1. Why credit money doesn’t have to crash And why it always does
Steve Keen
University of Western Sydney
Debunking Economics

2. The Great Moderation to The Great Recession
Everything was going SO well…
Unemployment
Inflation & Unemploment Falling
Deflation

3. What the hell happened? A debt bubble burst… Should that matter?
Not according to conventional “neoclassical” economics…

4. 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)

5. 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

6. 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…

7. Model of credit money Pure credit money system: bank issues own notes
Like 19th century free banking in USA
No Central Bank
Private 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

8. 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:

9. 19th century free banking: Stage 1
Modelled using new software package QED
“Quesnay Economic Dynamics”
QED

10. 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
Is this even possible?

11. 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)

12. 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 empties…

13. 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:

14. 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 $ p.a.
Net Interest $3.72
Profit? p.a. (shown later)
Final step: new money
In 19th century: notes
In 20th century: credit
QED

15. Money creation in pure credit economy
19th century: add new notes to vault

16. Money creation in pure credit economy
20th century: simultaneously issue loan and deposit

17. 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 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 1982, p. 6; emphasis added)

18. 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)

19. 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)

20. 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

21. 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…

22. The Facts on Debt
2 obvious US debt bubbles in last century

23. Debt and Aggregate Demand
Conventional “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

24. Debt and Aggregate Demand
Crisis manifestation of deleveraging
Crisis by de-leveraging
But notice recent turnaround

25. Debt and Aggregate Demand
Correlation with unemployment
Crisis by de-leveraging
R2=-.7
But notice recent turnaround

26. 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...

27. Change in Debt & Change in Employment
Correlation with change in employment
Crisis begins
R2=.67
USA stalled crisis by slowdown in deleveraging

28. Change in Debt & Change in Employment
Summing up: Credit drives the economy
Acceleration in debt precedes change in GDP
Doesn’t have to drive it “over the cliff”
But always does
Why?
The temptation of Ponzi Finance
Putting it all together...

29. 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

30. 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

31. 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

32. 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 economy

33. 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

34. Modelling Minsky: Financial side
New Godley Table
“Line of credit”: 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)

35. 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

36. 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:

37. Modelling Minsky: Inherent cycles
Model generates cycles (but no growth since no population growth or technical change yet)…:
Cycles caused by essential nonlinearity:
Wage rate times employment
Behavioural nonlinearities not needed for cycles;
Instead, restrain values to realistic levels

38. 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 )
All 3 factors included in this model:
Rate of change of wages depends on…
Employment
Rate of change of employment
Inflation

39. 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 tS (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
In equilibrium, flow of physical supply = physical demand
Physical supply
Physical demand
Solving for equilibrium price:
Convergence over time
As a dynamic process:

40. Modelling Minsky: The full system
In scary equations…

41. Modelling Minsky: The full system
QED
In less scary QED format:

42. Modelling Minsky: The outcome
Model generates Great Moderation & Great Recession
Not yet calibrated on data yet qualitatively similar…

43. Modelling Minsky: The outcome
The full picture from QED

44. Modelling Minsky: The outcome
The full picture from QED

45. 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 Moderation”—Bernanke 2004)
But “Calm before the storm” (Keen 1995)

46. How does “Now” compare to “Then”?
Debt-financed proportion of aggregate demand:
Scale of downturn 2.5 years in
2000s
Scale of government response
1930s
1930s
2000s
Notice current turnaround in debt contribution

47. 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?

48. Where to from here?: Level
It’s a long way from the top if you’ve sold your soul...
Almost 100% of GDP reduction to get to pre-Great Depression level
Speculative debt still present
200% to get back to 50s level
Only productive debt
Decade with aggregate demand below GDP
The NBER thinks the recession ended here!

49. 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”

50. 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

51. 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
Learning complicated dynamics of debt the hard way
History implies crisis has many years to run…