Posts Tagged Private Debt

Debunking Economics, Part XI: Predicting the Crisis

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.


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Exogenous and Endogenous Money: Room for Reconciliation?

A common response made by economists to my previous post on the overwhelming evidence for endogenous money is: ‘so what?’ Economists rarely disagree about the mechanics, but assert that there are no major implications of endogenous money that differ from their theories.  This is a mistake. Reality is so complex that seemingly small errors in a model can have a big impact on its conclusions. As I will show, endorsement of the exogenous money theory causes economists to miss some key features of a capitalist economy.

It is worth noting that the names are perhaps misleading, as both theories contain endogenous and exogenous elements. In the case of exogenous money, the central bank expands the supply of base money, and the reaction of banks to this – how much they ‘lend out’ – is in large part endogenous. In the case of endogenous money, banks create loans as they please, except for an exogenous constraint (the interest rate), set by the monetary authority*. Clearly there is a large crossover between the two theories, but there are also subtle differences, which lead to important conclusions.

A point emphasised by endogenous money proponents is the robust correlation between private debt and other key variables such as growth, stocks and house prices:

Obviously correlation doesn’t equal causation, but it is based a theoretical link Keen often mentions – Minsky’s observation that, in order for aggregate demand to increase, planned spending must be greater than current income, and therefore credit must fill the gap. This is a pithy observation, but it seems to me that, contra Keen/Schumpeter/Minsky, the exogenous money model can account for this: the central bank fills the gap by increasing the money stock. This can cause both an increase in debt and an increase in aggregate demand, but, in contrast to the endogenous story, the increase in debt does not cause the increase in aggregate demand.

In other words, the exogenous story is that central bank expands the money supply, and this increases both debt and AD. The endogenous story is that banks expand credit, which expands aggregate demand and forces the central bank to expand the money stock. Thus both are compatible with the correlation between private debt and growth, although the exogenous story would not necessarily have the correlation so tight, or have private debt moving first every time.

In any case, given the other evidence – that credit money expansion precedes base money expansions, that central banks have failed to control base money in the past, and that anyone who actually works in a bank will tell you they make loans independently of the number of reserves they have – endogenous money appears to have the mechanics correct.

So why does this matter? Well, the exogenous story has the causality backwards: it assumes that banks receive reserves and then ‘lend them out,’ whereas what they actually do is make loans and then balance their reserve requirements afterwards. Obviously this means economics textbooks are wrong about the causal mechanics, but economists will likely plead that it doesn’t really matter. However, it matters for a couple of reasons.

The first is stability: if banks have adequate reserves before they make loans, a bad loan will cause problems for the bank that lent them out. But if the banks depend on each other for reserves, and look after the loans have been made, then bad loans can quickly destabilise the entire system as the availability of reserves dries up, triggering a positive feedback loop rather than a return to normality. Thus the system is highly interlinked, and far more vulnerable to systemic crises.

Even more crucially, endogenous theory means that money is effectively created and destroyed by the banking system. This is because debt-based assets and liabilities expand and contract simultaneously as debts are repaid; in other words, the loan-ee is both the saver and the borrower. When the loan is created it is deposited in the recipient’s bank account; as this is paid down both the asset and liability are discharged. Reserves are a secondary consideration and the availability of them does not affect lending decisions. It is true that, in name, the reserves ultimately come from the central bank. But really the expansion of spending power is an endogenous decision, though the central bank influences it via setting the price of reserves.

Simply put, debt does not cancel out at the macro level; it scales up. Just as it is true for a household that income can be scarce relative to debts, it is true for the economy**, which as a whole can find itself over-indebted.

Economists often realise that disequilibrium and finance are important, but their faulty view of the banking sector causes them to miss the mark. Take neoclassical models such as Krugman’s, which argue debt is merely a redistribution from savers to borrowers, and have to add ‘special case’ considerations to make debt matter. But this is misguided – debt always matters, because money enters the economy primarily as new debt, which the economy must expand to service. Hence, debt must go into productive investments, which create future income streams, rather than bidding up the price of assets. I doubt economists such as Krugman would object to the policy implications of this argument, but their models do not imply it is important.

