1. Dynamics of the Global Financial Crisis
Steve Keen
UWS

2. 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:

3. 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…

4. 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

5. 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...

6. 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

7. 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”…

8. Modelling Minsky & Endogenous Money…
Just one problem…
Data a lot worse than the model!

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

10. Ponzi Finance Difference between model debt/output 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:
And actual pattern:

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

12. 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

13. Prospects Government spending can’t counteract this
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:

14. 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
Economy more indebted than ever...
Private Debt Bubbles & Bursts...
Government pump primes (with debt)
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

15. 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…

16. 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?
Not likely!
Alternative theories of economics needed
Some exist but are underdeveloped
Best is Minsky’s Financial Instability Hypothesis

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