As many readers of this blog will know, Steve Keen is generally the economist credited with best foreseeing and warning about the 2008 financial crash. The 13th chapter of his book is dedicated to showing why his framework foresaw it, and what he did to warn of the coming crisis.
I have seen a few people saying that Keen didn’t really predict the crisis, and what predictions he did make were ‘chicken little’ predictions – repeating “there will be a crisis” until there was one. This is simply not true.
He certainly had the appropriate framework to foresee the financial crisis. His 1995 paper on Minsky and financial instability contains a model prone to endogenous fluctuations, and he concludes that any period of tranquility in a capitalist economy should not be accepted as anything other than a lull before the storm.
The key ingredient in Keen’s framework is, of course, private debt. Since banks create credit ‘out of nothing,’ new private debt adds to nominal aggregate demand. It follows from this that aggregate demand is current income plus the change in debt. I will quote Keen’s numerical example in full to explain why:
Consider an economy with a GDP of $1000 billion that is growing 10% per annum, where this is half due to inflation and half due to real growth, and which has a debt level of $1250 billion that is growing at 20% per annum. AD will therefore be $1250 billion: $1000 billion from GDP, and $250 billion from the increase in debt.
Imagine that the following year, GDP continues to grow at the same 10% rate, but debt growth slows down from 20% per annum to 10%. Demand from income will be $1,100 billion – 10% higher than the previous year – while demand from additional debt will be $150 billion.
Aggregate demand this year will therefore be $1250 billion – exactly the same as the year before. However, since inflation is running at 5%, that will mean a fall in output of 5% – a serious recession. So just a slowdown in the rate of growth of debt can be enough to trigger a recession.
For an economy to grow, either income must increase or private debt must
increase at an increasing rate accelerate; this means that even a slowdown in the rate at which debt is decreasing can create a recovery (as with the US in 2010). The higher the level of private debt relative to income, the more dependent the economy becomes, and the more vulnerable it can be to even a mild slowdown in the rate of change of debt. Thus, in the mid 2000s, when Keen looked up the levels of private debt in developed economies, he was taken aback by the exponential increase:
At this point he went public – most of the evidence for his warning of a coming crisis is from the blog he started, and the monthly reports he released on there, tracking the level of private debt and explaining why it mattered. These reports first analysed the Australian, and then the US economy. He also spoke at a number of events, as well as a few TV and radio appearances which I cannot find online (although the media didn’t really start to take notice until the crisis began).
As a brief aside, I’ve seen a few people mention his failed prediction of the Australian housing crash, and his subsequent having to take a long hike. It is true that he got this one wrong, but there is quite an easy explanation: the government injected a large amount of money into the housing market in the form of first time buyer grants. Coupled with Australia’s resource boom, and the demand from China, this has kept their economy afloat so far.
So the charge that Keen did not predict the crisis, or simply shouted ‘there will be a crisis’ for 10 years until there was one, is false. He has a clear analytical framework that has performed incredibly strongly empirically, both before and throughout the crisis, and he got the dates approximately right (he said 2006). In my next post I will take a more in-depth look at his models and their implications for where we are now.