Australian Debt

1
Australian Debt monetary model of financial
instability

• Steve KeenUniversity of Western Sydney

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Conventional Finance Theory

• Finance and Economics completely independent
• Finance markets
• In equilibrium
• Efficient
• The data according to CAPM founder Eugene Fama?
• the failure of the CAPM in empirical tests
  implies that most applications of the model are
  invalid. (Fama French 2004 25)
• New model needed to explain empirical data
• Most striking feature growth of debt relative to
  GDP
• E.g., Australia 1964-2008

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Australias debt driven economy

• Australias private debt to GDP ratio has risen
  exponentially at 4.2 p.a. for over 43 years

• Not an isolated phenomenon
• 15 other OECD nations have similar debt to GDP
  data

4
The global debt-driven economy

• 3 decades of growing debt to GDP across OECD

• Empirical questions
• Where would Romania fall on this continuum?
• Why is France an exception?
• Theoretical question
• How to explain phenomenon?
• An alternative theory

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Minskys Financial Instability Hypothesis

• A non-neoclassical vision of capitalism
• capitalism is inherently flawed, being prone to
  booms, crises and depressions.
• This instability, in my view, is due to
  characteristics the financial system must possess
  if it is to be consistent with full-blown
  capitalism.
• Such a financial system will be capable of both
  generating signals that induce an accelerating
  desire to invest and of financing that
  accelerating investment. (1969 224 emphasis
  added)
• Foundations in Marx, Schumpeter, Fisher, Keynes

Skip Quotes
6
Marx

• Theoretical a dialectical theory of prices
• What ... is the price of the loaned
  capital?... What the buyer of an ordinary
  commodity buys is its use-value what he pays for
  is its value. What the borrower of money buys is
  likewise its use-value as capital but what does
  he pay for? Surely not its price, or value, as in
  the case of ordinary commodities. (Marx 1894
  352)
• Colourful a sceptical view of banking
• ...The credit system gives this class of
  parasites the fabulous power, not only to
  periodically despoil industrial capitalists, but
  also to interfere in actual production in a most
  dangerous mannerand this gang knows nothing
  about production and has nothing to do with it."
  (Marx 1894 544-45)

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Schumpeter

• Well-known cyclical view of capitalism
• Creative destruction, clusters of innovations,
  etc.
• Less well-known endogenous view of credit
• In so far as credit cannot be given out of the
  results of past enterprise it can only consist
  of credit means of payment created ad hoc, which
  can be backed neither by money in the strict
  sense nor by products already in existence...
  (Schumpeter 1934 106)
• this again leads us to the heresy that money,
  and other means of payment, perform an
  essential function (95)

8
Fisher

• Debt-deflation theory of Great Depressions
• Non-equilibrium analysis
• New disturbances are, humanly speaking, sure to
  occur, so that, in actual fact, any variable is
  almost always above or below the ideal
  equilibrium (1933 339)
• two dominant factors are over-indebtedness to
  start with and deflation following soon after
• Thus over-investment and over-speculation are
  often important but they would have far less
  serious results were they not conducted with
  borrowed money
• I fancy that over-confidence seldom does any
  great harm except when, as, and if, it beguiles
  its victims into debt. (Fisher 1933 340-341)

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Keynes

• Well-known (if neglected) views on uncertainty
• Formalised in Kaleckis principle of increasing
  risk (Kalecki 1937, 1990 285-293)
• Investment limited not by declining marginal
  efficiency of capital but increasing financial
  risk
• Also post-General Theory two-price level
  analysis
• The scale of production of capital assets
• depends, of course, on the relation between
  their costs of production and the prices which
  they are expected to realise in the market.
  (Keynes 1937a 217)
• All blended by Minsky to produce Financial
  Instability Hypothesis

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Financial Instability Hypothesis

• Economy in historical time
• Debt-induced recession in recent past
• Firms and banks conservative re debt/equity
  ratios, asset valuation
• Only conservative projects are funded
• Recovery means conservative projects succeed
• Firms and banks revise risk premiums
• Accepted debt/equity ratio rises
• Assets revalued upwards

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The Euphoric Economy

• Self-fulfilling expectations
• Decline in risk aversion causes increase in
  investment
• Investment causes economy to grow faster
• Asset prices rise
• Speculation on assets becomes profitable
• Increased willingness to lend increases money
  supply
• Credit money endogenous
• Riskier investments enabled, more asset
  speculation
• Emergence of Ponzi financiers
• Cash flow always less than debt servicing costs
• Profits made by selling assets on a rising market
• Interest-rate insensitive demand for finance

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The Assets Boom and Bust

• Initial profitability of asset speculation
• reduces debt and interest rate sensitivity
• drives up supply of and demand for finance
• market interest rates rise
• But eventually
• rising interest rates make many once conservative
  projects speculative
• forces non-Ponzi investors to attempt to sell
  assets to service debts
• entry of new sellers floods asset markets
• rising trend of asset prices falters or reverses