Thus, the name for endogenous money strongly implies its conclusions: the system is easily destabilised endogenously, and the money stock endogenously expands and contracts to accommodate activity (thus rendering the ‘neutrality of money‘ an absurd proposition in any time frame). The differences in the fundamentals are perhaps more subtle than endogenous money proponents make out, but the conclusions are extremely different, and have strong implications for equilibrium analysis, crises and the relationship between finance and the real economy.

*They can also be constrained by regulation, but that is another story.

**This is the only time I will use a household analogy to communicate a point about the economy as a whole.

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Endogenous Versus Exogenous Money, One More Time

Few debates are as central to the heterodox-mainstream divide as endogenous and exogenous money theories. Neoclassical economists side with the exogenous ‘money multiplier’ idea, which says the banks receive reserves from the central bank, which they then lend out. Endogenous money proponents – generally post-Keynesian – side with another story, which says that banks create loans ‘out of nothing’ first, then the central bank more or less passively accommodates their demand for reserves.

In a final bid to demonstrate to economists that there is a difference between the two theories (and that theirs is wrong), I’m going to go through the age old scientific method known as ‘falsification,’ analysing each prediction of endogenous and exogenous money, and asking whether or not it corroborates with the data.

#1: exogenous money predicts reserves, or base money, would move first, followed by broader, credit based measures of the money supply as this was ‘lent out.’ Endogenous money predicts reserves would move last.

The relevant data was, ironically, put forward most conclusively by none other than the Real Business Cycle theorists Kydland and Prescott:

There is no evidence that either the monetary base or M1 leads the cycle, although some economists still believe this monetary myth. Both the monetary base and M1 series are generally procyclical and, if anything, the monetary base lags the cycle slightly.

By some measures the broader money supply moves many months before the monetary base. This is in keeping with the endogenous theory of money.

#2: exogenous money predicts that the central bank can control the quantity of base money at will. Endogenous money predicts it must play the role of passive accommodation, otherwise the economy will implode.

As John Kenneth Galbraith put it, “Milton Friedman’s misfortune is that his economic policies have been tried.” Monetarism was tried in the early 1980s: in the UK, the US and Chile. But the central banks consistently undershot their money targets and interest rates went wild. The policy certainly succeeded in increasing unemployment and therefore taming inflation, but the attempt to control the money base failed completely. Again, this is evidence in favour of endogenous money.

#3: exogenous money predicts that reserves factor into bank’s lending decisions; endogenous money predicts that they do not, and decisions about reserves are taken after loans are made.

Anyone from the real world – bankers, lawyers, accountants – will tell you banks do not consider reserves when lending. They use double entry bookkeeping to simultaneously create an asset (your loan) and a liability (your deposit, in which the loan is ‘stored.’) The books are balanced; if they need reserves they will borrow them from other banks or, failing that, the central bank.

That the central bank could say no means some might interpret endogenous money as a policy issue, but it isn’t – as I explained in my previous post, it reflects the reality of capitalism: banks must make lending decisions based on endogenous activity, and the central bank must accommodate this. If it does not, the credit markets will simply not work, and credit crunches will ensue.

#4: exogenous money predicts that only the distribution, not the level of private debt matters

In the exogenous story, banks act as intermediaries between savers and borrowers. Money is deposited; the bank lends this out. It does this until it either does not want to lend out for whatever reason, or until it hits the limit of how few reserves it can hold. Private debt simply represents a distribution from one person to another; the level alone should not have much macroeconomic impact.

