A new age of deleveraging

Bank of Canada's Mark Carney may well be the first OECD central bank governor to acknowledge the inevitability of debt defaults, but his models understate the problem.

There was movement at the station,
for the word had passed around
That the colt from old Regret had got away…

('Banjo' Patterson, The Man from Snowy River)

I’m delighted to see the governor of a central bank – Bank of Canada's Mark Carney – even refer to Hyman Minsky, let alone acknowledge that we are in a "Minsky Moment” (or should that be millennium?), to proclaim that we are now in an age of deleveraging, and to focus on the impact of changes in the aggregate level of debt and to countenance that debt write-offs may have a role to play in escaping from this never-ending crisis.

By way of contrast, so far as I am aware, the word "Minsky” has yet to pass from Ben Bernanke’s lips since this crisis began, and his discussion of Minsky prior to this crisis was, to put it politely, asinine. Bernanke devoted precisely two sentences to Hyman Minsky in his Essays on the Great Depression. I expect that sheer embarrassment may be one reason that Hyman’s name is taboo in Bernanke’s presence.

Figure 1: Result of search for "Minsky" in Federal Reserve Speeches

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Similarly, the impact of deleveraging on aggregate demand doesn’t even fit in Bernanke’s doggedly neoclassical mindset: from that point of view, only the distribution of debt matters, and not its aggregate level. Despite his popularly-believed status as an expert on the Great Depression, he simply refused to countenance any explanation of that event that didn’t fit into the neoclassical basket – as evidenced by his dismissal of Irving Fisher’s Debt Deflation Theory of Great Depressions:

"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…" (Bernanke 2000, p. 24; emphasis added).

The highlighted section of this quote shows how little thought Bernanke gave to the actual process of debt-deflation: during such a crisis, many debtors can’t repay their debts and therefore there is no zero-sum "redistribution from debtors to creditors”, but widespread debt defaults. As Carney emphasises in his speech, 'Growth in the age of deleveraging', defaults are inevitable and policymakers may make things worse if they simply try to avoid debt write-offs:

"Whether we like it or not, debt restructuring may happen. If it is to be done, it is best done quickly. Policymakers need to be careful about delaying the inevitable and merely funding the private exit" (p. 6).

So bravo to governor Mark Carney for being probably the first OECD central bank governor to acknowledge Minsky, deleveraging, and the inevitability of debt defaults (though not the first central bank governor in the world; that honour almost certainly belongs to Mercedes Marc del Pont, governor of the Central Bank of Argentina).

That said, there are several points on which I’ll quibble with Carney’s analysis.

Private debt is different

Carney lumps private sector and public sector debt together, and excludes financial sector debt from his statistics – clearly in the belief that finance sector debt doesn’t matter, and presumably (since he doesn’t provide his reasoning for doing so) in the belief that finance sector debt to the finance sector is a 'zero sum game'.

Figure 2: Carney's key debt to GDP ratio chart

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From the perspectives of Minsky's theory, the empirical record and the process of private money and debt creation, both these decisions – lumping government and private sector debt together, and ignoring finance sector debt – are in error.

Minsky’s 'Financial Instability Hypothesis' focused upon the dynamics of private debt, with the core concept being that leveraged speculation would rise during a period of tranquil growth in a capitalist economy because tranquillity was the exception rather than the rule.

Minsky saw properly-managed public spending – and hence public debt – as a potential "homeostatic stabiliser” to this dynamic of private debt. Rising taxation and declining social security payments during a boom made a public sector surplus likely, which would take money out of circulation and reduce the scale of private speculation, while declining taxation and rising social security payments during a slump would give private businesses a cash flow they wouldn’t otherwise have, making it easier to repay debts. I modelled this aspect of his hypothesis in my first papers on Minsky, and got the outcome that Minsky predicted: a private system that was prone to a debt-deflation could be stabilised by counter-cyclical government spending.

Figure 3: A Minsky model without government spending

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Figure 4: A Minsky model with government spending

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In my model, the government sector was 'resolute' – increasing spending if unemployment exceeded 5 per cent and reducing it below that level. In the real world, governments have accepted rising unemployment, and accumulated debt in pursuit of follies (like the war in Iraq) as well as in pursuit of economic stability. But even so, the counter-cyclical role of government debt can be seen when one compares private sector debt – including financial sector debt – to government debt (see figure 5).

