically challenging as in 1933, which means not until the US experiences a period price deflation. But the US government has been creating inflation via depreciation of the dollar since 2002 as part of an effort to boost exports to support economic growth. Six years later that policy has developed into a self-reinforcing cycle of currency depreciation and inflation.
Has the stage for the necessary wage inflation been set as a consequence of previous policy accidents?
In Part II for iTulip Select subscribers Dr. Keen explains where he believes the US debt deflation is headed and Janszen introduces the concept of America's unique post credit bubble dual demand destruction spirals. Part II ($ubscription)
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