KeenHowCreditWorksWhyItFails.ppt - Misunderstanding the Great by suchenfz


									Credit money: how it works & why it fails

                     Steve Keen
           University of Western Sydney
                Debunking Economics
 2008 and all‘s well…
• ―the past two decades has seen not only significant
  improvements in economic growth and productivity but also
  a marked reduction in economic volatility… a phenomenon
  that has been dubbed "the Great Moderation.‖ (Bernanke)
                                           • Whoa!
                                           • Did anybody
                                              get the
                                              number of
                                              that Black
                                           • Nope:
                                            • ―Nobody could
                                               have seen it
―Nobody could have seen it coming…‖
                       • ―The Queen asked me: ‗If these
                         things were so large, how come
                         everyone missed them? Why did
                         nobody notice it?‘.‖
                       • When Garicano explained that at
                         ―every stage, someone was relying
                         on somebody else and everyone
                         thought they were doing the right
                         thing‖, she commented: ―Awful.‖

• As obvious as the nose on a swan‘s face to some of us…
• A debt-driven boom and collapse
What the hell happened?
• A debt bubble burst…

                          • Should that
                          • Not according
                            to conventional
Credit Money Myths
• Neoclassical economics
   – Debt not a problem because loans = savings
      • ―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).‖ (Bernanke 2000, p. 24)
• Populist (& many non-neoclassical economists)
   – Inevitable problem because interest can‘t be paid
      • ―The existence of monetary profits at the
        macroeconomic level has always been a conundrum …
        not only are firms unable to create profits, they
        also cannot raise sufficient funds to cover the
        payment of interest.‖ (Rochon 2005, p. 125)
Neoclassical myth: ―Deposits create loans‖
• Creation process:
   – Government creates Base Money (e.g., welfare cheque)
   – Public puts BM in bank account
   – Bank keeps fraction (RR%: ―reserve requirement‖)
   – Lends rest: MB*(1-RR%)
   – Borrower deposits loan in another bank…
   – Iterative process generates BM/RR dollars
• Banks as
   – Passive amplifiers of government money creation
   – Mere intermediaries between savers & borrowers
      • Loan transfers money from saver to borrower
   – Private Debt has minimal macroeconomic effect
      • Only if borrower has higher propensity to spend
Reality: Endogenous money
• Banks create credit money ―out of nothing‖
   – ―In the real world banks extend credit, creating
     deposits in the process, and look for the reserves
     later‖ (Moore (1979, p. 539)—quoting Fed economist)
   – ―There is no evidence that … the monetary base …
     leads the cycle, although some economists still believe
     this monetary myth…, if anything, the monetary base
     lags the cycle slightly…
   – The difference of M2-M1 leads the cycle by even
     more than M2 with the lead being about three
     quarters." (Kydland & Prescott 1990, p. 14)
• So credit money created ―ab initio‖ by banks
• And that doesn‘t have to be a problem…
                                               Skip money model
 How is credit money created?
• European Circuitist School: realistic model of credit money
• Ignore creation of fiat (―outside‖) money by government
• Focus on creation of debt-based money by banks
   – ―the money stock is increased or decreased by means of
     debt and credit operations taking place between the
     Central Bank and commercial banks . The ideal model of
     the theory of the circuit therefore resembles the so-
     called Wicksellian model of a pure credit economy , with
     the addition of a Central Bank.‖ (Graziani 1989: p. 3)
   – But money seen as essentially different to credit:
      • ―If in a credit economy at the end of the period some
        agents still owe money … a final payment is needed,
        which means that no money has been used.‖ (3)
Conditions for money
• (1) Must be a token (otherwise a barter model if a
   – ―The starting point of the theory of the circuit, is
      that a true monetary economy is inconsistent with the
      presence of a commodity money.
   – A commodity money is by definition a kind of money
      that any producer can produce for himself. But an
      economy using as money a commodity coming out of a
      regular process of production, cannot be distinguished
      from a barter economy.
   – A true monetary economy must therefore be using a
      token money, which is nowadays a paper currency‖ (3)
Conditions for money
• (2) ―money has to be accepted as a means of final
  settlement of the transaction (otherwise it would be
  credit and not money).‖ (3)
• (3) Must not grant ―rights of seignorage‖ (agents can‘t
  create it indefinitely at negligible cost [as formally
  Governments can with fiat money])
   – If seller A & buyer B accept ―tokens‖ issued by Bank C
     as final settlement, can‘t have C use its own tokens to
     be a buyer
       • Like paying for goods with ―IOU‖s
Conditions for money
• Putting it all together:
   – ―The only way to satisfy those three conditions is to
     have payments made by means of promises of a third
     agent‖ (3)
      • Essential point in circuitist case (and endogenous
        money in general)
          – transactions are all 3 sided
              • Buyer, Seller, and Banker.
      • Banks an essential aspect of capitalism
• Fundamentally different to a barter system
   – Can‘t model money by extending model of barter
      • Which is what neoclassical economics has done…
Commodity money just ―n+1‖ barter economy
• Barter economy: 2 sided, 2 commodity exchanges:
   – person A gives person B δ units of commodity X
   – in return for ψ units of commodity Y
• Calling one ―the money commodity‖ simply semantics

