House price hit yet to comePublished 7:45 AM, 20 Oct 2011 Last update 10:35 AM, 20 Oct 2011
University of Western Sydney associate professor of economics and finance Steve Keen explains why:
– Australian house prices are set to fall 20 per cent by the end of 2013
– There's no sense trying to recapitalise European banks if they maintain current levels of debt, and wide-scale debt abolition is the way to go
– The current global debt crisis will take ten to 20 years to resolve
– The Reserve Bank's inflation policy is inadequate
– Decelerating debt has placed the Australian economy on a knife-edge, with positive jobs data a blip in a downward trend
* This interview was conducted by Business Spectator's Amber Plum on October 17.
Amber Plum: Steve, you’ve just launched a second version of your book, Debunking Economics. Why the need for another one?
Steve Keen: Two reasons. One is that since I wrote the last I’ve expanded the critique that I’ve written of neoclassical economics and added a substantial amount of potential alternative paradigm to economics. Secondly, a large part of the motivation for writing the first edition of the book was the belief that the serious economic crisis was not too far in the future and of course when the crisis hit in 2005, I focused my work on warning about it and then slowly developing a stronger analysis of it. Now is the time to put the two together.
AP: What’s the biggest flaw you saw in the response to the GFC?
SK: One thing I satirise in the new edition is the speech that Obama made back in August 2009 explaining his policy response, a large part of which of course was to drastically beef up the amount of money in the reserve accounts of the banking sector. In typical Obama-speak, he said ‘a lot of Americans are complaining to me that the money is going to the banks rather than them'.
He said, and this is virtually a direct quote, 'the truth is that an extra dollar in the banking system generates eight or ten more dollars of loans, therefore kick-starting economic activity by giving us more bang for our buck'. That’s a fallacy. It’s based on the neoclassical theory of how money is created called the money multiplier which argues you have to have reserves before banks can lend.
The reality is that when banks lend they create deposits at the same time and they get the reserves later, and this has been known empirically for about 50 years by people who actually follow empirical data – which does not include the vast majority of neoclassical macroeconomists.
When you put that money in the reserve account of the banking sector, it stays there because what’s actually happened is they’ve slowed down their rate of lending, people who are in debt are paying their debt back more rapidly, so the reserve is actually drastically accelerated. But very little additional lending occurs, and you have very little effect from putting that money into the system.
On the other hand if you gave that money to the debtors, giving it directly to the firms that are in debt or to households and saying please spend this money, that circulates much more rapidly. That’s something I actually modelled in using both the new macroeconomic systems I’ve devised and are included in the book as well.
If you look at what would happen with, say, an economy worth roughly a trillion dollars and an injection of a hundred billion dollars one year after a crisis begins, you do get about three times as much bang for your buck by giving it to the households than giving it to the banks. So, Obama effectively wasted two thirds of the money he gave to the banking sector – if he’s lucky. In fact, that’s probably an underestimation.
AP: What implications does this have for the debate around Europe’s bank recapitalisation and liquidity issues?
SK: There’s no sense trying to recapitalise the banks if you are also trying to maintain the debt they have currently issued and continue having the debtors have to repay that debt. If they’re talking about instead doing what’s now happening with Greece where they’re going to abolish about 50 per cent of the debt, that’s much more sensible. Basically the amount of money which was generated by lending activity of the banks was most drastically excessive. They made a mistake and they basically have to wear the consequences of it and that therefore means writing off the debt.
The trouble is it’s also being compliant with an austerity program and the trouble about the austerity program is that that itself bites back on itself by reducing the cash flows that are then needed to pay the government sector, and in fact the end result of an austerity program is that often the budget deficit gets worse rather than better. I would be in favour of wide-scale debt abolition, guaranteeing depositors funds at the same time, putting in mechanisms to mean that people who are genuine savers didn’t get disadvantaged from the whole thing. Fundamentally, it would be a dramatic shift in the proportion of money that was effectively credit money across to being effectively fiat money instead.
AP: What size of a shift are you talking about?
SK: If the finance sector was doing what it should be doing, which is simply providing working capital for the non-bank financial sector and businesses and innovation funds for entrepreneurs and so on, in an American case it would mean reducing the size of the finance sector by a factor of four or five. It’s literally that much too big. Of course it would mean large numbers of finance brokers, finance advisers, bank staff, would be out of a job and I’d be shot for it, but the reality is over time that’s going to happen anyway and I’d just be bringing it on more suddenly. But I’d be blamed for causing it.
AP: What timeframe do you have in mind?
SK: It’ll take about one or two decades. If you look at the level of debt that caused the Great Depression, then it began at about 175 per cent of GDP, where the vast majority of that was owed by businesses. The business sector debt was about a 125 per cent of GDP I think when the crisis began. The rest was household and a trivial amount of debt, believe it or not, was actually owed by the non-bank financial sector, the shadow banking sector as we call it now. But the aggregate level was a 175 per cent of GDP in America. This time it peaked at 300 per cent, so we are that much more in debt.
Now, getting out of the debt bubble of the Great Depression the Second World War took 15 years effectively from the peak levels of debt prior to fall back to low levels of debt once more for the private sector and that then restarted the whole system once more. I’m not being too much of a pessimist to put something of the order of one or two decades on how long it’ll take us to get through it this time.
AP: In layman’s terms, can you explain what’s new in your second book?