Figure 5: Separating out private sector and public sector debt in the US

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This is more apparent when we look just at the change in debt: private and public debt move in opposite directions.

Figure 6: Private and public debt move in opposite directions

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Finance sector debt matters

Ignoring finance sector debt is a mistake. Firstly, it’s huge: by far the largest component of debt, private or public, in the US (see figure 6).

Secondly, finance sector debt is not a 'zero sum game'. Though lending by a non-bank financial company to another entity doesn’t create money, it does create debt; and the initial lending by a bank to a non-bank creates both credit money and debt. Since the finance sector was the source of most of the speculative debt that fuelled the bubble, and it is by far the major force in deleveraging now, leaving it out of the analysis exempts a major causal factor in both the pre-2008 boom and the post-2008 debacle.


Figure 7
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Thirdly, by lumping together private and government debt and ignoring finance sector debt, Carney’s aggregation obscures the comparison of today with the Great Depression, understates the growth of debt since the end of WWII, mis-identifies the start of the Age of Deleveraging, and understates the degree of deleveraging to date.

According to Carney’s aggregation, 'peak debt' during the Great Depression was 285 per cent of GDP versus 254 per cent today, the build-up in debt only began in 1980, peak debt occurred in August 2009, and deleveraging has been relatively mild since then.

However, if we consider just private sector debt and include the finance sector, peak debt in the Great Depression was 238 per cent versus 303 per cent today, the build-up in debt began right from 1945, peak debt occurred in February 2009, and deleveraging since then has been stark.

If we considering all private and public debt together, the situation today is worse than the Great Depression (307 per cent then versus 373 per cent today), the debt build-up dates to 1950, peak debt was in March 2009, and deleveraging – despite a huge increase in government debt – has been marked.

Figure 8: Comparing debt ratios

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So which aggregation is better? This is best answered by looking at why aggregate debt matters, which is the role of changing debt levels in aggregate demand. In the credit-based economy in which we live, aggregate demand is the sum of incomes plus the change in debt. This monetary demand is then expended on both goods and services and claims on financial assets.

This is a case made well by both Joseph Schumpeter and Minsky, but has been ignored by neoclassical economics (and forgotten even by some modern non-neoclassical economists).

We can use this to show that Carney’s aggregation is misleading, because using his aggregation, there has been no deleveraging. The change in debt, on his measure, remained positive right through the crisis.

Figure 9: Change in debt in $US million

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But when the financial sector is included and government sector excluded, there has been a huge turnaround from rising debt (adding almost 30 per cent to aggregate demand at the peak of the bubble, and then subtracting 20 per cent from aggregate demand at its trough).

Figure 10: Change in debt as percent of GDP

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The final clincher is the correlation of these measures to unemployment. There is a strong negative correlation between change in debt and the level of unemployment, since increasing debt increases aggregate demand and reduces unemployment (Carney’s mixed private-public-minus-finance measure has a reasonable correlation to unemployment of -0.45, but the private-only-including-finance has a correlation of -0.94).

Figure 11: Far stronger correlation of change in Private debt to Unemployment

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The horse has bolted

Carney’s measure makes it very hard to identify when the crisis began: the change in debt in his measure remains positive, and all that can be identified is a slight slowdown in the rate of growth of debt (from 14 per cent of GDP per annum to 7 per cent, after which it 'recovers' back to about 10 per cent). Peak debt occurs in August 2009 – two years after the crisis began.

The private-including-finance measure, however, clearly identifies the end of 2007 as the beginning of the crisis – when the change in debt plunged from almost 30 per cent of GDP per annum down to minus 20 per cent at its nadir in early 2010. So "the colt from old Regret” got away two years before the first central banker noticed.

While I’m again very thankful that Governor Carney has put Minsky into the vocabulary of Western central bankers, we would have been far better off had Minsky’s wisdom been heeded decades ago, rather than after the GFC. This would have been possible because knowledge of Minsky wasn’t limited to a few obscure non-orthodox economists like myself: the head of the BIS’s research department from 1995 until 2008 was another Canadian, Bill White, and he was an out and out Minsky fan whose warnings of a potential crisis were ignored.

That said, it’s good to see that sensible economics, rather than the fantasy that is neoclassical economics, is finally being considered in the realms of central banks.

Steve Keen is Professor of Economics & Finance at the University of Western Sydney and author of Debunking Economics and the blog Debtwatch. A longer version of this article appeared on Debtwatch on December 19.

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