Posted by: CS | July 27, 2011

Why Economics Is Bunk and What That Means for the Economy

Steve Keen is a professor or economics.

Economics, he say, is bunk.

Why?

Because the textbook models of the economy ignore the role of the financial sector in credit creation.

Why do the textbooks ignore private sector credit creation?

Because, they maintain that what banks lend, someone else must first save and deposit with the bank. Thus the creation of a loan has no net effect on aggregate demand: my debt-fueled expenditure is balanced by your thrift-driven saving.

On the contrary, says Keen, your borrowed dollar is either deposited in your bank account or, when you spend it, in someone else’s account. That new deposit provides the basis for another loan, which result in another new deposit, and so on ad infinitum. Thus, in the absence of adequate financial sector regulation, the private banking system has the potential for causing unlimited growth in credit and, hence, demand.

It is credit creation, largely by private institutions, says Keen, that drives economic expansion.

In a healthy economy, privately created credit is employed mainly in productive investment, for example, in factories, machinery, software, or R and D, all of which produce income with which to service the debt and eventually pay off the principal.

But if credit expansion is too rapid, money is diverted to speculation, resulting in bubbles of various kinds, for example the tech sector stock market bubble during the 90’s, the US housing boom until 2006, and the subsequent bubble in commodities, including gold and silver.

Once the economy enters this Ponzi stage, it is only a matter of time before the price of tulip bulbs, shares in the South Sea Company, or whatever reach absurd heights, falter and then collapse.

As asset prices slump and paper profits turn to losses, people seek to cut their liabilities by reducing debt. The resultant credit contraction accelerates collapse of the bubbles and contraction in the real economy as people divert income from consumption and real investment to debt repayment.

Source: Steve Keen’s Debtwatch

Based on this theory, where are we now?

On the evidence of the adjacent chart, in the worst of all possible world’s.

Before the Great Depression US private debt equalled about 150% of GDP, growing to about 230% after the stock market crash of ’29, as the economy contracted faster than debts were repayed.

Thereafter, US private debt fell almost linearly for more than a decade, i.e., throughout the Great Depression, and throughout the war years, reaching a low of less than 50% of GDP in 1945.

Since 1945, U.S. debt to GDP ratio has grown almost continuously, passing the 1930’s peak early in the 2000’s and in a near vertical, Greenspan-fueled ascent, peaking at 300% in 2009, falling thereafter to around 265% of GDP.

There is no prospect, Keen believes, in reinflating the credit bubble now. What we should expect, so he predicts, is a long-continued contraction in credit, and stagnation or contraction in the real economy.

How long before the misery is over for America and most of the other western economies, which followed the American lead in financial deregulation and Ponzi economics?

About 15 years, Keen suggests.

In this, I am slightly more optimistic, inasmuch as I believe that the debts will in large part be inflated away through depreciation of both the US dollar and the Euro against the currencies of the low-wage Asian economies, particularly of India and China.

As discussed here, I believe we will see unending money printing, aka quantitative easing, in the US and elsewhere, which will drive down real wages in the Western world, thus restoring some competitiveness with the low-wage economies.

If we assume that half the debt is sloughed off through inflation, then it seems possible that we will see a decent revival in Western economies by the middle of the present decade.

By that time, our standard of living will have been very much reduced. But at least we will see a return to something like full employment.

See also:
America’s inflationary depression
USA versus China: Wage Convergence, Wealth Divergence and Global Hegemony
US Economy: Expecting the Unexpected
USA Boom or Bust: The Next Decade
Why China Booms While America Slumps
China’s Economy Already Larger Than America’s

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