CanSpeccy: Economic Growth, Asset Markets and the Credit Accelerator

From Steve Keen's DebtWatch

By Steve Keen

Neoclassical economists ignore the level of private debt, on the basis of the a priori argument that “one man’s liability is another man’s asset”, so that the aggregate level of debt has no macroeconomic impact. They reason that the increase in the debtor’s spending power is offset by the fall in the lender’s spending power, and there is therefore no change to aggregate demand.
Lest it be said that I’m parodying neoclassical economics, or relying on what lesser lights believe when the leaders of the profession know better, here are two apposite quotes from Ben Bernanke and Paul Krugman.
Bernanke in his Essays on the Great Depression, explaining why neoclassical economists didn’t take Fisher’s Debt Deflation Theory of Great Depressions (Irving Fisher, 1933) seriously:

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). Absent implausibly large differences in marginal spending propensities among the groups, it was suggested, pure redistributions should have no significant macro-economic effects… (Ben S. Bernanke, 2000, p. 24)

Krugman in his most recent draft academic paper on the crisis:

Given both the prominence of debt in popular discussion of our current economic difficulties and the long tradition of invoking debt as a key factor in major economic contractions, one might have expected debt to be at the heart of most mainstream macroeconomic models—especially the analysis of monetary and fiscal policy. Perhaps somewhat surprisingly, however, it is quite common to abstract altogether from this feature of the economy. Even economists trying to analyze the problems of monetary and fiscal policy at the zero lower bound—and yes, that includes the authors—have often adopted representative-agent models in which everyone is alike, and in which the shock that pushes the economy into a situation in which even a zero interest rate isn’t low enough takes the form of a shift in everyone’s preferences…

Ignoring the foreign component, or looking at the world as a whole, the overall level of debt makes no difference to aggregate net worth — one person’s liability is another person’s asset. (Paul Krugman and Gauti B. Eggertsson, 2010, pp. 2-3; emphasis added)

They are profoundly wrong on this point because neoclassical economists do not understand how money is created by the private banking system—despite decades of empirical research to the contrary, they continue to cling to the textbook vision of banks as mere intermediaries between savers and borrowers.
This is bizarre, since as long as 4 decades ago, the actual situation was put very simply by the then Senior Vice President, Federal Reserve Bank of New York, Alan Holmes. Holmes explained why the then faddish Monetarist policy of controlling inflation by controlling the growth of Base Money had failed, saying that it suffered from “a naive assumption” that:

the banking system only expands loans after the [Federal Reserve] System (or market factors) have put reserves in the banking system. In the real world, banks extend credit, creating deposits in the process, and look for the reserves later. The question then becomes one of whether and how the Federal Reserve will accommodate the demand for reserves. In the very short run, the Federal Reserve has little or no choice about accommodating that demand; over time, its influence can obviously be felt. (Alan R. Holmes, 1969, p. 73; emphasis added)

The empirical fact that “loans create deposits” means that the change in the level of private debt is matched by a change in the level of money, which boosts aggregate demand. The level of private debt therefore cannot be ignored—and the fact that neoclassical economists did ignore it (and, with the likes of Greenspan running the Fed, actively promoted its growth) is why this is no “garden variety” downturn.
In all the post-WWII recessions on which Lazear’s regression was based, the downturn ended when the growth of private debt turned positive again and boosted aggregate demand. This of itself is not a bad thing: as Schumpeter argued decades ago, in a well-functioning capitalist system, the main recipients of credit are entrepreneurs who have an idea, but not the money needed to put it into action:

“[I]n so far as credit cannot be given out of the results of past enterprise … it can only consist of credit means of payment created ad hoc, which can be backed neither by money in the strict sense nor by products already in existence…

It provides us with the connection between lending and credit means of payment, and leads us to what I regard as the nature of the credit phenomenon… credit is essentially the creation of purchasing power for the purpose of transferring it to the entrepreneur, but not simply the transfer of existing purchasing power.” (Joseph Alois Schumpeter, 1934, pp. 106-107)

