Camille Pissarro ‘Avenue de l’Opera, Place du Theatre Francais: Misty Weather’Professor Steve Keen has posted a video of his New York talk – which I attended – and it is worth a listen:
New York Debtwatch Talk: Modelling Debt Deflation
Published in July 14th, 2010The blog now has over 5000 members, and about 40 of them crowded into a small room in the FlatIron district of New York to hear me give a talk on debt-deflation. Since I had the luxury of more time than you get at an academic conference, and an engaging and intelligent audience, I gave a lot more detail on my modelling approach. The questions were also superb, and would have continued for much longer if I hadn’t called quits at an opportune point (the whole caboodle of presentation and discussion is almost 70 minutes long). My answers come through loud and clear on this video; I just hope that the questions themselves can be heard by better ears than mine!
Steve Keen’s Debtwatch Podcast with Stuart Cameron
The presentation slides are linked here, and the paper here. The presentation is new and much more detailed than the one I gave at the Levy; the paper is the same as that linked to the Levy presentation.
I am still doing some development work on this model, including expanding it to include fiat as well as credit money (and I hope ultimately to fit it to the US data as well), but for now it’s the most complete single sectoral model of debt-deflation I’ve put together.
I’ve also linked an MP4 format file here, since the Flash Video compression seems to result in rather hard to read text on the slides.
PS I’ve just checked part of the video above, and after a while there’s a very large gap between the visuals and my commentary. This is probably due to my stuff-up when I got back from New York: I used an automatic backup program to transfer files from the camera to my computer, and then deleted the files from the camera–only to find that the New York material hadn’t been transferred!
Okay, it’s a surreal video.
Ours is a surreal economy in a surreal world.
Keen argues that economic models must earn their keep: reflect reality rather than the potential employability of economists who claim (or pretend) to use them.
Classic macro- modeling and theory attempts to justify the ‘waste based’ economy that profits by metering the flow of finite material resources (capital) into landfills. it does so by falsely categorizing and mispricing inputs and then lying about the mispricing. The mispricing and the lying are features, not bugs. That these features are impossible to sustain and are causing The Great Credit Unwinding does not deter the establishment which requires its institutions to defend them. Economists aren’t incompetent so much as compromised.
Professor Keen uses analysis tools like those the ‘real, PhD’ economists use who work for the Federal Reserve. He crafts a model based on Hyman Minsky’s Financial Instability Hypothesis;
… chaotic dynamics … should warn us against accepting a period of relative tranquility in a capitalist economy as anything other than a lull before the storm” ((Keen 1995, p. 634)). That storm duly arrived, after the lull of the “Great Moderation”. Only a Fisher-Keynes- Minsky vision of the macroeconomy can make sense of this crisis, and the need for a fully fledged Minskian monetary dynamic macroeconomic model is now clearly acute.
I regard aggregate demand in our dynamic credit-driven economy as the sum of GDP plus the change in debt:
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 and that some market technique exist by which aggregate spending in excess of aggregate anticipated income can be financed. 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)
This model is Professor Keen’s ‘life’s work’ and deserves more careful analysis than I can give in a humble (and widely unread) blog. Looking over the model it suggest ways of looking at our waste- based economy. It describes how the mechanism of accumulated excess debt works and how it falls apart. It leaves open why the excess debt accumulates in the first place along with what might amplify the falling part.
Two things that jump out are treatment of capital and exogenous flows.
Treatment of capital
Keen’s model subjects Wynne Godley’s accounting entity approach to flow of funds. Keen recognizes that funds are lent into existence for a purpose; they flow through structures, from banks to businesses and to workers and back to banks.
Accounting entity aspect of this model is very important because it demonstrates that any input to an economic entity must be an output to another. To a large degree, the accounts between entities are zero- sum.
As credit is the instrument of aggregate demand, changes in credit effect employment. Keen demonstrates the correlation between changes in debt and employment. The model uses an employment dynamic alongside debt that eventually runs amok. At some point deleveraging takes place as the overall debt level is unsupportable. Unemployment is the consequence.
The blue line is the deleveraging.
The black line is the unemployment!
A useful metric in gauging the impact of debt on demand is to compare the change in debt to the sum of GDP plus the change in debt (the dynamic measure of aggregate demand as per (Minsky 1982, p. 6).
The model acknowledges finite capital stock but emphasises the debt- funding for it; finance- driven asset hyperinflation (more debt chasing relatively fixed capital):
Modeling Minsky
How do we make sense of this empirical reality? Certainly mainstream economics, with its equilibrium fetish and ignorance of credit, is a waste of time—it functioned more as a means to divert attention from what mattered in the economy than as a means to understand it. Minsky provides the foundation from which our predicament can be understood, but our rendition of his vision is still sparse compared to the worthless but elaborate Neoclassical tapestry. We need an inherently monetary, historically realistic and non-equilibrium macroeconomics.
