A superior kind of Fed stimulus

As America delevers, traditional government stimulus won't be enough to propel a proper recovery. Instead, the Fed needs to inject money into the public's bank accounts – but with one condition.

URPE – The Union for Radical Political Economics – is holding a summer school for the Occupy movement, and as part of that invited papers that explained the crisis in 1000 words or less (so that they can be printed on one double-sided sheet). Here’s my effort in somewhat less than 1,000 words (though with two figures). In the interests of URPE’s objective in this exercise, here’s the PDF of this blog post for general download.

Both the crisis and the apparent boom before it were caused by the change in private debt. Rising aggregate private debt adds to demand, and falling debt subtracts from it. This point is vehemently denied on conventional theoretical grounds by economists like Paul Krugman, but it is obvious in the empirical data. The crisis itself began in 2008, precisely when the growth of private debt plunged from its peak of almost 30 per cent of GDP per annum. down to its depth of minus 20 per cent in 2010. The recovery, such as it was, began when the rate of decline of debt slowed. Across recession, boom and bust between 1990 and 2012, the correlation between the annual change in private debt and the unemployment rate was -0.92.


The causation behind this correlation is that money is created 'endogenously' when the banking sector creates loans, and this newly created money adds to aggregate demand – as argued by non-orthodox economists from Schumpeter through to Minsky. When this debt finances genuine investment, it is a necessary part of a growing capitalist economy, it grows but shows no trend relative to GDP, and leads to modest profits by the financial sector. But when it finances speculation on asset prices, it grows faster than GDP, leads obscene profits by the financial sector and generates Ponzi schemes which are to sustainable economic growth as cancer is to biological growth.

When those Ponzi schemes unravel, the rate of growth of debt collapses and the boost to demand from rising debt becomes a drag on demand as debt falls. In all other post-WWII downturns, growth resumed when debt began to rise relative to GDP once more. However the bubble we have just been through has pushed debt levels past anything recorded in history, triggering a deleveraging process that is the hallmark of a Depression.


The last Depression saw debt levels fall from 240 per cent to 45 per cent of GDP over a 13-year period, and the ensuing period of low debt led to the longest boom in America’s history. We commenced deleveraging from 303 per cent of GDP. After three years it is still 10 per cent higher than the peak reached during the Great Depression. On current trends it will take till 2027 to bring the level back to that which applied in the early 1970s, when America had already exited what Minsky described as the "robust financial society” that underpinned the Golden Age that ended in 1966.

While we delever, investment by American corporations will be timid, and economic growth will be faltering at best. The stimulus imparted by government deficits will attenuate the downturn – and the much larger scale of government spending now than in the 1930s explains why this far greater deleveraging process has not led to as severe a Depression – but deficits alone will not be enough. If America is to avoid two 'lost decades', the level of private debt has to be reduced by deliberate cancellation, as well as by the slow processes of deleveraging and bankruptcy.

In ancient times, this was done by a Jubilee, but the securitisation of debt since the 1980s has complicated this enormously. Whereas only the money lenders lost under an ancient Jubilee, debt cancellation today would bankrupt many pension funds, municipalities and the like who purchased securitised debt instruments from banks.

I have therefore proposed that a 'Modern Debt Jubilee' should take the form of 'Quantitative Easing for the Public': monetary injections by the Federal Reserve not into the reserve accounts of banks, but into the bank accounts of the public – but on condition that its first function must be to pay debts down. This would reduce debt directly, but not advantage debtors over savers, and would reduce the profitability of the financial sector while not affecting its solvency.

Without a policy of this nature, America is destined to spend up to two decades learning the truth of Michael Hudson’s simple aphorism that "Debts that can’t be repaid, won’t be repaid”.

Steve Keen is a professor of economics and finance at the University of Western Sydney and author of Debunking Economics and the blog Debtwatch.

Related Articles