Dynamics of the Global Financial Crisis Steve Keen UWS

Appalling guidance by neoclassical economists OECD World Economic Outlook, June 2007, p. 9: –“the current economic situation is in many ways better than what we have experienced in years… –Our central forecast remains indeed quite benign: a soft landing in the United States, a strong and sustained recovery in Europe, a solid trajectory in Japan and buoyant activity in China and India. In line with recent trends, sustained growth in OECD economies would be underpinned by strong job creation and falling unemployment.” –Jean-Philippe Cotis, Chief Economist Crisis began August —just 2 months later! –BNP closes 3 funds with strong subprime exposure… Different theory needed to understand crisis:

Minsky’s “Financial Instability Hypothesis” Explanation for regular credit-driven cycles & crises: –Economy in historical time –Debt-induced recession in recent past –Firms and banks conservative re debt/equity, assets –Only conservative projects are funded Recovery means most projects succeed –Firms and banks revise risk premiums Accepted debt/equity ratio rises Assets revalued upwards… –“Stability is destabilising” Period of tranquility causes expectations to rise…

The Euphoric Economy Self-fulfilling expectations –Decline in risk aversion causes increase in investment Investment expansion causes economy to grow faster –Asset prices rise speculation on assets profitable –Increased willingness to lend increases money supply Money supply endogenous money, not under RBA control –Riskier investments enabled, asset speculation rises The emergence of “Ponzi” (Bond, Skase…) financiers –Cash flow less than debt servicing costs –Profit by selling assets on rising market –Interest-rate insensitive demand for finance

The Assets Boom and Bust Eventually: –Rising rates make conservative projects speculative –Non-Ponzi investors sell assets to service debts –Entry of new sellers floods asset markets –Rising trend of asset prices falters or reverses Ponzi financiers go bankrupt: –Can no longer sell assets for a profit –Debt servicing on assets far exceeds cash flows Asset prices collapse, increasing debt/equity ratios Endogenous expansion of money supply reverses Investment evaporates; economic growth slows Economy enters a debt-induced recession –Back where we started...

Crisis and Aftermath High Inflation? –Debts repaid by rising price level –Economic growth remains low: Stagflation –Renewal of cycle once debt levels reduced Low Inflation? –Debts cannot be repaid –Bankruptcy affects even non-speculative businesses –Economic activity remains suppressed: a Depression Big Government? –Anti-cyclical spending enables debts to be repaid –Renewal of cycle once debt levels reduced

Crisis and Aftermath Modelling Minsky –Extension of Goodwin’s Growth Cycle to include debt 3 “stylised facts” –Wages share grows if wage rises exceed productivity –Employment rises if growth exceeds productivity + population increase –Bank lend money to finance investment Dynamics –Borrow money to finance investment during a boom Repay some of it during a slump –Debt to income levels ratchets up through series of booms/busts –Eventually one boom where debt accumulation passes “point of no return”…

Modelling Minsky & Endogenous Money… Just one problem…

The Global Debt Bubbles Worse than the 1920s… Model’s main missing ingredient: –Ponzi Investing

Ponzi Finance Difference between model debt/output pattern: And actual pattern: Absence of “Ponzi Finance” in base model –All borrowing leads to growth in productive capacity in model In Minsky’s theory (and in reality!), much of borrowing simply finances speculation on asset prices –No addition to productive capacity –But addition to debt! Modelled by introducing Ponzi Capital component:

Ponzi Finance Honouring irresponsibly created debt will lock us into a permanent slump… Ponzi model pattern closer to actual data Implies can’t overcome crisis without debt reduction –Via deliberate inflation; or –Widespread debt moratoria Problem too big to “paper over”

The problem Debt/GDP twice as bad as prior to Great Depression –USA 1929: 150% 2008: 290% –Australia 1929: 64% 2008: 165% Common across OECD: Position probably far worse once impact of derivatives, off balance sheet SIVs, etc. included

Prospects Government deficit spending justified –Cash flow to private sector assists debt repayment But scale of problem will overwhelm financial rescue –Spending sum of GDP + Change in Debt Last year GDP $1,080bn; change in debt $259bn Change in debt≈20% aggregate demand –Even debt stabilisation means drastic drop in demand Debt stabilisation $259bn cut to spending Debt reduction to say 75% GDP (triple 60s level) – $100bn/year cut in demand for next 10 years? –Government spending can’t counteract this Witness Japan:

Omens Japan’s “Bubble Economy” crisis a precursor to Subprime Crisis –Debt-financed speculative bubble –Burst end-1989 –Two decades later, still in low level Depression –Government debt far higher, private debt slightly lower… But economy still mired in economic slump Can’t “pump prime” way out of debt crisis this big… Simply swaps public debt for private –Debt should never have been issued in the first place

Solutions? Only solutions involve drastic cut in Debt/GDP ratio –Deliberate Inflation? –Debt moratoria? Post-crisis reforms –Palliative reforms (Glass-Steagall Act, etc.) will be “reformed” away once they cause prolonged stability –Long term success only if possibility of profitable asset price speculation virtually eliminated Alter nature of share ownership Alter property valuation Re-assign risk from borrowers to lenders And think differently about the economy in future… –Less ideology (left or right!) and more knowledge…

Alternative economic theory needed too! Economic theory in part got us into this mess –Ignoring role of money & debt –Fetish on equilibrium when economy far from it –Naïve view of role of finance markets “Efficient Market Hypothesis”… –Insane view of rationality rationality as ability to predict the future! Didn’t see this crisis coming… Can you trust conventional (neoclassical) theory to –Know what comes next? –Get us out of it? Alternative theories of economics needed –Some exist but are underdeveloped –Best is Minsky’s Financial Instability Hypothesis

Don’t get fooled again… Some other alternatives –Post-Keynesian economics –Evolutionary economics tionary_economics.htmhttp:// tionary_economics.htm –Complex systems analysis & “Econophysics” Physicists doing economics – For more information & analysis: