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Why banks cause crises (and how to stop them)
Steve KeenUniversity of Western Sydneywww.debtdeflation.com/blogs
Banks don’t have to cause crises…• Banks can create money “out of nothing”
– Richard last night; Schumpeter in 1934• And not cause financial crises
– But they almost always do… Why?• Versus two popular (but false) beliefs
– Bank lending must cause crises• Lend $100, expect $105 back—rising debt must lead to
crisis– Banks don’t matter at all
• Bank lending controlled by Central Bank• Belief that “banks are different” is for “banking
mystics”– “I’m all for including the banking sector in stories
where it’s relevant; but why is it so crucial to a story about debt and leverage?” (Paul Krugman, 2012)
• Tackling the 1st fallacy– Consider a pure credit economy, like 19th century “Free
Banking”…
Popular Fallacy: Crises inevitable• 19th century experiment with “pure” private money
– Private banks printed own notes across USA, Australia, Scotland
Popular Fallacy: Crises inevitable• Simple model:
– Bank prints notes & stores them in “Vault”– Lends to Firms by transferring $ from Vault to Firm
Deposits– Firm hires workers by transferring $ from Firm to Worker
Deposits– Workers and Banks consume by transferring $ to Firm
Deposit– Bank charges loan interest & pays deposit interest
• Should be unsustainable according to “lend $100, expect $105 back”– Constant economic activity should need rising debt; or– Firms’ bank balance should head to zero with constant
money stock• What actually happens?
– Develop model of financial flows using accounting table…
Popular Fallacy: Crises inevitableType of Account Bank Assets Bank Liabilities
(Deposits)Income
Action Vault Loans Firms Workers Safe
Lend -Loan +Loan
Record Loan +Loan
Charge Interest +Interest
Pay Interest -Interest +Interest
Record Payment
-Interest
Hire Workers -Wage +Wage
Deposit Interest +DF +DW -DF-DW
Consume +CW+CB -CW -CB
Repay Loan +Repay -Repay
Record Repayment
-Repay
Popular Fallacy: Crises inevitable• Stable stock of money finances stable level of economic activity:
Popular Fallacy: Crises inevitable• Warning… “Wonkish”…• Model a system of “Ordinary Differential Equations”:
ODEs P1
tBV t( )d
dRepay Loan
tFL t( )d
dLoan Repay
tFD t( )d
dCB CW DF Interest Loan Repay Wage
tWD t( )d
dDW CW Wage
tBS t( )d
dInterest DF DW CB
• Yes, it’s complicated!• But if you understood
previous table, you understand this
• Realistic parameter values (workers share of output roughly 70%, Loan rate 5%, 7 years to repay loans, etc.) can derive equilibrium incomes…
• With functions substituted for “Repay” etc., it becomes…
ODEs P1
tBV t( )d
d
FL t( )
RL
BV t( )
V
tFL t( )d
d
BV t( )
V
FL t( )
RL
tFD t( )d
drD FD t( ) rL FL t( )
BS t( )
B
BV t( )
V
FL t( )
RL
WD t( )
W
FD t( ) s 1( )
S
tWD t( )d
drD WD t( )
WD t( )
W
FD t( ) s 1( )
S
tBS t( )d
drL FL t( ) rD FD t( ) rD WD t( )
BS t( )
B
Popular Fallacy: Crises inevitable• With $100m in circulation, incomes settle down to:
Income Gross
Wages 228.687 p.a.
Profits 98.009 p.a.
Interest 4.667 p.a.
Sum 331.362 p.a.
• Incomes exceed loan level by factor of 3!• $100m in cash turns over several times a year
– Generates incomes out of which interest is paid• Popular “can’t repay loan” fallacy a stock/flow confusion
– Loan: $—Stock– Incomes: $/Year—Flow
• Borrow $100, generate $300 p.a. in turnover, pay $200 p.a. in costs, pay $5 p.a. in interest from $100 profit—no big deal
• Now the 2nd Neoclassical fallacy
Neoclassical Economic Fallacy—Banks don’t matter
• Krugman on Keen:– Minsky and Methodology (Wonkish):
• “Keen then goes on to assert that lending is, by definition (at least as I understand it), an addition to aggregate demand.
• I guess I don’t get that at all.• If I decide to cut back on my spending and stash the funds
in a bank, which lends them out to someone else, this doesn’t have to represent a net increase in demand…”
– Banking Mysticism• “… banking is where left and right meet. Both the
Austrians and the self-proclaimed true Minskyites view banks as institutions that are somehow outside the rules that apply to the rest of the economy, as having unique powers for good and/or evil…
• Banks don’t create demand out of thin air any more than anyone does by choosing to spend more; and banks are just one channel linking lenders to borrowers.”
Neoclassical Economic Fallacy—Banks don’t matter
• Patient lends to Impatient
• Patient’s spending power goes down• Impatient’s spending power goes up• No change in aggregate demand• Banks mere intermediaries (ignored in analysis)
Neoclassical Economic Fallacy—Banks don’t matter
• The real world: Entrepreneur (or speculator) approaches bank for loan
• Bank grants loan & Bank grants loan & creates deposit creates deposit simultaneouslysimultaneously
• Alan Holmes, Alan Holmes, Senior V-P, New Senior V-P, New York FedYork Fed
• ““In the real world, In the real world, banks extend banks extend credit, creating credit, creating deposits in the deposits in the process, and look process, and look for the reserves for the reserves later.” (1969)later.” (1969)
• New loan puts additional spending power into New loan puts additional spending power into circulationcirculation
• Aggregate demand Aggregate demand exceeds exceeds demand from income demand from income alonealone
• Neoclassical macro wrong to ignore change in debtNeoclassical macro wrong to ignore change in debt
Neoclassical Economic Fallacy—Banks don’t matter
• Neoclassicals ignorant of own literature:– Kydland & Prescott: Credit money leads base money
• “There is no evidence that either the monetary base or M1 leads the cycle, although some economists still believe this monetary myth…
• The difference of M2-M1 leads the cycle by even more than M2, with the lead being about three quarters…” (1990, p. 4)
– Fama & French: change in debt finances investment• “The source of financing most correlated with investment
is long-term debt. The correlation between It and dLTDt is 0.79….
• debt plays a key role in accommodating year-by-year variation in investment.” (1999, p. 1954)
• So debt & endogenous increase in demand do matter– Rising debt main source of investment finance (good) and
speculative finance (bad)• But neoclassical models ignore banks, debt & money completely!
– Not to mention fallacies in own models
The absurd foundations of Neoclassical macro
• “The preferred model has a single representative consumer optimizing over infinite time with perfect foresight or rational expectations, in an environment that realizes the resulting plans more or less flawlessly through perfectly competitive forward-looking markets for goods and labor, and perfectly flexible prices and wages.
• How could anyone expect a sensible short-to-medium-run macroeconomics to come out of that set-up?... (Solow 2003, p. 1)
• ‘The simpler sort of RBC model that I have been using for expository purposes has had little or no empirical success…
• As a result, some of the freer spirits [i.e., Woodford, Krugman, Bernanke, Blanchard] in the RBC school have begun to loosen up the basic framework by allowing for 'imperfections' in the labor market, and even in the capital market…
• The model then sounds better and fits the data better. This is not surprising: these imperfections were chosen by intelligent economists to make the models work better...” (Solow 2001, p. 26)
The absurd foundations of Neoclassical macro
• “the main argument for this modeling strategy has been a more aesthetic one:
• its virtue is said to be that it is compatible with general equilibrium theory, and thus it is superior to ad hoc descriptive models that are not related to ‘deep’ structural parameters.
• The preferred nickname for this class of models is ‘DSGE’ (dynamic stochastic general equilibrium). I think that this argument is fundamentally misconceived…
• The cover story about ‘microfoundations’ can in no way justify recourse to the narrow representative-agent construct...” (2007, p. 8)
• Solow’s critique noted the “SMD” conditions (Sonnenschein–Mantel–Debreu)– These invalidate “microfoundations” macroeconomics
• Even invalidate “supply & demand” in single market!
The absurd foundations of Neoclassical macro
• SMD theorem:– “we prove that every polynomial … is an excess demand
function for a specified commodity in some n commodity economy… every continuous real-valued function is approximately an excess demand function.” (Sonnenschein 1972 , pp. 549-550)
• Market demand curves do not obey the "Law of Demand"• Even if summing "well behaved" individual demand curves
PP
PP
PP
• Can’t even treat single market demand curve as “scaled up consumer”
• Yet Neoclassicals model entire macroeconomy as scaled-up individual
• Their advice on macroeconomy—and banks, debt & money—is useless
• Back to why banks don’t have to cause crises, but do…
Why bank cause crises• Bank income depends on how much debt they create
– Main way to create more is to finance investment or speculation
0 1 2 3 4 5 6 7 8 9 100
2.5
5
7.5
10
12.5
15
17.5
20
22.5
25
Base CaseRecycle * 2Repay / 2Invest * 2
Bank income if...
www.debtdeflation.com/blogs
Inte
rest
inco
me
p.a.
Why bank cause crises• Best way to encourage debt is to finance speculation on asset prices
– Australian households, for example:
1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 20148
10
12
14
Personal Debt
1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 20140
20
40
60
80
100
Personal DebtMortgage Debt
• Bank lending actually causes asset price rises
• Positive feedback loop that caused both boom of “Great Moderation” and this crisis
• We need monetary analysis of capitalism…
A strictly monetary view of aggregate demand
• Two sources of monetary demand– Income (Wages + Profits)– Borrowing (Change in Debt)
• Two categories of supply– Goods & Services (Consumer + Investment
Goods/Services)– Net new financial assets
• Schumpeter:– Incomes mainly spent on consumption– Change in debt main source of funds for investment
• Minsky: Change in debt also finances Ponzi behavior
dWages Profits D Consumption Investment NetFIRE
dt
Walras-Schumpeter-Minsky Law• Aggregate Demand = Income + Change in Debt• Aggregate Supply = Good & Services + Net Asset Turnover
dY D GDP NetFIRE
dt
A A ANetFIRE P Q T
2
2 A A A
d d d dY D GDP P Q T
dt dt dt dt
• Implications for macro & finance:– Change in debt a factor in level of employment,
output– Debt acceleration drives change in GDP & asset
prices
• Change in debt explains crisis (& “Great Moderation” before it)
• Accelerating debt explains why asset bubbles must burst
1920 1930 1940 1950 1960 1970 1980 1990 2000 2010 20200
20
40
60
80
100
120
140
160
180
200
220
240
260
280
300
320
PrivatePublic
US Debt to GDP
www.debtdeflation.com/blogs
Perc
ent o
f GD
PAggregate debt overview
• Private debt far more important than government debt:
• Only the Great Depression compares to now
• & “Roaring Twenties” to “The Great Moderation”
Change in Debt & Aggregate Demand• Today—compared to Then
1920 1922 1924 1926 1928 1930 1932 1934 1936 1938 1940300003500040000
4500050000
5500060000
6500070000
750008000085000
9000095000
100000105000
110000115000
120000
Nominal GDP+Change in Private Debt+Change in Public Debt
US Aggregate Demand 1920-1940
www.debtdeflation.com/blogs
US
$ m
illio
n p.
a.
1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 20143 10
64 10
6
5 106
6 106
7 106
8 106
9 106
1 107
1.1 107
1.2 107
1.3 107
1.4 107
1.5 107
1.6 107
1.7 107
1.8 107
1.9 107
Nominal GDP+Change in Private Debt+Change in Public Debt
US Aggregate Demand 1980-2012
www.debtdeflation.com/blogs
US
$ m
illio
n p.
a.
Acceleration in Debt & Change in Employment
• Now (compared to then)
1980198219841986 198819901992 1994199619982000 200220042006 200820102012 201430
25
20
15
10
5
0
5
10
15
6
5
4
3
2
1
0
1
2
3
Credit AccelerationEmployment Change
Credit Acceleration & Employment Change (Corr=0.69)
www.debtdeflation.com/blogs
Pri
vate
Deb
t Acc
eler
atio
n p.
a. a
s pe
rcen
t of
GD
P
Cha
nge
in 1
00 m
inus
une
mpl
oym
ent r
ate
p.a.
0
1920 1922 1924 1926 1928 1930 1932 1934 1936 1938 194030
25
20
15
10
5
0
5
10
15
20
15
12.5
10
7.5
5
2.5
0
2.5
5
7.5
10
Credit AccelerationEmployment Change
Credit Acceleration & Employment Change (Corr=0.76)
www.debtdeflation.com/blogs
Pri
vate
Deb
t Acc
eler
atio
n p.
a. a
s pe
rcen
t of
GD
P
Cha
nge
in 1
00 m
inus
une
mpl
oym
ent r
ate
p.a.
0
Acceleration in Debt & Change in Dow Jones
• Now (compared to then)
1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 201430
25
20
15
10
5
0
5
10
15
20
150
125
100
75
50
25
0
25
50
75
100
Credit AccelerationDJIA Change
Credit Accelerator & DJIA Deviation from Trend (Corr=0.34)
www.debtdeflation.com/blogs
Cre
dit A
ccel
erat
ion
p.a.