It becomes a bad thing when this additional credit goes, not to entrepreneurs, but to Ponzi merchants in the finance sector, who use it not to innovate or add to productive capacity, but to gamble on asset prices. This adds to debt levels without adding to the economy’s capacity to service them, leading to a blowout in the ratio of private debt to GDP. Ultimately, this process leads to a crisis like the one we are now in, where so much debt has been taken on that the growth of debt comes to an end. The economy then enters not a recession, but a Depression.
For a while though, it looked like a recovery was afoot: growth did rebound from the depths of the Great Recession, and very quickly compared to the Great Depression (though slowly when compared to Post-WWII recessions).
Clearly the scale of government spending, and the enormous increase in Base Money by Bernanke, had some impact—but nowhere near as much as they were hoping for. However the main factor that caused the brief recovery—and will also cause the dreaded “double dip”—is the Credit Accelerator.
I’ve previously called this the “Credit Impulse” (using the name bestowed by Michael Biggs et al., 2010), but I think “Credit Accelerator” is both move evocative and more accurate. The Credit Accelerator at any point in time is the change in the change in debt over previous year, divided by the GDP figure for that point in time. From first principles, here is why it matters.
Firstly, and contrary to the neoclassical model, a capitalist economy is characterized by excess supply at virtually all times: there is normally excess labor and excess productive capacity, even during booms. This is not per se a bad thing but merely an inherent characteristic of capitalism—and it is one of the reasons that capitalist economies generate a much higher rate of innovation than did socialist economies (Janos Kornai, 1980). The main constraint facing capitalist economies is therefore not supply, but demand.
Secondly, all demand is monetary, and there are two sources of money: incomes, and the change in debt. The second factor is ignored by neoclassical economics, but is vital to understanding a capitalist economy. Aggregate demand is therefore equal to Aggregate Supply plus the change in debt.
Thirdly, this Aggregate Demand is expended not merely on new goods and services, but also on net sales of existing assets. Walras’ Law, that mainstay of neoclassical economics, is thus false in a credit-based economy—which happens to be the type of economy in which we live. Its replacement is the following expression, where the left hand is monetary demand and the right hand is the monetary value of production and asset sales:

Income + Change in Debt = Output + Net Asset Sales;

In symbols (where I’m using an arrow to indicate the direction of causation rather than an equals sign), this is:

This means that it is impossible to separate the study of “Finance”—largely, the behaviour of asset markets—from the study of macroeconomics. Income and new credit are expended on both newly produced goods and services, and the two are as entwined as a scrambled egg.
Net Asset Sales can be broken down into three components:

The asset price Level; times
The fraction of assets sold; times
The quantity of assets

Putting this in symbols:

That covers the levels of aggregate demand, aggregate supply and net asset sales. To consider economic growth—and asset price change—we have to look at the rate of change. That leads to the expression:

Therefore the rate of change of asset prices is related to the acceleration of debt. It’s not the only factor obviously—change in incomes is also a factor, and as Schumpeter argued, there will be a link between accelerating debt and rising income if that debt is used to finance entrepreneurial activity. Our great misfortune is that accelerating debt hasn’t been primarily used for that purpose, but has instead financed asset price bubbles.
There isn’t a one-to-one link between accelerating debt and asset price rises: some of the borrowed money drives up production (think SUVs during the boom), consumer prices, the fraction of existing assets sold, and the production of new assets (think McMansions during the boom). But the more the economy becomes a disguised Ponzi Scheme, the more the acceleration of debt turns up in rising asset prices.
As Schumpeter’s analysis shows, accelerating debt should lead change in output in a well-functioning economy; we unfortunately live in a Ponzi economy where accelerating debt leads to asset price bubbles.
In a well-functioning economy, periods of acceleration of debt would be followed by periods of deceleration, so that the ratio of debt to GDP cycled but did not rise over time. In a Ponzi economy, the acceleration of debt remains positive most of the time, leading not merely to cycles in the debt to GDP ratio, but a secular trend towards rising debt. When that trend exhausts itself, a Depression ensues—which is where we are now. Deleveraging replaces rising debt, the debt to GDP ratio falls, and debt starts to reduce aggregate demand rather than increase it as happens during a boom.
Even in that situation, however, the acceleration of debt can still give the economy a temporary boost—as Biggs, Meyer and Pick pointed out. A slowdown in the rate of decline of debt means that debt is accelerating: therefore even when aggregate private debt is falling—as it has since 2009—a slowdown in that rate of decline can give the economy a boost.
That’s the major factor that generated the apparent recovery from the Great Recession: a slowdown in the rate of decline of private debt gave the economy a temporary boost. The same force caused the apparent boom of the Great Moderation: it wasn’t “improved monetary policy” that caused the Great Moderation, as Bernanke once argued (Ben S. Bernanke, 2004), but bad monetary policy that wrongly ignored the impact of rising private debt upon the economy.
Figure 5

The factor that makes the recent recovery phase different to all previous ones—save the Great Depression itself—is that this strong boost from the Credit Accelerator has occurred while the change in private debt is still massively negative. I return to this point later when considering why the recovery is now petering out.
The last 20 years of economic data shows the impact that the Credit Accelerator has on the economy. The recent recovery in unemployment was largely caused by the dramatic reversal of the Credit Accelerator—from strongly negative to strongly positive—since late 2009:
Figure 6