A comprehensive view of how economic theory and policy need to be reformed to make sense of the real world and allow rational to prevent future crises. This is adapted from Steve Keen's Debtwatch Manifesto.
Preventing a future crisis will require a redefinition of financial claims upon the real economy which eliminates the appeal of leveraged speculation.
Three primary objectives:
- To develop a realistic, empirically based, dynamic monetary approach to economic theory and policy;
- To develop and promote a "modern Jubilee" by which private debt can be reduced while doing the minimum possible harm to aggregate demand and social equity; and
- To develop and promote new definitions of equity and property ownership that will minimize the destructive instabilities of capitalism and promote its creative instabilities.
[Steve Keen w/Alan Harvey]
Michael Hudson’s simple phrase “Debts that can’t be repaid, won’t be repaid” sums up the economic dilemma of our times. This does not involve sanctioning “moral hazard”, since the real moral hazard was in the behavior of the finance sector in creating this debt in the first place. Most of this debt should never have been created. All it did was fund disguised Ponzi schemes that inflated asset values without adding to society’s productivity. The irresponsibility—and Moral Hazard—clearly lay with the lenders rather than the borrowers.
The question we face is not whether to repay this debt, but how to go about not repaying it?
The standard means of reducing debt—personal and corporate bankruptcies for some, slow repayment of debt in depressed economic conditions for others—could have us mired in deleveraging for one and a half decades, given its current rate. That would be one and a half decades where the boost to demand that rising debt should provide—as it finances investment rather than speculation—is absent. Growth is too slow to absorb new entrants into the workforce, innovation is muted, and political unrest rises--with all the social consequences. Just as it did in the Great Depression.
So it is incumbent for society to reduce the debt burden sooner rather than later, so as to reduce the period spent in the damaging process of deleveraging. Pre-Capitalist societies instituted the practice of the Jubilee to escape from similar traps, and debt defaults have been a common experience in the history of Capitalism too. So a prima facie alternative to 15 years of deleveraging is an old-fashioned debt Jubilee.
But a Jubilee in modern Capitalism faces two dilemmas. Firstly, a debt Jubilee would paralyse the financial sector by destroying bank assets. Secondly, in our era of securitized finance, the ownership of debt permeates society in the form of asset based securities (ABS) that generate income streams on which a multitude of non-bank recipients depend. Debt abolition would inevitably destroy both the assets and the income streams of owners of ABSs, most of whom are innocent bystanders to the delusion and fraud that gave us the subprime xrisis, and the myriad fiascos that Wall Street has perpetrated in the 25 years since the 1987 stock market Crash.
We therefore need a way to short-circuit the process of debt-deleveraging, while not destroying the assets of both the banking sector and the members of the non-banking public who purchased ABSs. One feasible means to do this is a “Modern Jubilee”, which could also be described as “Quantitative Easing for the public”.
Quantitative Easing was undertaken in the false belief that this would “kick start” the economy by spurring bank lending. Barack Obama put it:
And although there are a lot of Americans who understandably think that government money would be better spent going directly to families and businesses instead of banks – “Where is our bailout?,” they ask – the truth is that a dollar of capital in a bank can actually result in eight or ten dollars of loans to families and businesses, a multiplier effect that can ultimately lead to a faster pace of economic growth. (Obama 2009)
Instead, QE's main effect was to dramatically increase the idle reserves of the banking sector while the broad money supply stagnated or fell (see figure). There is already too much private sector debt, and neither lenders nor the public want to take on more debt.
A Modern Jubilee would create fiat money in the same way as QE, but would direct that money to the bank accounts of the public with the requirement that the first use of this money would be to reduce debt. Debtors whose debt exceeded their injection would have their debt reduced but not eliminated, while at the other extreme, recipients with no debt would receive a cash injection into their deposit accounts.