              X             • 1st essential insight
                               – Money a non-commodity
                               – ―A true monetary
                                  economy must therefore
     A                  B         be using a token money,
                                  which is nowadays a
                                  paper currency.‖ (3)

Conditions for money
• Monetary economy: 3 sided,
  single commodity, financial
   – person A gives person B δ
     units of commodity X
   – in return for person B
     having bank Z transfer ψ       A         δX         B
     currency units from B's
     account A's account
• Not only are all exchanges 3-
                                        A=         B=
• also can‘t lump firms & banks                    -$ψ
   – Fulfil essentially different             Z
     roles in capitalist system:
Conditions for money
• ―[B]anks and firms must be considered as two distinct
  kinds of agents.
• Firms are present in the market as sellers or buyers of
  commodities and make recourse to banks in order to
  perform their payments; banks on the other hand
  produce means of payment, and act as clearing houses
  among firms.
• In any model of a monetary economy, banks and firms
  cannot be aggregated into one single sector.‖ (4)
• Monetary economy fundamentally different to barter
• Next: simple model of how credit money system works
Model of credit money
• Pure credit money system: bank issues own notes
   – Like 19th century free banking in USA
• Bank formed by elite
• Notes backed by own wealth
• Lends to local businesses…
• How did it work?

• Stylised model with 5 accounts
   • ―Vault‖—where bank stores its wealth
   • ―Safe‖—for spending, payment & receipt of interest
   • ―Loans‖—ledger recording who owes bank how much
   • ―Firms‖—deposit account for firms
   • ―Workers‖—deposit account for workers
• System starts with Notes (say $1 million) in Vault
19th century free banking: Stage 1
•   $1 million in Vault, all other accounts zero…
•   Bank loans transfer notes from Vault to Firms
•   Bank records loans in its Loans ledger
•   Bank charges interest on loans
•   Firm pays interest which Bank deposits in its Safe
•   Bank records payment of interest on Loans ledger
•   Bank pays deposit interest to Firm
•   End result at this point:
     • Over time, Vault emptied of Notes
     • Notes pass via Firms back to Banks‘ Safe:
19th century free banking: Stage 1
• Modelled using new software package QED
  – ―Quesnay Economic Dynamics‖

19th century free banking: Stage 2
•   Closing the system: workers, factories & consumption
•   Firms pay wages to Workers
•   Bank pays workers interest on deposits
•   Workers and Bankers consume
•   End result at this point: System sustainable
     • Firms make profits
     • Workers earn wages, Banks earn interest
Non-Neoclassical myth: ―Interest can‘t be repaid‖
• Common belief in Post-Keynesian economics & populist
  views of money: No it isn‘t
   – Interest can‘t be repaid because loan less than loan +
     interest; and firms can‘t make monetary profits:
       • ―The existence of monetary profits at the
         macroeconomic level has always been a conundrum
         for theoreticians of the monetary circuit… not only
         are firms unable to create profits, they also cannot
         raise sufficient funds to cover the payment of
         interest. In other words, how can M become M`?‖
         (Rochon 2005, p. 125)
   – Wrong!
   – Confusion of stock (size of loan in $) with flow
     (turnover of economic activity in $/year)
Non-Neoclassical myth: ―Interest can‘t be repaid‖
• System is stable if accounts can stabilise
• Vault empties over time: all bank assets Loans to Firms

