The global debt bubble Steve Keen University of Western Sydney

A booming economy… Seventeen years of growth…

A booming economy… Fifteen years of falling unemployment…

A booming economy… And 43 years of debt rising faster than GDP…

Having the (borrowed) time of our lives… Another look at the medium term trend… Does that look sustainable to you?

Asset Rich and Debt Poor… Assets are rising too… But not as fast as debt has risen…

Asset Rich and Debt Poor… And housing assets have risen only because they’ve become more expensive…

Volatile Prices & Sluggish Output Additions to housing stock lower in 2004 than in 1997… We had a borrowing boom, not a building boom…

Volatile Prices & Sluggish Output Which is why we’re having a rental crisis… But even rents haven’t kept pace with debt servicing: Apparent high value of assets illusory

Volatile Prices & Sluggish Output Houses more expensive simply because we’ve been willing to borrow more money to buy them… –Prices up 250% since 1996; mortgage debt up 520%

Who’s having a housing bubble then? Australia’s house price bubble even bigger than USA’s And still growing!

Ponzi Households Lending for housing rose from 5-25% of GDP: Proportion that financed construction fell from 30% to under 10%: No wonder we’re having a rental crisis… – –We didn’t build (m)any houses! What’s driving the debt?

Having the (borrowed) time of our lives… There’s something systematic going on here… And we’re not alone… unfortunately

Having the (borrowed) time of our lives… Not for the first time in our history either…

The Ponzi Economy

Correlation isn’t causation, but… Clearly exponential process Biggest bubble in our history Serious Depressions after previous two debt bubbles What can we expect after this one? According to RBA, there’s nothing to worry about!…

Efficient markets & financial democracy? Ric Battellino, Deputy Governor, RBA: –“Has the expansion of household credit run its course? Will it reverse? We cannot know the answer to these questions with any certainty, but my guess is that the democratisation of finance which has underpinned this rise in household debt probably has not yet run its course...” –“Eventually, household debt will reach a point where it is in some form of equilibrium relative to GDP or income, but the evidence suggests that this point is higher than current levels.” (Battellino, “Some Observations on Financial Trends”, 25 September 2007) Skip Model Skip Model Skip Model Skip Model

Another interpretation: limitless lending Who’s in control of the money supply and debt? –Economics textbooks The Government/Central Bank –Central Bank creates “base money” –Sets “money multiplier” –Credit Money = Base Money * Credit Money –Economic data “There is no evidence that either the monetary base … leads the cycle, although some economists still believe this monetary myth. … the monetary base lags the cycle slightly… The difference of M 2 -M 1 leads the cycle by … about three quarters.” (Kydland & Prescott 1990, p. 15)

The new monetary paradigm Money supply “endogenous” –Credit money not under government control Inherent bias towards providing as much debt as can flog How does it work? Simple! –Consider bank loan of $L to Firm –Simultaneously creates Deposit $L and Loan $L –Charges r L % p.a. on loan –Pays r D % p.a. on deposit –And so on… Put together flows & you can understand credit creation –Starting from the beginning Loan by bank created both money and debt…

“Money from nothing, but your cheques ain’t free” Loan an asset of bank Simultaneously creates liability of money in firm’s deposit account: Sets off series of obligations: – –Interest charged on loan at r L % p.a. – –Interest paid on deposit at r D % p.a. where r L > r D – –Third account needed to record this: Bank Deposit B D

“Money from nothing, but your cheques ain’t free” Full system is: Interest flows: bank firm Wage flows: firm―>workers Interest flows: bank―>workers Consumption flows: bank & workers―>firms New Money/Debt flows: bank firms Debt repayment flows: firms ―>bank Reserve relending flows: bank―>firms Table describes self-sustaining pure credit economy Can now ask “What happens to bank income if…” – –New money created more quickly – –Loans repaid more quickly – –Reserves re-lent more quickly?

“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?

“Money from nothing, but your cheques ain’t free” “Credit Crunch”: –Rate of money creation drops –Repayment of loans increases –Relending drops… Loans—Assets in circulation fall even without bankruptcy Credit-driven economic reversal…

Why do borrowers accept debt in the first place? Hyman Minsky’s “Financial Instability Hypothesis” –An explanation for debt-driven booms & depressions 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

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

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

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

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 Sounds like history lesson rather than economic theory…

Meanwhile, in the real world… Combination of record Debt/GDP, high nominal interest rates and low inflation means huge real interest burden: Debt servicing pressure will constrain debt growth at some point – –Borrowers cease borrowing – –Lenders cause credit crunch…

The Ponzi Economy Rising debt in the economic driver’s seat –No influence on unemployment in the 60s –Accounts for 90% of unemployment now What happens next?...

Back in the USA… USA Housing Bubble has clearly burst: House prices falling by more than 1% per month!

In China we trust?… 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 Even stabilising debt/GDP ratio will cause 5%+ cut in spending Serious downturn inevitable Counter forces –Possible global warming/peak oil inflation Inflation reduces debt burden –China boom… We are entering stormy economic waters…

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