The broad effects of a Modern Jubilee would be:
Debtors would have their debt level reduced;
Non-debtors would receive a cash injection;
The value of bank assets would remain constant, but the distribution would alter with debt-instruments declining in value and cash assets rising;
Bank income would fall, since debt is an income-earning asset for a bank while cash reserves are not;
The income flows to asset-backed securities would fall, since a substantial proportion of the debt backing such securities would be paid off; and
Members of the public (both individuals and corporations) who owned asset-backed-securities would have increased cash holdings out of which they could spend in lieu of the income stream from ABS’s on which they were previously dependent.
Clearly there are numerous and complex issues to be considered in such a policy:
- The scale of money creation needed to have a significant positive impact (without excessive negative effects. [There will obviously be such effects, but their importance should be judged against the alternative of continued deleveraging.]
- The mechanics of the money creation process itself (which could replicate those of Quantitative Easing, but may also require changes to regulation prohibitiing Reserve Banks from buying government bonds directly from the Treasury).
- The basis on which the funds would be distributed to the public;
- Managing bank liquidity problems (since though banks would not be made insolvent by such a policy, they would suffer significant drops in their income streams);
- Ensuring that the program did not simply start another asset bubble.
Reducing the size of the financial sector
Finance performs genuine, essential services in a Capitalist economy when it limits itself to
- Providing working capital to non-financial corporations;
- Funding investment and entrepreneurial activity, whether directly or indirectly;
- Funding housing purchase for strictly residential purposes, whether to owner-occupiers for purchase or to investors for the provision of rental properties;
- Providing finance to households for large expenditures such as automobiles, home renovations, etc.
It is a destructive force in Capitalism when it promotes leveraged speculation on asset or commodity prices, and funds activities (like levered buyouts) that drive debt levels up and rely upon rising asset prices for their success. Such activities are the overwhelming focus of the non-bank financial sector today, and are the primary reason why financial sector debt has risen from trivial levels of below 10 percent of GDP before the 1970s to the peak of over 120 percent in early 2009.
Returning Capitalism to a financially robust state must involve a dramatic fall in the level of private debt and the size of the financial sector, policies that return the financial sector to a service role to the real economy.
The percentage of total wages and profits earned by the FIRE sector (as defined in the NIPA tables) gives another guide. America’s period of robust economic growth coincided with FIRE sector profits being between 10 and 20 percent of total profits, and wages in the FIRE sector being below 5 percent of total wages. Finance sector profits peaked at over 50% of total profits in 2001, while wages in the FIRE sector peaked at over 9 percent of total wages.
Since finance sector profits are primarily a function of the level of private debt, this implies that the level of debt needs to shrink by a factor of between three and four, while employment in the finance sector needs to roughly halve. At the maximum, the finance sector should be no more than 50% of its current size.
Such a large contraction in the size of the sector means that the majority of those who currently work there will need to find gainful employment elsewhere. Individuals who can actually evaluate investment proposals—generally speaking, engineers rather than financial engineers—will need to be hired in their place. Many of the standard practices of that sector today will have to be eliminated or drastically curtailed, while many practices that have been largely abandoned will have to be reinstated.
Taming the Credit Accelerator
Capitalism’s crises have always been caused by the financial sector funding speculation on asset prices rather than funding business and innovation. This allows financial sector profits to grow far larger than is warranted, on the foundation of a far larger level of private debt than society can support. This lending causes a feedback loop between accelerating debt and rising asset prices, leading to both a debt and asset price bubble. The asset price bubble must burst—because it relies upon accelerating debt for its maintenance—but once it bursts, society is still left with the debt.
The underlying cause is the relationship between debt and asset prices in a credit-based economy. Aggregate demand is the sum of income plus the change in debt , and this is expended on both newly produced goods and services and buying financial claims on existing assets.
Some acceleration of debt is vital for a growing economy. Change in debt is the main source of funds for investment, and as Josef Schumpeter explained, the interplay between investment and the internal ("endogenous") creation of spending power by the banking system ensures that this will be a cyclical process. Debt acceleration during a boom and deceleration during a slump are thus essential aspects of capitalism.