                                    • Accounts do stabilise
                                    • What‘s happening?
                                    • After the vault
Non-Neoclassical myth: ―Interest can‘t be repaid‖
• Long run dynamics in final 8 rows of table:

                                                       Add up columns
• System stable if sum of flows in each column equal zero
          Flow conditions for stability of all accounts except Vault
Account   Outflows                         Inflows
Loans     Interest charged                 Interest paid
Firms     Interest on Loans + Wages        Deposit Interest + Consumption
Safe      Deposit interest + Consumption   Interest on Loans
Workers Consumption                        Wages + Deposit Interest
• Vault stabilises too if loan repayment equals rate of loans:
19th century free banking: Stage 3
• Firm repays loan which Bank puts back in Vault
• Bank records repayment on Loan ledger

• Sustainable system
• Bank assets now unlent Notes in Vault plus Loans to Firms
                                • Incomes for all classes
                                   • Wages $310.47 p.a.
                                   • Net Interest $3.72
                                   • Profit? 217.33 p.a.
                                     (shown later)
                                • Final step: new money
         QED                       • In 19th century: notes
                                   • In 20th century: credit
Money creation in pure credit economy
• 19th century: add new notes to vault
Money creation in pure credit economy
• 20th century: simultaneously issue loan and deposit
Money creation in pure credit economy
• System not inherently unstable
   – Firms can pay interest & make a profit
   – Debt can remain low & constant relative to GDP
   – Rising debt also necessary for expanding economy…
      • ―If income is to grow, the financial markets … must
        generate an aggregate demand that, aside from
        brief intervals, is ever rising.
      • For real aggregate demand to be increasing, … it is
        necessary that current spending plans, summed over
        all sectors, be greater than current received
      • It follows that over a period during which economic
       growth takes place, at least some sectors finance a
       part of their spending by emitting debt or selling
       assets.‖ (Minsky 1982, p. 6; emphasis added)
Money creation in pure credit economy
• Schumpeter on same issue: growing debt adds demand
  beyond that generated by sales of goods & services
• Debt essential for entrepreneurial function
   – Entrepreneur often has idea but no money
   – Needs purchasing power before has goods to sell
   – Gets purchasing power via loan from bank
   – Entrepreneurial demand thus not financed by ―circular
     flow of commodities‖ but by new bank credit
   – Since entrepreneurial activities essential feature of
     growing economy, in real life ―total credit must be
     greater than it could be if there were only fully
     covered credit. The credit structure projects not only
     beyond the existing gold basis, but also beyond the
     existing commodity basis.‖ (Schumpeter 1934, p. 101)
Money creation in pure credit economy
• But incentive to instability exists:
   – Bank income rises if
      • New money issued more rapidly
      • Debt repaid more slowly (or not at all)
Money creation in pure credit economy
• Same result in modern banking; bank income rises if
   – Bank reserves circulated more rapidly
   – Loans paid off more slowly
   – New loans created more rapidly
Money creation in our real economy
• Banks have inherent bias to create debt
• Borrowers control whether that bias is expressed
• Income based borrowing—inherently limited
• The ―Solution‖: lend to finance Ponzi Schemes
   – Potential borrower expects asset price to rise
   – Borrows money to buy asset
   – Drives price of asset up
   – Rise entices other borrowers into market
• Positive feedback from leverage to prices causes asset
  price bubble
• Scheme ―works until it fails‖:
   – Rising debt-financed spending boosts economy
   – Requires acceleration in debt to continue forever…
Debt and Aggregate Demand
• Conventional neoclassical ―exogenous money‖ economics
   – Debt has minor macroeconomic effects
      • Redistributes money from lender to borrower
      • ―Absent implausibly large differences in marginal
        spending propensities among the groups, it was
        suggested, pure redistributions should have no
        significant macroeconomic effects.‖ (Bernanke
        2000, p. 24)
• Realistic ―endogenous money‖ economics
   – Increasing debt expands aggregate spending
   – Aggregate demand equals GDP plus change in debt
      • Spent on all markets—goods + existing assets
   – Volatile ―change in Debt‖ component dominates
     economy as debt grows relative to income
The Facts on Debt
• 2 obvious US debt bubbles in last century
Debt and aggregate demand
• Debt and GDP 1920-1940
Debt and aggregate demand
• Aggregate Demand 1920-1940: GDP + Change in Debt
Debt and aggregate demand
• Aggregate demand & unemployment 1920-1940
   – Far stronger correlation than for M1 & unemployment
   – And applies in boom (Roaring 20s) as well as bust…
Debt and aggregate demand
• Effect even stronger for current period
Debt and aggregate demand
• Aggregate Demand 1990-2010: GDP + Change in Debt
Debt and Aggregate Demand
• US experienced a crisis via deleveraging

