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Why banks cause crises (and how to stop them) Steve Keen University of Western Sydney www.debtdeflation.com/blogs
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Why banks cause crises (and how to stop them) Steve Keen University of Western Sydney .

Mar 26, 2015

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Page 1: Why banks cause crises (and how to stop them) Steve Keen University of Western Sydney .

Why banks cause crises (and how to stop them)

Steve KeenUniversity of Western Sydneywww.debtdeflation.com/blogs

Page 2: Why banks cause crises (and how to stop them) Steve Keen University of Western Sydney .

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”…

Page 3: Why banks cause crises (and how to stop them) Steve Keen University of Western Sydney .

Popular Fallacy: Crises inevitable• 19th century experiment with “pure” private money

– Private banks printed own notes across USA, Australia, Scotland

Page 4: Why banks cause crises (and how to stop them) Steve Keen University of Western Sydney .

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…

Page 5: Why banks cause crises (and how to stop them) Steve Keen University of Western Sydney .

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

Page 6: Why banks cause crises (and how to stop them) Steve Keen University of Western Sydney .

Popular Fallacy: Crises inevitable• Stable stock of money finances stable level of economic activity:

Page 7: Why banks cause crises (and how to stop them) Steve Keen University of Western Sydney .

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

Page 8: Why banks cause crises (and how to stop them) Steve Keen University of Western Sydney .

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

Page 9: Why banks cause crises (and how to stop them) Steve Keen University of Western Sydney .

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.”

Page 10: Why banks cause crises (and how to stop them) Steve Keen University of Western Sydney .

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)

Page 11: Why banks cause crises (and how to stop them) Steve Keen University of Western Sydney .

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

Page 12: Why banks cause crises (and how to stop them) Steve Keen University of Western Sydney .

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

Page 13: Why banks cause crises (and how to stop them) Steve Keen University of Western Sydney .

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)

Page 14: Why banks cause crises (and how to stop them) Steve Keen University of Western Sydney .

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!

Page 15: Why banks cause crises (and how to stop them) Steve Keen University of Western Sydney .

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

qq

PP

qq

PP

QQ

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…

Page 16: Why banks cause crises (and how to stop them) Steve Keen University of Western Sydney .

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.

Page 17: Why banks cause crises (and how to stop them) Steve Keen University of Western Sydney .

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…

Page 18: Why banks cause crises (and how to stop them) Steve Keen University of Western Sydney .

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

Page 19: Why banks cause crises (and how to stop them) Steve Keen University of Western Sydney .

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

Page 20: Why banks cause crises (and how to stop them) Steve Keen University of Western Sydney .

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”

Page 21: Why banks cause crises (and how to stop them) Steve Keen University of Western Sydney .

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.

Page 22: Why banks cause crises (and how to stop them) Steve Keen University of Western Sydney .

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

Page 23: Why banks cause crises (and how to stop them) Steve Keen University of Western Sydney .

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

Page 24: Why banks cause crises (and how to stop them) Steve Keen University of Western Sydney .

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)

Page 25: Why banks cause crises (and how to stop them) Steve Keen University of Western Sydney .

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

Page 26: Why banks cause crises (and how to stop them) Steve Keen University of Western Sydney .

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

Page 27: Why banks cause crises (and how to stop them) Steve Keen University of Western Sydney .

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

Page 28: Why banks cause crises (and how to stop them) Steve Keen University of Western Sydney .

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

Page 29: Why banks cause crises (and how to stop them) Steve Keen University of Western Sydney .

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

Page 30: Why banks cause crises (and how to stop them) Steve Keen University of Western Sydney .

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

Page 31: Why banks cause crises (and how to stop them) Steve Keen University of Western Sydney .

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