Steve Keen and the spectre of terminal debt

Say I’m a politician and I am concerned about my re-election prospects in 2010.  I have been a member of Congress for seven years now and have developed a good reputation as a reform-minded economic realist willing to listen to a number of competing economic ideas. However, right now I am a bit concerned about my likely 2010 rival, a respected district attorney known for being tough on crime and equally pragmatic ideologically speaking.

This past week, President Obama delivered a worthy speech on the need for reform in the financial sector. I agree with some of the broad strokes. But, quite frankly, the speech lacked in detail.  What’s more is my economic advisors have counselled me that the worst of the panic is over.  They tell me stimulus – fiscal and monetary – has worked and we are on the road to a welcome though weak recovery.

Meanwhile, I have been informed that a number of well-connected people in the financial industry are considering backing my potential 2010 rival. I have had enough money problems on my plate due to healthcare targeting my district. As I desperately need more money for my re-election campaign, getting on the finance industry’s bad side is something I do not want to happen.

What do I do?

The inside the beltway mentality

Well, unless the economy tanks between now and 2010, I would be a fool to support reforms in the financial sector, which could jeopardize my seat in Congress. Mind you, I am truly a reform-minded individual and it has been a part of my platform since I was elected in 2002. I don’t like Wall Street fat cats earning tens of millions each while people lose their homes and jobs. But, right now, everyone I respect says recovery is here. Retail sales in August just came in – up a massive 2.7%. Fed Chairman Ben Bernanke came out and said outright that recovery has arrived. I am no economist, but these guys make sense. I believe them. That’s why I am loath to even mention financial sector reform – presently being demonized by my 2010 rival as big government.

Earlier this year as things were falling apart, I had decided to inform myself. I read a number of well-respected financial blogs – some of which predicted imminent economic collapse if our big banks were not nationalized. These bloggers claimed that a depression was upon us and drastic government intervention was necessary – and, again, I tended to believe them. After all, one was a recent Nobel Prize winner and another was a winner just a few years ago.

But these individuals have since been discredited, as events have not played out as they suggested. So, as we head into 2010, I am much more interested in reining in uncontrolled government spending – as this is something about which my constituency seems to care. With recovery upon us, there is zero appetite for financial reforms in Washington and I am certainly not going to put a target on my back by trying to get some passed.

Edward here. A lot of politicians are probably thinking along these lines right now. And quite frankly, this makes sense from a political perspective.  If you are looking for reform in the financial sector, the moment has passed. And only to the degree that the underlying weaknesses in the global financial system are made manifest and threaten the economy will we see any appetite for reform amongst politicians. So, as I see it, the Obama administration has missed the opportunity for reform.

Another interpretation of events

Irrespective, I believe the need for reform is clear. Those gloom & doom economists were right because the economic model which brought us to the brink of disaster in 2008 is the same one we have at present and that necessarily means another crisis will come.

Steve Keen, an Australian economist whose theories are heavily influenced by Hyman Minsky, has a cogent analysis of the true structural deficits in the current economic model that I think bears repeating here. He warns that we are trying to kick the can down the road and this will lead to an even larger bust.

In his most recent post, he put it in terms anyone can understand.

You have just come from your annual medical checkup, where your doctor assures you that you are in robust health.

Walking jauntily down the street, you bump into a practitioner of alternative medicine. He takes one look at you and declares “You have a serious tumour! It must be removed or you will die”.

You ignore him as you always have, and continue your merry way down the street. One day later, a stabbing pain suddenly cripples you, and you collapse to the pavement.

In agony, your call your doctor, who initially refuses to send an ambulance because he knows you are well.

When you lapse into a coma and stop talking mid-sentence, your doctor concludes that perhaps something is wrong, and sends an ambulance to take you to hospital.

Initially the doctor waits for you to revive spontaneously, because he still knows there’s nothing really wrong with you. But as your pulse starts to weaken, he reluctantly calls a retired doctor who had experience of a similar inexplicable malady in the distant past.

She prescribes massive doses of tranquilisers, painkillers, vitamins, and oxygen—all substances that had been removed from the medical panoply due to recent advances in medical theory. Reluctantly, your doctor follows his retired colleague’s advice—and miraculously, you start to revive.

After a year of expensive medical treatment, you return to the same robust health you displayed before your inexplicable illness. Triumphant, if somewhat puzzled, your doctor declares you well once more, and releases you from intensive care.

As you stride confidently away from the hospital, you have the misfortune to once again bump into the practitioner of alternative medicine.

“But they haven’t removed the tumour!”, he declares.

One shouldn’t have to spell out the details of such an analogy, but in times of widespread denial, one has to:

  • You are the economy;
  • The tumour is a massive accumulation of private debt;
  • Your doctor is Neoclassical Economics, and the retired colleague is a so-called “Keynesian” Economist — who doesn’t know it, since her medical textbooks were poorly written, but he’s actually following another economist called Paul Samuelson, not Keynes (and your doctor’s textbooks are so bad they don’t warrant discussion);
  • The alternative medicine practitioner follows Hyman Minsky’s “Financial Instability Hypothesis” (which is based on what Keynes actually did say—as well as the wisdom of Joseph Schumpeter and, in whispers, Karl Marx);
  • The moment you hit the pavement is the beginning of the Subprime Crisis; The collapse of Lehman Brothers is the moment when you slip into a coma; and
  • The day the doctor takes you off life support and declares all is well … is next month.