However this relation also implies that the acceleration of debt is a factor in the rate of change of asset prices (along with the change in income) and that when asset prices grow faster than incomes and consumer prices, the motive force behind it will be the acceleration of debt. At the same time, the growth in asset prices is the major incentive to accelerating debt: this is the positive feedback loop on which all asset bubbles are based, and it is why they must ultimately burst.. This is the foundation of Ponzi finance, and it is this aspect of finance that has to be tamed to reduce the destructive impact of finance on Capitalism.
It is not likely that regulation alone will achieve this aim, for two reasons.
- Minsky’s proposition that “stability is destabilizing” applies to regulators as well as to markets. If regulations actually succeed in enforcing responsible finance, the relative tranquillity that results from that will lead to the belief that such tranquillity is the norm, and the regulations will ultimately be abolished. This is what happened after the last Great Depression.
- Banks profit by creating debt, and they are always going to want to create more debt. This is simply the nature of banking. Regulations are always going to be attempting to restrain this tendency, and in this struggle between an “immovable object” and an “irresistible force”, I have no doubt that the force will ultimately win.
Relying on regulation alone to tame the financial sector, then it will be tamed while the memory of the crisis it caused persists, only to be overthrown by a resurgent financial sector some decades hence.
There are thus only two options to limit Capitalism’s tendencies to financial crises: to change the nature of either borrowers or lenders in a fundamental way.
Reducing the appeal of leveraged speculation on asset prices:
As already noted, the key determinant of profits in the finance sector is the level of debt it can generate. So the prospects of a fundamental change in behavior are dim. In whatever way it is organized and with whatever limits are placed on it, the finance sector will want to create more debt.
There are, however, prospects for altering the behaviour of the non-financial sector towards debt because, fundamentally, debt is a bad thing for the borrower: the spending power of debt now is an enticement at the outset, but it comes with the burden servicing in the future. For that reason, when either investment or consumption is the reason for taking on debt, borrowers will be restrained in how much they will accept. Only when they succumb to the enticement of leveraged speculation will borrowers take on a level of debt that can become systemically dangerous.
Regardless of the endless inducements from the finance sector to enter into personal debt, data show that commitments by the public to personal debt are generally related to and regulated by income. Commitments to debt for the purchase of assets, on the other hand, are related not to income, but to expectations of leveraged profits on rising asset prices—when the factor most responsible for causing growth in asset prices is accelerating debt.
This relationship between debt acceleration and change in asset prices is especially apparent for mortgage debt. Though debt acceleration can enable increased construction or turnover, the far greater flexibility of prices, and the treatment of housing as a vehicle for speculation rather than accommodation, means that the brunt of the acceleration drives house price appreciation. The same effect applies in the far more volatile equity markets. Accelerating debt leads to rising asset prices, which encourages more debt acceleration.
The link between accelerating debt levels and rising asset prices is therefore the basis of capitalism’s tendency to experience financial crises. That link has to be broken if financial crises are to be made less likely—if not avoided entirely. This requires a redefinition of financial assets in such a way that the temptations of Ponzi Finance can be eliminated.
The key factor that allows Ponzi Schemes to work in asset markets is the “Greater Fool” promise that a share bought today for $1 can be sold tomorrow for $10. No interest rate, no regulation, can hold against the charge to insanity that such a feasible promise ferments, and on such a foundation the now almost forgotten folly of the DotCom Bubble was built.
Jubilee Shares is a redefinition of shares in such a way that the enticement of limitless price appreciation can be removed, and the primary market can take precedence over the secondary market. A share bought in an IPO or rights offer would last forever (for as long as the company exists) as now with all the rights it currently confers. It could be sold once onto the secondary market with all the same privileges. But on its next sale it would have a life span of 50 years, at which point it would terminate.
