Steve Keen: Why the meltdown will last

private debt is far higher than Government debt, even after the increase last year due to Rudd’s stimulus package. Government debt is currently 5.5% of GDP, whereas private debt—even though it has fallen slightly due to business deleveraging—is over 150% of GDP: 27 times the size of Government debt. The so-called debate that the major parties are having over the size of Government debt is an embarrassment.

Australian economist Steve Keen has a very good explanation why our economic system is not able to jumpstart itself, it’s a must read to understand the fundamentals of this systemic shock.

The original article has many graphs.

Excerpts from Steve Keen:

1. The role of the level of debt and deleveraging:

“Debt reduction is now the real story of the American economy, just as real story behind the apparent free lunch of the last two decades was rising debt. The secret that has completely eluded Bernanke is that aggregate demand is the sum of GDP plus the change in debt. So when debt is rising demand exceeds what it could be on the basis of earned incomes alone, and when debt is falling the opposite happens.

I’ve been banging the drum on this for years now, but it’s a hard idea to communicate because it’s so alien to the way most economists (and many people) think. For a start, it involves a redefinition of aggregate demand. Most economists are conditioned to think of commodity markets and asset markets as two separate spheres, but my definition lumps them together: aggregate demand is the sum of expenditure on goods and services, PLUS the net amount of money spent buying assets (shares and property) on the secondary markets. This expenditure is financed by the sum of what we earn from productive activities (largely wages and profits) PLUS the change in our debt levels. So total demand in the economy is the sum of GDP plus the change in debt.

the GDP and the change in debt for the two years 2008 and 2010: in 2007-2008, GDP was $14.3 trillion while the change in private sector debt was $4 trillion, so aggregate private sector demand was $18.3 trillion. In calendar year 2009-10, GDP was $14.5 trillion, but the change in debt was minus $1.9 trillion, so that aggregate private sector demand was $12.6 trillion. The turnaround in two years in the change of debt has literally sucked almost $6 trillion out of the US economy.

That sucking sound will continue for many years, because the level of debt that was racked up under Bernanke’s watch, and that of his predecessor Alan Greenspan, was truly enormous. In the years from 1987, when Greenspan first rescued the financial system from its own follies, till 2009 when the US hit Peak Debt, the US private sector added $34 trillion in debt. Over the same period, the USA’s nominal GDP grew by a mere $9 trillion.

Ignoring this growth in debt—championing it even in the belief that the financial sector was being clever when in fact it was running a disguised Ponzi Scheme—was the greatest failing of the Federal Reserve and its many counterparts around the world.”

2. The ideological blinders of the neoliberal belief system:

“Though this might beggar belief, there is nothing sinister in Bernanke’s failure to realize this: it’s a failing that he shares in common with the vast majority of economists. His problem is the theory he learnt in high school and university that he thought was simply “economics”—as if it was the only way one could think about how the economy operated. In reality, it was “Neoclassical economics”, which is just one of the many schools of thought within economics. In the same way that Christianity is not the only religion in the world, there are other schools of thought in economics. And just as different religions have different beliefs, so too do schools of thought within economics—only economists tend to call their beliefs “assumptions” because this sounds more scientific than “beliefs”.

Let’s call a spade a spade: two of the key beliefs of the Neoclassical school of thought are now coming to haunt Bernanke—because they are false. These are that the economy is (almost) always in equilibrium, and that private debt doesn’t matter.

One of Bernanke’s predecessors who also once believed these two things was Irving Fisher, and just like Bernanke, he was originally utterly flummoxed when the US economy collapsed from prosperity to Depression back in 1930. But ultimately he came around to a different way of thinking that he christened “The Debt Deflation Theory of Great Depressions” (Fisher 1933).

You would think Bernanke, as the alleged expert on the Great Depression—after all, that’s one of the main reasons he got the job as Chairman of the Federal Reserve—had read Fisher’s papers. And you’d be right. But the problem is that he didn’t understand them—and here we come back to the belief problem. The Great Depression forced Fisher—who was also a Neoclassical economist—to realize that the belief that the economy was always in equilibrium was false. When Bernanke read Fisher, he completely failed to grasp this point. Just as a religious scholar from, for example, the Hindu tradition might completely miss the key points in the Christian Bible, Bernanke didn’t even register how important abandoning the belief in equilibrium was to Fisher.

We might not be in such a pickle now if economics had started to become more of a science and less of a religion by following Fisher’s lead, and abandoning key beliefs when reality made a mockery of them. But instead neoclassical economics completely rebuilt its belief system after the Great Depression, and here we are again, once more experiencing the disconnect between neoclassical beliefs and economic reality.”

3. The role of the banks and their unsustainable profit levels

“Because of that debt level, bank profits have gone through the roof as a share of GDP. Back before we had a financial crisis—when debt levels were far lower than today—so too were bank profits as a share of GDP. A sustainable level of bank profits appears to be about 1% of GDP. The blowout from this level to virtually six times as much began when bank deregulation.”