SK: In the first edition of the book, one of the chapters, talked about the neoclassical theory of competition. It basically supports small competitive firms and criticises monopoly and the argument behind it goes that if you have competitive firms, demand will be equal to supply and the price level will give you a low price at a high volume of output. Whereas if you have monopolies, they’ll set where marginal cost is equal to marginal revenue which is lower than price and you’ll have a higher price, lower level of output.
I wrote up a logical critique of this in the first edition. That caused an absolute fracas and as the neoclassical economists attacked me all over the globe, I went further into the mathematics and basically proved that their idea about what was profit maximising behaviour was false.
Probably the most important thing in the book though is a better explanation for a condition which goes by the incredibly complicated name Sonnenschein Mantel Debreu conditions. That explains that if you have a market consisting of lots of individual consumers whose behaviour all obeys what economists call the law of demand – which means that they’ve got downward sliding demand curves, so if you decrease price they’ll demand more of the product – if you add them up, you can have a market demand curve that can have any shape at all. It can look like a squiggly line. And I explain that critique in much more detail and much more clearly in the second edition than I did in the first, using what is known in mathematics as a proof by contradiction. It basically proves that you can’t even use supply and demand analysis for a single market, let alone an entire economy, so it just invalidates the foundation of neoclassical economics. And ironically this particular problem was discovered by neoclassical economists.
And of course the irony and the reason why they missed the global financial crisis so completely is over the last twenty or thirty years they’ve managed to redefine macroeconomics as being applied microeconomics and that is actually not possible.
AP: What does this mean for the Reserve Bank’s inflation controls?
SK: They’ve got a model of the economy that is almost but not completely totally unlike the economy in which we live. So they’re obsessing about the rate of inflation. In Lucy Ellis’s recent speech – the platypus speech – she argued that there is no need to have a target for the ratio of debt to GDP. That’s because their model doesn’t include the impact of private debt on aggregate demand. When you include the fact, as I do, that growth in debt finances the increase in aggregate demand, then not only does the ratio of debt to GDP matter, but the change in that ratio also matters.
If we had an economics model that said the level of private debt compared with GDP is an important economic indicator and should not be allowed to grow exponentially – let alone get past some set level, then we would have addressed this crisis in Australia’s case back in the early ‘70s.
Instead we let the level of debt go from 25 per cent of GDP back in 1965 to 160 per cent last year and that’s a more than six-fold increase in the level of debt to GDP. The growth in that ratio gave us an apparent boom at various times in the last 40 years, but the reality was it was a Ponzi system fundamentally and we’ve let a Ponzi scheme grow that big in the Australian economy and now we’re paying the consequences for it with the crisis in which we’re in.
AP: Wayne Swan is very firm that there is no crisis, in fact the opposite – we have strong terms of trade, our housing market has continued to grow over the long term.
SK: I’d say wait and see. Fundamentally the only reason that we got through the financial crisis with almost no pain compared with the rest of the world was courtesy of the first home vendor’s boost. And we’re the only country to restart the housing bubble with something like the first home vendor’s boost.
Now, when the first home buyer's… vendor’s boost began to slow down with its impact on the economy, then China’s stimulus hit on the other side. It was the biggest stimulus on the planet, with Korea then Australia next in terms of the size of the fiscal response. Of course our exports to China started going through the roof both in terms of volume and the prices we get for our commodities, so that really gave us a huge boost.
Now, we’re seeing China arguably, getting to the stage where its bubbles are bursting and we’re therefore seeing that particular wind coming out of the Australian economy. But that wind up has balanced the wind down coming out of the decline in credit growth because what we did through the first home vendor’s boost was reboost borrowing, so debt… private debt began to rise compared with income rather than fall which is totally different from the experience in America. Now, that that’s worked out of the system, we’re now seeing it starting to fall. The two-speed economy we’re seeing is… the negative side of that is coming out of the reduction in credit growth which we can’t stop. You know, you simply can’t hold it at those levels, so that is now dragging the economy down and China is pushing us up.
Overall, we’ve seen it being on a knife-edge where unemployment has actually risen of course in the most recent months and that was unexpected by the RBA and Treasury and co were expecting a continuing boom. I don’t regard that most recent data as anything other than a blip. When the last set of figures came through, there was a 0.1 per cent fall in the unemployment rate, but there was also a 0.5 per cent fall in hours worked. So, there’s something. You know, it’s murky data, but the trend appears to be for rising unemployment now and of course the falling house prices at the same time. So I think the ‘everything is wonderful here’ argument partially is based on the important role of China, but it’s also based on the same delusion that made Iceland think it was hot shit before it fell apart.
AP: How specific a forecast for house prices are you willing to give for the next year?
SK: Despite the property lobby’s best attempt to tar me with saying, you know, a 40 per cent fall over the next few years – which is a shitty little quote from The Daily Telegraph that Chris Joye touts all over the place – I’ve always been strong in saying that will be over 10 to 15 years.
But in terms of bringing it to a tighter timeframe, I think you could tie me down to saying I’d expect something of the order of a 20 per cent fall from peak to trough, whatever the peak might be, whatever the trough’s going to be. I’d be quite happy now to say the last price peak was the overall peak and so I’d expect something of the order of a 20 per cent fall between now and say the end of 2013.
AP: Steve, thanks for your time.
SK: Thank you.
Read more:
http://www.businessspectator.com.au/bs.nsf/Article/property-interest-rates-RBA-eurozone-debt-crisis-h-pd20111019-MS7H7