The objective of this proposal is to eliminate the appeal of using debt to buy existing shares, while still making it attractive to fund innovative firms or startups via the primary market, and still making purchase of the share of an established company on the secondary market attractive to those seeking an annuity income.
This basic proposal might be refined, while still maintaining the primary objective of making leveraged speculation on the price of existing share unattractive. The termination date could be made a function of how long a share was held; the number of sales on the secondary market before the Jubilee effect applied could be more than one. But the basic idea has to be to make borrowing money to gamble on the prices of existing shares a very unattractive proposition.
At present, if two individuals with the same savings and income are competing for a property, then the one who can secure a larger loan wins. This reality gives borrowers an incentive to want to have the loan to valuation ratio increased, which underpins the finance sector’s ability to expand debt for property purchases.
Since the acceleration of debt drives the rise in house prices, we get both the bubble and the bust. But since houses turn over much more slowly than do shares, this process can go on for a lot longer. The buildup of mortgage debt therefore also goes on for much longer.
Limits on bank lending for mortgage finance are obviously necessary, but while those controls focus on the income of the borrower, both the lender and the borrower have an incentive to relax those limits over time. This relaxation is in turn the factor that enables a house price bubble to form while driving up the level of mortgage debt per head.
PILL (Property Income Limited Leverage) is a propal tying the maximum debt that can be used to purchase a property to the income (actual or imputed) of the property itself. Lenders would only be able to lend up to a fixed multiple of the income-earning capacity of the property being purchased—regardless of the income of the borrower. A useful multiple would be 10, so that if a property rented for $30,000 p.a., the maximum amount of money that could be borrowed to purchase it would be $300,000.
Under this regime, if two parties were vying for the same property, the one who raised more money via savings would win. There would therefore be a negative feedback relationship between leverage and house prices: an general increase in house prices would mean a general fall in leverage.
PILL is much simpler than Jubilee Shares, and less in need of tinkering before it could be finalized. Its real problem is in the implementation phase, since if it were introduced in a country where the property bubble had not fully burst, it could cause a sharp fall in prices. It would therefore need to be phased in slowly over time—except in a country like Japan where the house price bubble is well and truly over (even though house prices are still falling).
There are many other proposals for reforming finance, most of which focus on changing the nature of the monetary system itself. The best of these focus on instituting a system that removes the capacity of the banking system to create money via “Full Reserve Banking”.
Technically, these proposals would work. But the banking system’s capacity to create money is not the fundamental cause of crises, so much as the uses to which that money is put. As Schumpeter explains so well, the endogenous creation of money by the banking sector gives entrepreneurs spending power that exceeds that coming out of “the circular flow” alone. When the money created is put to Schumpeterian uses, it is an integral part of the inherent dynamic of capitalism. The problem comes when that money is created instead for Ponzi Finance reasons, and inflates asset prices rather than enabling the creation of new assets.
Full reserve banking systems would make the endogenous expansion of spending power the responsibility of the State alone. Although government's counter-cyclical spending is essential, it is doubtful that government agencies or bureaucracies would get the creation of money right at all times. This is not to say that the private sector has done a better job—far from it! But the private banking system will always be there—even if changed in nature—ready to exploit any slipups in government behaviour that can be used to justify a return to the system we are currently in. Slipups will surely occur, especially if the new system still enables speculation on asset prices to occur.
Since in the real world, people forget and die, the memory of current chaos won’t be part of the mindset when those slipups occur, especially if the end of the Age of Deleveraging ushers in a period of economic tranquillity like the 1950s. We could well have 100% money reforms “reformed” out of existence once more.
Schumpeterian banking also inherently includes the capacity to make mistakes: to fund a venture that doesn’t succeed, and yet to be willing to take that risk again in the hope of funding one that succeeds spectacularly. I am wary of the capacity of that mindset to co-exist with the bureaucratic one that dominates government.