Real Vision have just publicly released this interview they did with me on February 4th last year (2018). It’s timely, given Larry Summers’ recent conversion to Post Keynesian economics as he attempts to explain why economic growth has been anaemic ever since the 2008 financial crisis.

I’d use a different title–“How Debt Zombies Will Cause Credit Stagnation”, but that’s about my only complaint. It’s good—in one sense—to see that most of my calls in that video have come to pass. It’s bad, because they were about continued stagnation caused by low levels of credit, and because the Federal Reserve uses economic models in which credit plays no role, and therefore triggers downturns that it can’t explain when it puts rates up.

There are a number of statements that I make about data in this interview that I’ll back up here with that data. At the end, I explain how credit adds to aggregate demand and aggregate income—and why mainstream economists are therefore wrong to totally neglect the role of credit in macroeconomics.

Long term US debt data

All three of America’s great economic crises—the Great Recession, the Great Depression, and the long forgotten Panic of 1837—involved sustained periods of negative credit.

The Roaring Twenties till the Golden Age of Capitalism

The rise in America’s private debt to GDP ratio during the 1930s occurred while private debt was actually falling—debt was falling as debtors went bankrupt and those that remained solvent paid their debts down rather than spending, but GDP was falling faster still, so the debt ratio rose.

Private debt fell rapidly relative to GDP under the New Deal (and before Roosevelt’s ill-fated decision to attempt to return the government budget to surplus caused a recession and a revival in deflation). WWII completed the debt reduction job, with enormous levels of government spending and private sector investment for the war effort (both before the USA formally entered the war when it was supplying the UK with weaponry under Cash and Carry, and of course after), private debt halved from about 80% to 40% of GDP. Then the 20-year-long long “Golden Age of Capitalism” began, with credit boosting aggregate demand—and also driving private debt levels up.

Credit and US Unemployment during the Great Depression

The timing is complicated, because debt data then was annual and recorded at the end of the year, while the unemployment data is monthly, but the negative correlation of credit and unemployment is visually obvious. At the end of this post, I explain the causal relationship between credit and economic activity, and hence the unemployment rate.

Credit and unemployment, house prices across 1990-2019

Having not learnt from the Great Depression thanks to mainstream economists (especially J.R. Hicks and Paul Samuelson) mangling Keynes into the “Keynesian Neoclassical Synthesis” and totally ignoring Irving Fisher’s Debt Deflation Theory of Great Depressions, the USA repeated the same folly of ignoring a private debt bubble. To this day, mainstream economists continue being perplexed about what caused the Great Recession, while the data makes it screamingly obvious that it was caused by the collapse of that bubble, which turned credit from plus 15% of GDP in 2007 to minus 5% in 2009.

With quarterly debt data today, the correlation of credit and unemployment is much more obvious. This is the “smoking gun of credit” that the mainstream continues to ignore.

Federal Reserve rate

As I note in the interview, you can summarise mainstream macroeconomics with 3 numbers: 2, 3 and 4. The models they use—so-called Dynamic Stochastic General Equilibrium (DSGE) models, which are neither truly Dynamic nor truly General)—are almost all hard-wired with the beliefs that the “natural rates” of inflation, growth and reserve interest rates are 2%, 3% and 4% respectively.

When it began its rate rise campaign in 2016, The Fed was planning to get its reserve rate back to 4%. But it has been forced by reality (and a reality TV star!) to reverse direction well before 4% was reached.

Private sector debt service ratio

The reason is that something that mainstream economists think won’t affect aggregate demand—the level of outstanding private debt, and therefore the debt service burden, which depends on both the level of private debt and interest rates—does affect aggregate demand. Their “loanable funds” model of banks is structurally false, as the Bank of England and the Bundesbank have forced the mainstream to accept; but they still haven’t (and never will) accept the macroeconomic corollary that credit is a major component of aggregate demand and income.

CAPE Index

Japanese data

Link to modern debt jubilee post

This needs updating, but here is my proposal for a Modern Debt Jubilee.

Velocity of money FRED

One thing that I expect a Modern Debt Jubilee would do is revive the rate of turnover of existing money, which is at historic lows now—I believe mainly in response to the debt levels the private sector is carrying, which leads people to try to hoard existing money to be able to service their debt levels. In fact, that behaviour simply reduces the contribution of existing money to GDP, leading to a yet greater dependence on credit.