              US crisis by

                       But notice recent
Debt and Aggregate Demand
• Correlation with unemployment, USA

                      US crisis by

                     But notice recent
Acceleration in Debt & Change in Employment
• Since AD = GDP +DD
   – DAD = DGDP +DDD
   – Changes in aggregate demand
      • & hence changes in employment
   – Correlated not with change in debt (DD)
      • But with acceleration/deceleration in debt (DDD)
• Defining ―credit impulse‖ (Biggs, Meyer & Pick) as

• Empirically, credit—ignored by neoclassical economics—is
  the key driver of the economy...
Change in Debt & Change in Employment
• Correlation with change in employment, USA

                         Crisis begins

         USA stalled crisis by
       slowdown in deleveraging
Change in Debt & Change in Employment
• Summing up: Credit drives the economy
                                      • Doesn‘t have to
                                        drive it ―over the
                                      • But always does
                                      • Why?
                                      • The temptation
                                        of Ponzi Finance
                                      • Putting it all
Finance and Economic Breakdown
• Economy is
   – Inherently cyclical
      • Waves of innovation/destruction (Schumpeter)
      • Struggles over income distribution (Marx, Goodwin)
      • Complex & aperiodic (Lorenz, Mandelbrot, Prigogine)
   – Inherently monetary
      • Moore, Graziani
   – Inherently afflicted by uncertainty
      • Keynes (not IS-LM!)
• Given nature of capital assets
   – Banks‘ desire to create debt leads to financial crises
• The Financial Instability Hypothesis: Minsky
                                      Skip Minsky Model
Minsky‘s ―Financial Instability Hypothesis‖
• Economy in historical time
   – Both ignored by conventional ―neoclassical‖ economics)
• 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…
• Self-fulfilling expectations
   – Decline in risk aversion causes increase in investment
   – Investment expansion causes economy to grow faster
The Euphoric Economy
• Asset prices rise: speculation on assets profitable
• Increased willingness to lend increases money supply
   – Money supply endogenous , 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
• Rising debt levels & interest rates lead to crisis
   – 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
The Assets Boom and Bust
• 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...
• Process repeats once debt levels fall
   – But starts from higher debt to GDP level
• Eventually final crisis where debt burden overwhelms
Modelling Minsky
• Modelled by
  – Introducing nonlinear functions
     • Capitalist desire to invest
     • Debt repayment rate
     • Money relending rate
  – Endogenous money creation via ―line of credit‖
     • Firm investment desire funded by increased deposit
     • Simultaneous increase in debt
  – Modelling production & price formation
     • Also growth in population & labor productivity

                                      Skip the Math
 Modelling Minsky: Financial side
• New Godley Table
                                                 ―Line of
                                               money & debt
                                                created at
                                                same time