My contribution to this has been to extend my original Minsky model ((Keen 1995))—built on the foundations of Goodwin’s model of a cyclical economy (Goodwin 1967) —by developing models of endogenous money creation derived from Circuit Theory ((Graziani 1989), (Graziani 2003)), and by–tentatively–combining the two.
My basic Minsky model extended Goodwin’s pioneering “predator-prey” model of a cyclical economy by replacing the unrealistic assumption that capitalist invest all their profits with the realistic nonlinear proposition that they invest more during booms and less during slumps—with the variation accommodated by a financial sector that lends money at interest. That led to a chaotic model which could, given appropriate initial conditions, generate a debt-induced crisis—but which had a stable equilibrium. This was part of the way towards Minsky. However, while the fact that the equilibrium was stable was consistent with (Fisher 1933, p. 339, point 9), it was rather awkward when judged against Minsky’s famous statement that “Stability—or tranquility—in a world with a cyclical past and capitalist financial institutions is destabilizing” ((Minsky 1982, p. 101)).
What was missing in my original Minsky model was Ponzi finance. Put simply, this is debt-financed speculation on asset prices, which we can now see as the driving force behind the accumulation of debt in the last two decades, and the consequent inflation of asset prices. In my original model, all debt was related to the construction of new capital equipment, which is inherently a non-Ponzi behavior. I introduced a simulacrum of Ponzi finance ((Keen 2009)), with additional debt being taken on when the rate of growth exceeds a threshold level, without adding to the capital stock (the 4th equation in ). This simulates speculation on asset prices, though without explicitly modeling asset prices themselves.
We already knew that, right?
Here is petroleum production compared to the inflation (dollar) adjusted price since 2000 (economic peak oil taking place in 1998):
Stuart Staniford ‘Oil Price In Blue’.
Yowza! The 600% increase in fuel input cost from 1998 ($12/bbl) to the beginning of 2008 ($73) represents an extraordinary capital expense! How is that for asset hyperinflation? In inflation adjusted terms the current price is punishingly high. Mere depreciation is pointless. The asset has been placed under extreme consumption pressure. It has has stopped being treated as capital, rather it has been (mis)perceived as an ordinary input. The resulting increase in price is both cause and effect of crude oil’s ‘asset- ness’ reasserting itself.
Debt becomes a substitute for increasingly scarce resources/energy . It is a means to enable demand while at the same time rationing it. This idea derives from the observation that an increase in any input cost must be paid at the expense of the other inputs, be they wages, profits or interest.
What matters is the effect of the credit- driven price of inputs measured against the effect of the same credit on aggregate demand!
This is the input corollary to GDP- plus change in debt that is demanded by this model! Think about it …
Exogenous Flows
The accounting entity grid of balancing, sequential transfer is the core of Professor Keen’s model. Expanding on Wynne Godley’s observation that a surplus of goods or funds must have a corresponding deficit elsewhere, the model illustrates the transfers between entities over time.
The grid is expanded by inserting exogenous funds to the grid to illustrate the effectiveness of intervention either to finance or to households. Keen demonstrates that funds directed toward finance have little effect because there is little demand for new credit and the multipliers are idle.
What the expanded grid leaves out is the flow of funds OUT of the system (exogenous flows) that represent payments for the necessary inputs.
When the exogenous outflow is equal to or exceeds exogenous inflows the consequence is ineffective (non- existent) intervention.
The outflow at issue is the funds sent out of the system for energy, which offsets any injections of funds in the form of new fiat. Paul Krugman puts a number on fiscal ‘stimulus’:
Keynesian analysis provides numbers as well as qualitative predictions, and given reasonable projections of the economy’s path in January 2009, the proposed stimulus just wasn’t big enough.
… one of the key elements of the plan — aid to state and local governments — was cut back sharply in the Senate. We ended up with only about $600 billion of real stimulus over that two-year period.
$300 billion per year is only a bit larger than our annual fuel import bill, (which leaves out the cost of Middle East military adventures.) The US taxpayers have ‘stimulated’ the economies of Mexico, Canada, Saudi Arabia and a bunch of African nations!
If that pace continues, total crude oil imports will cost an estimated $181 billion for 2010 – America’s second-highest expenditure on imported crude over the past 10 years. The total oil bill for 2010 will have been exceeded only by the $259.3-billion bill spent on imported crude oil during 2008.
The marketplace takes note of an apparent input scarcity by giving a price signal. Economists ignore the signal but the credit market doesn’t. The price rise is both the cause of new credit and the effect of it. Credit becomes the allocation mechanism: fuel is rationing by access to credit rather than by access to fuel itself.