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Crisis and Aftermath

• Ponzi financiers go bankrupt
• can no longer sell assets for a profit
• debt servicing on assets far exceeds cash flows
• Asset prices collapse, drastically increasing
  debt/equity ratios
• Endogenous expansion of money supply reverses
• Investment evaporates economic growth slows or
  reverses
• Economy enters a debt-induced recession ...
• High Inflation?
• Debts repaid by rising price level
• Economic growth remains low Stagflation
• Renewal of cycle once debt levels reduced

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Crisis and Aftermath

• Low Inflation?
• Debts cannot be repaid
• Chain of bankruptcy affects even non-speculative
  businesses
• Economic activity remains suppressed a
  Depression
• Big Government?
• Anti-cyclical spending and taxation of government
  enables debts to be repaid
• Renewal of cycle once debt levels reduced
• Persuasive verbal model but no successful
  mathematical rendition
• My research objective

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Mathematical Foundations

• Goodwins predator-prey growth cycle model
• Verbal truisms
• Workers share of output will rise if (real) wage
  demands exceed sum of population growth and
  labour productivity
• Employment will rise if the rate of economic
  growth exceeds the rate of population growth
• In mathematical form, two coupled differential
  equations

Phillips Curve
Depreciation, Productivity Population growth
rates
Workers share of output
Investment Function
Employment rate
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Mathematical Foundations

• Generates closed cycle

• Add financial truisms
• Banks finance investment and charge interest
• Generates 3rd order system
• Debt to output ratio added

Net real interest rate
Profit now net of interest payments
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The beginnings of chaos

• Two classes of outcome
• Convergence to equilibrium

• If capitalists accumulate negative debt

• But if they dont

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The beginnings of chaos

• An unstable cycle

• And debt that ratchets up over time to a
  debt-crisis

• How well does this simple model match empirical
  data?
• Not very
• Because the empirical data is much worse!

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The Ponzi Economy

• Australias private debt to GDP ratio has risen
  exponentially at 4.2 p.a. for over 43 years

• Not for the first time in our history either
• Long term RBA data shows three bubbles in
  Australias financial history
• Current bubble is the biggest by far!

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The Ponzi Economy
And Our Generation?
The Baby Boomers Follies
1890s Depression
Great Depression
Melbourne Land Boom
Roaring Twenties
What comes next?
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The Ponzi Economy

• Correlation isnt causation, but

Clearly exponential process
Biggest bubble in our history

• There is a macroeconomic link
• Aggregate demand GDP change in debt
• As debt rises, dependence on change in debt has
  risen
• Now accounts for 18 of aggregate demand
• Unemployment increasingly linked to change in
  debt

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The Ponzi Economy

• Correlation debts contribution to aggregate
  demand of to unemployment initially trivial
• Exceeds -0.9 by early 1980s

• Formation of debt also increasingly dominated by
  speculation rather than investment

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Ponzi Households

• Lending for housing rises from 5-25 of GDP

• Proportion that financed housing construction
  falls from 30 to under 10

• Back to modelling
• Clear omissions from basic Minsky model are
• Endogenous money
• Speculative lending

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Endogenous Money

• Exponential growth in credit despite regulatory
  regime implies endogenous (market-determined)
  money
• Common belief in non-neoclassical schools of
  thought
• Empirically supported by Kydland Prescott

• But no accepted mathematical model of process
• One can be derived from double-entry book-keeping

Skip Systems Note
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A simple approach to dynamic systems

• Each column represents a stock (system state)
• Each row entry represents a flow between stocks
• Specify relations between system states across
  rows

Relations
Equations

• To generate the model, add up each column
• Sum of column is differential equation for stock

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Money creation in a pure credit economy

• Stylized linear model with three (classes of)
  agents
• Banks
• lend money to firms
• record all transactions
• Firms
• own factories that produce output and
• Workers
• work in factories.
• Model starts with loan L from bank to firm
• Created out of thin airsimply simultaneous
  recording of asset (debt) and liability (deposit)
  in banks double-entry book-keeping system

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Money from nothing, but your cheques aint free

• Loan an asset of bank
• Simultaneously creates liability of money in
  firms deposit account

• Sets off series of obligations
• Interest charged on loan at rL p.a.
• Interest paid on deposit at rD p.a. where rL gt
  rD
• Third account needed to record this Bank Deposit
  BD

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Money from nothing, but your cheques aint free

• Full system is

Interest flows banklt?gtfirm
Add up terms
Wage flows firm?gtworkers
Interest flows bank?gtworkers
Consumption flows bank workers?gtfirms

• System of coupled differential equations

Get equation

• System conservative
• Amount of money
• ( debt)
• remains constant

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Money from nothing, but your cheques aint free

• Growth in output requires new money to
• Hire more workers
• Pay for intermediate inputs
• Simultaneous creation of new debt and new money