In the endogenous story, banks create purchasing power out of nothing by crediting their customer’s accounts. This implies that an increase in private debt will add to nominal aggregate demand, and hence that private debt expansion will precede nominal growth, and also be correlated with other economic variables:*

We might expect some correlation between economic activity and private debt in the neoclassical model. But a correlation as robust as this, with private debt moving first, strongly supports the endogenous money theory.

#5: exogenous money predicts that increases in the money base will have an impact on bank’s lending and other economic indicators (with some qualifiers). Endogenous money predicts this will be minimal (though reserves may ‘oil the wheels’ of the system somewhat).

Ben Bernanke’s unprecedented doubling of the monetary base obviously did not lead to a massive surge in lending. Neoclassical economists do have some explanations for this, namely that the ‘money multiplier’ collapsed – in other words, banks do not want to lend out the reserves, or there is a lack of demand. This is believable, but really it’s just a tautology – if reserves will increase lending except when they won’t, economists have told us nothing. We do not have a scientific proposition.

Overall I’ll put this one down as ambiguous, but its certainly not a falsification of endogenous money.

I’ve always sided with endogenous money because it is supported by the evidence. If anyone can offer me contrary evidence about the above or other relevant hypotheses, I’ll be happy to listen. But economist-y special pleading about how, even though exogenous money is wrong, the economy behaves as if it is right, or about how I’m not allowed to refute ‘centuries of theory,’ is simply not enough when the evidence is this strong.

*If you are wondering what the ‘credit accelerator’ is, it is the change in the change in debt (acceleration), which is what matters when you do the basic calculations. For more, see here.

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Debunking Economics, Part X: Causes of the Great Depression (and Great Recession)

Chapter 12 of Steve Keen’s Debunking Economics is a critique of a pervasive neoclassical interpretation of the Great Depression (and, by extension, the Great Recession): that the severity of the downturn can be attributed to contractionary monetary policy at the Federal Reserve. As you’d expect, this doesn’t mesh well with the endogenous money theory to which Keen (and I) subscribe, which says that the money supply is largely controlled by private banks.

Keen begins by cataloging Ben Bernanke’s evaluation of the Great Depression, which built on Friedman and Schwartz’ A Monetary History of the United States. From the quotes Keen presents, Bernanke’s offering really seems to be neoclassical economics at its reality denying worst:

the failure of nominal wages (and, similarly, prices) to adjust seems inconsistent with the postulate of economic rationality


[On Minsky’s FIH] I do not deny the possible importance of irrationality in economic life; however it seems that the best research strategy is to push the rationality postulate as far as it will go.

Having said that, the case that the Federal Reserve exacerbated the Great Depression by contracting the money supply does have some substance to it, and is worth discussing.

There is no denying that the Federal Reserve contracted base money at the onset of the Great Depression. But it is a leap to suggest this was the primary cause of the prolonged slump – firstly, the contraction of base money was less than 2% on average. Secondly, there has been one other occasion where base money has contracted nominally (1948-50), and six other occasions where it has contracted when adjusted for inflation. All of these – bar one – were correlated with recessions, but none were correlated with depressions.

Keen presents a graph showing a complete lack of correlation between unemployment and M0:

Instead, there is a much clearer correlation with broader, credit-based measures of the money supply:

From this, it’s quite clear from that the primary cause of the Great Depression was a collapse in aggregate demand, caused by a contraction of credit by private banks. Bernanke and other neoclassical economists are reluctant to accept this conclusion, because it conflicts with the neoclassical vision of the economy as inherently stable, bar perhaps a few frictions, and also renders invalid many of their preferred modelling techniques. For someone like Friedman, the conclusion is simply unacceptable, because it conflicts with his insistence that ‘the government’ is the cause of most significant problems.

The money multiplier, again

Keen catalogues the evidence against the money multiplier story that lies behind Bernanke and Friedman’s interpretation of the Great Depression. In this story, the Central Bank (CB) expands reserves, and private banks then make loans, keeping a fraction of the reserves so that they can accommodate demand for money from customers. These loans are then deposited, and a fraction is kept, and this process continues until no more can be lent out. The amount of loans is that inverse of the fraction banks are required to hold as reserves.