• Exponential functions for expectations under uncertainty:
   • Given uncertain future, investors assume that ―the
     present is a much more serviceable guide to the future
     than a candid examination of past experience would
     show it to have been hitherto‖ (Keynes 1936, p. 214)
Modelling Minsky: behavioural components
• Functions for wage setting (workers), investment (firms),
  loan repayment (firms) and money relending (banks)

• Purpose of functions not to generate cycles
   • System already inherently cyclical (Goodwin)
• But to constrain cycles to realistic levels
Modelling Minsky: Production Relations
• Capital K determines output Y via the accelerator:

• Y determines employment L via productivity a:

• L determines employment rate l via population N:

• l determines rate of change of wages w via Phillips Curve
                                 • (Linear Phillips curve for now)

• Integral of w determines W (given initial value)

• Y-W determines profits P and thus Investment I…

            • Closes the loop:
Modelling Minsky: Inherent cycles
• Model generates cycles (but no growth since no
  population growth or technical change yet)…:
                                            • Cycles caused
                                              by essential
                                            • Wage rate
                                            • Behavioural
                                              not needed for
                                            • Instead,
                                              restrain values
                                              to realistic
Modelling Minsky: Wage dynamics
• Phillips curve much maligned in economics
   – But used by almost all schools of thought
• Also misunderstood: three factors, not just one:
   – 1. Level of unemployment (highly nonlinear relationship)
   – 2. Rate of change of unemployment
   – 3. Rate of change of retail prices ―operating through
     cost of living adjustments in wage rates.‖ (Phillips 1958
     p. 283-4)
• All 3 factors included in this model:
   Rate of       Employ     Rate of change of     Inflation
  change of       ment         employment
depends on…
Modelling Minsky: Price dynamics
• Physical Output (Q) = Labor times L labor productivity a
• Labor = Money flow of wages divided by money wage W
• Flow of wages = worker share of output during turnover
  period t S (time from outlays to receipts)
• Money Demand = Annual flow of wages plus profits
   – = Money in Firms divided by turnover tS .
• Physical Demand = Money demand divided by Price level
        Physical      Physical
                       of physical supply = physical demand
• In equilibrium, flowdemand

• Solving for equilibrium price:
                              Convergence over time

• As a dynamic process:
Modelling Minsky: The full system
• In scary equations…
    Modelling Minsky: The full system
• In less scary QED format:

Modelling Minsky: The outcome
• Model generates Great Moderation & Great Recession
  – Not yet calibrated on data yet qualitatively similar…
Modelling Minsky: The outcome
• The full picture from QED
Modelling Minsky: The outcome
• The full picture from QED
Modelling Minsky: The insights
• Private debt causes both boom and crisis
• Workers pay for debt through reduced share of income:
                                • Reduced volatility with
                                  rising debt a sign of
                                   • Not increased
                                      stability (―The Great
                                      Bernanke 2004)
                                   • But ―Calm before the
                                      storm‖ (Keen 1995)
How does ―Now‖ compare to ―Then‖?
• Debt-financed proportion of aggregate demand:
Where to from here?
• 3 factors determine debt impact on economy
   – Level (relative to GDP)
      • Like distance between start and destination
      • How long before journey is over
   – Rate of change
      • Like speed of travel to destination
      • Affects aggregate demand
   – Rate of change of rate of change
      • Like acceleration/deceleration
      • Whether you‘re getting there more quickly or not
      • Affects rate of change of aggregate demand
          – Are things improving or getting worse right now?
Where to from here?: Level
• It‘s a long way from the top if you‘ve sold your soul...
                                         • Almost 100% of
     The NBER thinks the                   GDP reduction to
     recession ended here!                 get to pre-Great
                                           Depression level
                                            • Speculative
                                              debt still
                                         • 200% to get back
                                           to 50s level
                                            • Only productive
                                         • Decade with
                                           aggregate demand
                                           below GDP
Where to from here?: Rate of change
• Deleveraging impact equivalent to Great Depression level

• Debt reducing at Great Depression rate
• Levelling out implies sustained slump
   • ―Turning Japanese‖
 Where to from here?: Acceleration
• We‘re slowing down...