The final reason for me being a bear is that I am that practitioner of alternative medicine. Minsky’s “Financial Instability Hypothesis” has been ignored by conventional economists for reasons that are both ideological and delusional. A small band of “Post-Keynesian” economists, of whom I am one, have kept this theory alive.

According to Minsky’s theory:

  • Capitalist economies can and do periodically experience financial crises (something that believers in the dominant “Neoclassical” approach to economics vehemently denied until reality—in the form of the Global Financial Crisis—slapped them in the face last year);
  • These financial crises are caused by debt-financed speculation on asset prices, which leads to bubbles in asset prices;
  • These bubbles must eventually burst, because they add nothing to the economy’s productive capacity while simultaneously increasing the debt-servicing burden the economy faces;
  • When they burst, asset prices collapse but the debt remains;
  • The attempts by both borrowers and lenders to reduce leverage reduces aggregate demand, causing a recession;
  • If the economy survives such a crisis, it can go through the same process again, with another boom driving debt up even higher, followed by yet another crash; but
  • Ultimately this process has to lead to a level of debt that is so great that another revival becomes impossible since no-one is willing to take on any more debt. Then a Depression ensues.

Case for reform

I have removed the end of Keen’s post which you should most definitely read here. In it, he warns that the tumour collapse occurred in 1987 and that today we have finally reached a level of debt which is so great that another reflation is impossible.  The collapse is now.

But what if it isn’t?  For the sake of argument, let’s say that, just like in 1987, 1990, 1994, 1998, and 2002, there is indeed the ability to reflate the bubble – albeit on a diminished scale. Isn’t that what we see at present with equity prices up between 50-100% globally, with some commodity back at record high prices, and with oil up over 100% from its 2009 lows?

Why would any politician back reform if we seem out of the woods then? Reform doesn’t stuff campaign coffers. Reform doesn’t get your constituents jobs. Reform doesn’t pump up the economy in your district. And reform doesn’t get you elected.  Without imminent economic disaster to sharpen the mind, the case for reform just isn’t there for most politicians.

So, stop spinning the doomsday tale and develop a prevention plan. I happen to buy in to the doomsday scenario as the likely outcome. But unlike Keen, I am not convinced the time is now – it could be in one year.  It could be in two years – or four. Of course, others say, it isn’t coming at all.

Nevertheless, the case for real reform can be made even if it is divorced from the financial crisis, the present economic environment and the upcoming election cycle.

You are kidding yourself if you think real reform is coming to the financial sector before the mid-term elections, especially with health care, two wars and the need to ensure recovery still on politicians’ plates. Obama could go for real reform in 2011 – or in a second term in 2013. But, unless economic crisis is at our door, there isn’t a convincing argument which says reform is necessary. The same is true in Europe, by the way.

What I would like to see is economic thought leaders developing a blueprint of a financial crisis strategy which tackles both the immediate crisis issues (liquidity) and the structural, regulatory and monetary issues that create financial volatility (solvency). When crisis does occur, I believe it will be systemic in nature due to the forces Keen so lucidly explains. Therefore, a blueprint which is 1) heavy on tactics and, 2) if implemented in a real systemic crisis, is likely to work, builds credibility. This is political capital which will carry over to longer-term preventive strategies and reforms.

On the other hand, if Keen is right, we are on the verge of a very nasty relapse which will mean depression and debt deflation. And I reckon such a scenario means the political will should be there in spades.

  1. hbl says


    Nice political illustration… It seems right on the mark.

    Glad to see you addressing both Steve Keen and Richard Koo recently, as I think they offer the two best complementary descriptions of the crisis (though they differ from each other in predictions and prescriptions).

    IIRC Keen has commented that deleveraging may be slowed down by government response, for example pushing out the next nasty down-leg by 6-12 months… but that private sector deleveraging can’t be stopped this time. I agree with him on both counts. If correct, that seems to make a “reflation” lasting years unlikely (though not impossible if the global decoupling fantasy comes true very rapidly). I think where Keen may have a chance of being wrong is the potential for fiscal stimulus to create an outcome closer to Japan’s than the Great Depression. He has acknowledged that he hasn’t had time to add government explicitly to his dynamic models yet.

    As for “prevention plan”, Keen doesn’t seem to think this debt deflation can be prevented from running its course, though he has consistently made two specific reform proposals to prevent future large asset bubbles.

    UPDATE: I should clarify that while it isn’t strictly “prevention”, Steve Keen has brought up the need to ultimately abolish (via a modern version of a “debt jubilee”) a certain amount of excessive debt that shouldn’t have been taken on to begin with. So that is a concrete suggestion though I don’t think he expects it to be politically realistic unless a lot changes first.

  2. Anonymous says

    Loved the Keen piece-I go to his site regularly. And I agree w you that he’s a bit too definite-though his conclusion is correct; as Government is successfully adding a large new layer of leverage on top of somewhat shrinking private leverage. Gold has sniffed out the “money-printing”.

    IMO Mr. Obama should have tied financial reform into stimulus-as it’s our most vibrant economic sector- and gotten a twofer. For now, IMO he should cut a deal on health insurance reform AND do financial reform. And he should go back to the Bush strategy of doing not much of anything in Afghanistan, say that the Bush economic wreck makes a major war unaffordable, that the failure of Bush to do good things in Afghanistan because of the Iraq diversion makes victory in Afghanistan unlikely, and thereby be a truly transformative and supple politician.

    IMO he won’t do that because he’s a front man for the same financial Establishment as his predecessor, no matter his social views.

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