• System stable but no growth

Skip Quotes

• Violates Walras Law
• Supports Schumpeter Minsky on credit

New money flows bank?gtfirm
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Money from nothing, but your cheques aint free

• Schumpeter
• in so far as credit cannot be given out of the
  results of past enterprise it can only consist
  of credit means of payment created ad hoc, which
  can be backed neither by money in the strict
  sense nor by products already in existence...
  (Schumpeter 1934 106)
• Minsky
• If income is to grow, the financial markets
  must generate an aggregate demand that 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 income
• 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 1963
  1982 6)

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Money from nothing, but your cheques aint free

• Money and debt now grow over time

• System dissipative
• Rate of growth of money
• rate of growth of debt

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Repayment and Re-lending of Principal

• Model so far omits loan repayment
• Easily added by including seignorage free bank
  Vault
• Repaid loans have to go somewhere
• If into bank deposit account, bank can pay for
  goods using its money as IOUs
• NOT the same as re-lending deposited fiat money
• Pure credit money system requires quarantining
  of bank asset accounts from income (deposit)
  accounts
• Bank assets now sum of
• Outstanding Loans
• Loan Repayments

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Repayment and Re-lending of Principal

• Repayments of Loans and
• Recycling of Loans
• Transfer money from income to asset accounts

• Surplus from production drives all net income
• P is turnover period
• s is share going to firms
• (1-s) goes to workers

Wages flow shown as share of production surplus
Repayment flows firm?gtbank
Relending flows bank?gtfirm
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Would you like a credit card with that?

• Can now see what happens to bank income as
• New Money is created
• Loans are repaid
• Repaid money is re-lent

• Surprise surprise!
• Bank income rises if
• Loans are repaid slowly (or not at all)
• Repaid money is recycled more quickly and
• More new money is created
• Bank profits by extending more credit
• Structural explanation for real world phenomenon
  of rising debt to GDP ratio

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Would you like a credit card with that?

• Surprise surprise!
• Bank income rises if
• Loans are repaid slowly (or not at all)
• Repaid money is recycled more quickly and
• More new money is created

• Lenders profits by extending more credit
• Structural reason for lenders creating rising
  debt
• What if they decide to change direction?
• Impact of credit crunch

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Im sorry, you cant have a credit card with
that!

• US Economy now experiencing a Credit Crunch
• New money created less quickly
• Loans repaid more quickly
• Reserves re-lent more slowly?
• Key relation is link between creation of bank
  assets and liabilities
• In growing economy, growth of bank liabilities
  (active deposit accounts) positive
• In a credit crunch, growth of liabilities turns
  negative

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Dude, Who Moved My Economy?

• Credit Crunch rate of money creation drops
• repayment of loans increases
• relending drops

• Loans (Assets in circulation) fall even without
  bankruptcy
• Economy falls into recession
• Credit-driven economic reversal

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For future research

• Combine two models to produce monetary Minsky
  model
• Speculative investment motivated by increase in
  asset price index
• Adds to debt does not add to productive capacity
• First stage a monetary Goodwin model
• Also includes Phillipss full Monty
• Wage change related to
• Rate of employment
• Rate of change of employment
• Lagged response to inflation

Skip Model
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For future research

• Combine two models to produce monetary Minsky
  model
• Speculative investment motivated by increase in
  asset price index
• Adds to debt does not add to productive capacity
• First stage a monetary Goodwin model
• Also includes Phillipss full Monty
• Wage change related to
• Rate of employment
• Rate of change of employment
• Lagged response to inflation

Skip Model
40
A monetary Goodwin model

• Now six system states
• But remarkably simple model

Physical Capital

• Generates open cyclical model

Money Wage
Inflation
Lagged wage response
Technical changePopulation growth

• With Phillips surface rather than Phillips
  curve inflation and unemployment dynamics

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Meanwhile, in the real world

• Combination of record Debt/GDP, high nominal
  interest rates and low inflation means huge real
  interest burden

• Debt burden
• Aggregate demand effect of debt reduction
• Serious downturn inevitable
• Counter forces
• China boom
• Possible global warming/peak oil inflation

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Selected References

• Joseph Schumpeter (1934), The Theory of Economic
  Development An Inquiry into Profits, Capital,
  Credit, Interest, and the Business Cycle
  (republished 2004 by Transaction Publishers, New
  Brunswick)
• Charles Whalen, The U.S. Credit Crunch of 2007
  A Minsky Moment, http//ideas.repec.org/p/lev/lev
  ppb/ppb_92.html
• Some web-accessible references on Minskys work
• http//www.debunkingeconomics.com/FinancialInstabi
  lity.htm
• A Google Scholar search on Minsky
• http//scholar.google.com.au/scholar?qhymanminsk
  yhlenlr
• Some web-accessible references on endogenous
  money
• http//www.debunkingeconomics.com/Lectures/Index.h
  tmFE