        The acceleration effect might
        be why the NBER thinks the
        recession ended here!

• Less scary than accelerating fall (rising on quarterly data)
• But still not enough to increase employment
• Susceptible to future acceleration in fall
   • Much of rise driven by return to Ponzi investing
Where to from here?
• 2 most persistent debt metrics remain negative
   – Level of debt to GDP
   – Rate of change
• Most volatile currently positive
   – Deceleration of deleveraging has boosted economy
• History implies crisis has many years to run
   – Debt moratoria essential: Michael Hudson‘s point
      • ―Debts that can‘t be repaid, won‘t be repaid‖
• Reforms to prevent it recurring?
   – Monetary reform or regulation not enough
   – Credit money inherently ―double-entry bookkeeping‖
      • Near costless process
      • Money creators profit by creating debt
Where to from here?
• Can‘t control debt-creation ―at source‖
   – Lenders always want means to create more debt
• Have to instead control it ―at sink‖
   – Reduce desirability of debt to borrowers
   – Key unsustainable/limitless desire: asset price bubbles
      • Positive feedback process
          – Rising asset prices entice borrowers
          – Borrowing drives up asset prices
          – Rising debt/income level breaks cycle in crisis
   – Redefine assets to prevent leverage-driven bubbles
      • Jubilee share system
      • Rental income limits to property leverage
      • (Combined with debt abolition now…)
Jubilee shares
• Shares currently last forever
   – ―Greater fool‖ valuations possible
      • Share price rise feasibly infinite
      • Secondary sales far dominates primary share issue
• Redefine shares so that
   – Shares bought from company last forever
   – But once sold, become ―Jubilee shares‖
      • Expire after 50 years
         – Can be bought/sold
             • Really valued on expected dividend flows
         – Yield dividends, allow voting etc. as now
         – But terminal value zero
      • Far less likely to be bought with borrowed money
Limited Property Leverage
• Current property loans ―based‖ on income of borrower
   – Wealthier/riskier borrower outbids others
   – Positive feedback between leverage and price
   – Blowout in loan to valuation ratios
      • 60s-70s 70% LVR: $30K deposit$100K price
      • Current 97% LVR: $30K deposit$1M price
• Base leverage on (imputed) rental income of property
• Maximum secured loan (say) 10 times annual rental
   – Higher price means lower leverage
   – Break feedback between leverage and property prices
• Both reforms coupled with current debt write-offs
   – Or we‘ll be back here again in 70 years
   – If we survive Peak Oil & Global Warming…
 One exception to the rule…
 • My home country, Australia…
    – Does it hop to a different beat?
• In some respects, yes
   – Commodity exporter—benefits from China Boom
   – Anti-crisis policy gave money to households
      • More effective than US giving money to banks

• Floating Mortgage
  rates—4% cut in
• In other ways, the
  same tune…
The Facts on Debt
• Three obvious debt bubbles in Australian Data
Debt and Aggregate Demand
• Ponzi Economy: Rising debt means falling unemployment
Debt and Aggregate Demand
• Adding the change in debt to GDP…

                                      We avoided a
                                      crisis by re-
Debt and Aggregate Demand
• Correlation with unemployment, Australia

                                             We avoided a
                                             crisis by re-
Change in Debt & Change in Employment
• Correlation with change in employment, Australia

                               We avoided a
                               crisis by re-
Australia‘s ―This is Not a Bubble‖ Bubble
• House prices to GDP per head
Asset Price Inflation as a Macroeconomic Tool
• First Home Owners Scheme the anabolic steroid of
  economic policy
   – Introduce or boost FHOS during recessions
   – Stimulate economy at cost of rising house prices…
Asset Price Inflation as a Macroeconomic Tool
• Rudd Boost added $100 billion to aggregate demand:

Australia‘s ―This is Not a Bubble‖ Bubble
• A government-sponsored, debt-driven asset bubble...
Australia‘s ―This is Not a Bubble‖ Bubble
• Mortgage debt finally joining deleveraging trend
Australia‘s ―This is Not a Bubble‖ Bubble
• The Ponzi Party may be over…

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