The fuel input as a consequence is treated as a speculative asset which can be used as such by any business that has access to it; a finance company can hold it (or a derivative) and by that process increase its value to where its use in commerce becomes unprofitable. This is the waste- mispricing mechanism turned on its head! Credit expansion – collateralized by the asset itself – allows a speculator to buy and sell the fuel at a very high price at the expense of the commercial user.
Credit is distorted as the mispricing becomes apparent and funds are shifted away from physical production/wages toward speculation, including in fuel:
The employment-wages share dynamics of the original Goodwin model give way to a financial vortex that drives wages share cyclically down prior to the complete debt-deflationary collapse. The final debt-driven collapse, in which both wages and profitability plunge, gives the lie to the neoclassical perception that crises are caused by wages being too high, and the solution to the crisis is to reduce wages.What their blinkered ignorance of the role of the finance sector obscures is that the essential class conflict in financial capitalism is not between workers and capitalists, but between financial and industrial capital. The rising level of debt directly leads to a falling worker share of GDP, while leaving industrial capital’s share unaffected until the final collapse drives it too into oblivion.
Industrial capital cannot compete with finance for what is an input for the one group and a speculative asset for the other. It’s not wages that are too high, it is fuel that is too high!
Rising petroleum prices are paid out of wages, profits or interest with credit intermediating. Funds are diverted from wages, the accompanying decline in wage- purchasing power for which additional debt is substituted. The effect of the debt on the petroleum input is greater than the effect on wages. The consequence is falling firm profitablilty as customers vanish.
Firms consequently substitute their creditworthiness for profitability. The added credit is diverted to fuel costs. The effect of credit on petroleum is also greater than credit’s effect on profits, leading the firms to fail. The outcome is declining marginal productivity of debt over time as both Keen and others note:
The business response to increasing input costs has been to fire higher paid US workers and substitute cheaper import labor or make use of cheaper overseas labor (wage arbitrage). Both tactics result in lower aggregate demand as the loss of higher- wage workers/jobs is also the loss of paying customers.
The loss of high wage jobs also impinges on the creation of investment capital in a vicious cycle as wages decline and savings diminish. Consequently, more debt is substituted for savings as a means of capital formation.
Credit driven asset price increases require a constant expansion in the amount of available credit to allow the obtain of the assets needed to support business use – running faster just to keep in place. Eventually, business cash flow cannot service the debts.
Ultimately, firms fail because there are no profits.
Since fuel price increases allocate away from wage increases, hiring or profit margins the outcome of such increases is deflation. The rate of productivity (which is fuel dependent) must compete with the rate of credit- driven increase in the cost of the same fuel that drives the productivity! Since ‘labor productivity’ is a process with a long tail the outcome of an large increase in energy costs is to diminish the energy- derived or machine part of that productivity even before it is put to good use.
Implicit in Keen’s observation is that the Ponzi dynamic of credit- inflated asset price bubbles is also a response to energy cost driven declines in purchasing power as well as misallocation and expansion of credit during times of economic stability. Ponzi bubbles were allowed as hedges against rising fuel input prices. In the hedge approach, the credit expansion supported by (Ponzi) asset values would (hopefully) create credit faster than the value of fuel would increase.
This assumed that fuel would not become a speculative asset.
This grand hedge was attempted in Japan after the 1979 energy crisis, as well as in the US post- Reagan, accompanied the other great hedges; the EMU/euro currency bloc (which promised a non- dollar alternative reserve currency), Industry/labor Deregulation (to drive down labor and adminstrative input costs), also in the USA and invasion (in Iraq).
What is attempted is support of the waste- based economy as inputs that when priced too high a priori become too valuable to waste. In the waste- based economy what matters is the efficient and increasing flow – of valuable natural resources to the landfill. The economy that enables this must achieve the impossible, to transform the vital natural capital into worthlessness so that they might be disposed of at an incremental marginal return to ‘investment’ capital.
Some investment. Some capital!
Our crisis is a necessary repricing of risk but more importantly, the repricing of inputs. That our resources are now too valuable to waste causes unsurprising distortions in the credit system which has allocated more resources and brought forward more cheap demand than exists in the real world.
The most confused of any putative authorities are the academic economists, lost in the wilderness of their models and equations and their quaint expectations of the way things ought to go if you can tweak numbers. These are the people who believe with the faith of little children that if you can measure anything you can control it. They will go down in history as the greatest convocation of clowns ever assembled, surpassing all the collected alchemists, priests, and vizeers employed in the 1500 years following the fall of Rome.
-James Howard Kunstler
Not all of them.