Why credit is part of Aggregate Demand and Income

The mainstream has the model of “Loanable Funds” etched into its collective brain. In this model, banks are “intermediaries” between savers and borrowers—they don’t actually lend money themselves. Consequently, a loan simply redistributes existing money between non-bank entities: it doesn’t alter the money supply, nor does it alter aggregate demand unless savers and borrowers have markedly different propensities to consume. This was the basis of Bernanke not seriously considering Fisher’s Debt-Deflation Theory of Great Depressions in his “Essays on the Great Depression”:

The idea of debt-deflation goes back to Irving Fisher (1933). Fisher envisioned a dynamic process in which falling asset and commodity prices created pressure on nominal debtors, forcing them into distress sales of assets, which in turn led to further price declines and financial difficulties. His diagnosis led him to urge President Roosevelt to subordinate exchange-rate considerations to the need for reflation, advice that (ultimately) FDR followed. Fisher’s idea was less influential in academic circles, though, because of the counterargument that debt-deflation represented no more than a redistribution from one group (debtors) to another (creditors). Absent implausibly large differences in marginal spending propensities among the groups, it was suggested, pure redistributions should have no significant macro¬economic effects.
(Essays on the Great Depression, p. 24)

As the Bank of England and Bundesbank have thankfully both emphasized, Loanable Funds (and the “Money Multiplier” and “Fractional Reserve Banking”) are all textbook model that are simply false descriptions of the real world.

The macroeconomic corollary is that credit is part of aggregate demand and income. I prove this using what I call a “Moore Table” in honour of Basil Moore, the pioneer of the Post Keynesian theory of Endogenous Money (which I prefer to call Bank Originated Money and Debt, or BOMD). The table shows expenditure by one sector on each row, and income for each sector on each column. The diagonal entries are negative, representing expenditure by a given sector; the off-diagonal entries are positive, representing the income that expenditure generates. Each row therefore necessarily sums to zero, while the columns can differ from zero (a sector’s income from other sectors can be greater than its expenditure on those sectors).

The “Say’s Law” case is a world in which money exists, but no borrowing or lending takes place. The symbols A to F represent spending per year by one sector on another—so Sector 3, for example, is spending E dollars per year on Sector 1, and F dollars per year on Sector 2.

When you add up either the diagonal entries (the negative sum of which is aggregate expenditure) or the off-diagonal entries (the sum of which is aggregate income), you necessarily get the same result: aggregate demand and income is the sum A to F, which can be regarded as Milton Friedman’s “quantity theory of money”: aggregate demand and income is the product of the amount of money in existence (M) times how often it turns over (V).

The Neoclassical model of “Loanable Funds” has one non-bank sector lending to another non-bank sector, in return for interest payments on outstanding debt. This is shown in the next table, with financial transfers (loans) being shown along the diagonal.

When you sum the diagonal (or the off-diagonal) here, you find that Interest payments are part of aggregate demand and income—but not credit, which cancels out.

In the real world, a bank loan increases the banking sector’s assets (the level of outstanding debt) and its liabilities (deposit accounts) by the same amount; the borrower then uses that credit to buy goods or services or assets off someone else (no-one borrows for the sheer pleasure of being in debt).

When you sum either the diagonal or the off diagonals, you find that in this real-world situation, credit is part of aggregate demand and income. This is the factor that the mainstream continues to ignore—and always will ignore—which is why they can’t understand where the 2008 crisis came from, nor why its aftermath is a relatively stagnant economy, despite zero interest rates for a decade and relatively expansionary fiscal policy (in the USA).

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Real Vision

Real Vision (along with MacroVoices) is a bastion of realism in the fantasy-dominated world of economics and finance. Here’s their intro to this video, and

Steve Keen is a ‘renegade economist’ who has been debunking classical economic theory for decades. Steve argues that ever-rising levels of private debt are unsustainable in the face of rising interest rates, but that the US Federal Reserve will continue to raise them anyway until the credit cycle implodes – at which point the Fed will turn about and inevitably return to stimulative policies. The economist maintains that until the level of private debt is addressed, the Fed will remain intellectually locked in a never-ending cycle of massive asset bubbles and extraordinary busts. Filmed January 23rd, 2018 in London.

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Credit Zombies and the Walking Dead of Debt (w/ Steve Keen) | Real Vision Classics