Per
cent
of
GD
P
Ann
ual C
hang
e D
evia
tion
from
Tre
nd D
JIA
Per
cent
0
1920 1922 1924 1926 1928 1930 1932 1934 1936 1938 1940 194230
25
20
15
10
5
0
5
10
15
20
300
250
200
150
100
50
0
50
100
150
200
Credit AccelerationDJIA Change
Credit Accelerator & DJIA Deviation from Trend (Corr=0.65)
www.debtdeflation.com/blogs
Cre
dit A
ccel
erat
ion
p.a.
Per
cent
of
GD
P (1
yea
r la
g)
Ann
ual C
hang
e D
evia
tion
from
Tre
nd D
JIA
Per
cent
0
1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010 20200
25
50
75
100
125
150
175
200
225
250
275
300
Index (2006/04: 262; 2012/01: 173)Mean 1890-1997 (98)
Real House Price Index
www.debtdeflation.com/blogs; Case-Shiller Index
Inde
x 18
90 =
100
Greenspan
House Prices deflated by CPI—the long view
• N0 trend; long term average 1890-1995 was 98
• ““a "bubble" in home prices does not appear a "bubble" in home prices does not appear likelylikely
• home price declines, were they to occur, likely home price declines, were they to occur, likely would not have substantial macroeconomic would not have substantial macroeconomic implications.” (Greenspan to Congress, August implications.” (Greenspan to Congress, August 2005)2005)
Acceleration in Mortgages & Change in House Prices
1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 20147
6
5
4
3
2
1
0
1
2
3
4
5
6
7
21
18
15
12
9
6
3
0
3
6
9
12
15
18
21
Mortgage AcceleratorChange in Real House Prices
Mortgage Acceleration & House Price Movements (Corr=0.78)
www.debtdeflation.com/blogs
Perc
ent o
f GD
P
Perc
ent c
hang
e in
rea
l Cas
e-Sh
iller
Ind
ex p
.a.
0
What about England?• Faster your seat belts… on the Roller Coaster of Debt
1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 20140
100
200
300
400
500
UKUSA
Total Private Debt
www.debtdeflation.com/blogs
Per
cent
of
GD
P
• Remedies Remedies left till left till later later given given time time constraintconstraintss
What about England? Employment…
1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 201460
50
40
30
20
10
0
10
20
30
6
4
2
0
2
Credit AcceleratorUnemployment Change
Credit Accelerator & Employment Change UK (Corr=0.5)
www.debtdeflation.com/blogs
Per
cent
of
GD
P
Per
cent
cha
nge
p.a.
0
What about England? House Prices…
1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 201410
8
6
4
2
0
2
4
6
8
10
40
32
24
16
8
0
8
16
24
32
40
Household Credit AcceleratorHouse Price Change
Credit Accelerator & Real House Price Change UK (Corr=0.695)
www.debtdeflation.com/blogs
Per
cent
of
GD
P
Per
cent
cha
nge
p.a.
0
What about England? Shares…
1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 201460
50
40
30
20
10
0
10
20
30
40
120
100
80
60
40
20
0
20
40
60
80
Credit AcceleratorMonthly Change in FTSE
Credit Accelerator & Real FTSE Change (Corr=0.35)
www.debtdeflation.com/blogs
Per
cent
of
GD
P
Per
cent
cha
nge
p.a.
0
Sources & Remedies• Accelerating debt THE source of asset price bubbles• Breaking debt-asset price nexus essential to stop bubbles• Two modest but fundamental proposals
– ““Jubilee Shares”Jubilee Shares”• Last forever when purchased from firm• Can be sold on secondary market 7 times• After 7th sale, last 50 years then expire
– ““The Pill”The Pill”• Property Income Limited Leverage
– Maximum mortgage (say) 1o times property income
• NO reliance on regulators, fine tuning, etc.• Negative feedback loop between asset prices & change in
debt• Debt reserved for beneficial investment, not Ponzi
Schemes
Remedy for today’s crisis• “Modern Debt Jubilee”
– “Quantitative easing for the public”• Cancel irresponsibly created debt without penalizing
savers– Fiat money injection via private bank accounts
• First usage must be debt reduction• Bank debt necessarily paid down
– Solvency maintained, liquidity challenged• Bonds reduced in value• But non-debtor bond-holders receive cash injection
– Minimal damage to aggregate demand, inflation/deflation