What are the problems with this story? First, the observed reality in banks is that they create loans and deposits simultaneously, and as such do not require reserves before they lend. Second, the change in credit and broader measures of the money supply precedes changes in reserves, rather than the other way around. Third, the failure of monetarism – a disastrous policy used in the 1980s where the CB tried to stabilise money growth, but consistently overshot their target. Fourth, Bernanke’s increases in base money during 2008, which resulted in little to no change in economic activity:

For a more in-depth treatment of the money multiplier by Keen himself, see here.

It is worth noting that it is strictly true that the CB controls base money, and as such some might interpret the endogenous interpretation as one of policy. But the fact is that endogenous money reflects the reality of capitalism: firms need capital before they make sales, and banks must accommodate this to keep the economy moving. The CB – though it has some discretion – simply has to play the role of passively accommodating endogenous activity, otherwise capitalism will not work.

Onto the Great Recession

Keen ends the chapter by documenting a few papers that have attempted to understand the Great Recession – McKibbin and Stoeckel (2009); Ireland (2011); and Krugman and Eggertson (2011). The first two, unfortunately, do not even attempt to create a role for private debt. Instead, the recession is due to a series of external shocks – such as changes in preferences and technology – whilst its length can be attributed to factors such as wage and price rigidity, which get in the way of capitalism’s underlying tendency to stability.

Krugman and Eggertson’s, on the other hand, commendably notices how important private debt seems to be, but only gets as far as modelling it as a special case, in which ‘patient’ agents save, and ‘impatient’ agents borrow. In some ways this observation is true – when money is paid back, it disappears into extremely ‘patient’ agents: banks, who have an MPC of 0. However, banks create rather than save this money, and hence it is added to aggregate demand. This process is, unfortunately, something Krugman says he “just doesn’t get.”

Ultimately, Krugman’s paper is the same story as the others: a one-off event, imperfection, special case, creates a problem in an otherwise stable economy. All three papers fit Bob Solow’s characterisation of New Keynesian models – they fit the data better because economists add “imperfections…chosen by intelligent economists to make the models work better.” All briefly reconsider building new theories from scratch, before simply reasserting the neoclassical core. There really needs to be more soul-searching from economists than this.

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A Few Questions for Exogenous Money Proponents

The Krugman/Keen controversy seems like as good a time as any to post my views on endogenous versus exogenous money.

Naturally, I support the endogenous money theory, as it has all the evidence behind it. Economists even seem to acknowledge that the standard textbook story is somewhat behind the times, although they then cling to the money multiplier model, choosing to add epicycles instead of abandoning their core theory (they have a habit of doing this).

As far as I’m concerned, the evidence is so overwhelmingly opposed to exogenous money the burden of proof is on them. So here are a couple of questions:

(1) Why do expansions of the broader measures of money generally precede rather than succeed expansions of the base? Surely in the money multiplier model banks would require reserves before expanding lending? Evidence:

There is no evidence that either the monetary base or M1 leads the cycle, although some economists still believe this monetary myth. Both the monetary base and M1 series are generally procyclical and, if anything, the monetary base lags the cycle slightly.

(2) A corollary of (1): why do fiat expansions not necessarily result in M1+ expansions? For example 2008:

and similar results can be found during the onset of the Great Depression:

(3) Surely, if banks can create deposits with loans (which they simply can in the real world), by definition a loan adds new purchasing power and increases nominal demand? So by extension, the level of private debt in the economy is crucial to understanding it? How else do you explain the robust empirical link between private debt growth and indicators such as unemployment, housing prices and GDP?

Attempts to answer this framework should also avoid the standard circular tactic of assuming the money multiplier, then describing everything in terms of the money multiplier. But even when doing that, I just don’t see how you can square all the evidence with the exogenous money model. Prove me wrong.

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