Economics in the Age of Deleveraging

By Steve Keen

as originally posted at Steve Keen’s Debtwatch

The “Global Financial Crisis”, which began in late 2007, marked a turning point in the nature of market economies. Their performance from at least the mid-1960s had been under-written by a faster growth of private debt than of GDP: this was the “Age of Leverage”. In late 2007, the growth rate of private debt fell, and since then we have been in the Age of Deleveraging.

The statistics of the Ages are stark enough: private debt rose sixfold compared to GDP in America from 1945, and sixfold in Australia from 1965. Pre-1988 figures aren’t available for UK debt, but clearly it has exploded since 1988. All three ratios peaked after 2007, and have since been falling. The fall in the US ratio is clearly unprecedented in the post-WWII period: only the Great Depression compares.

Figure 1

The change in debt data is just as stark—and it points out one substantive difference between Australia on the one hand and the USA & UK and most of the Western OECD on the other. Australian private debt is still rising (though more slowly than nominal GDP), whereas US private debt has been falling in absolute terms, and the UK has fluctuated between rising and falling debt.

Figure 2

Non-economists might expect professional economists to pay great heed to these indicators—after all, surely private debt affects the economy? However, the dominant approach to economics—known as “Neoclassical Economics” —ignores them completely, on the a priori grounds that the aggregate level of private debt doesn’t matter: only its distribution can have macroeconomic impacts.

The argument is that a rise in debt merely indicates a transfer of spending power from a saver to a borrower. The debtor’s spending power rises, but saver’s spending power also falls, so in the aggregate there will only be a macroeconomic effect if there is a very large difference in behaviour between the saver and borrower. Therefore only the distribution of debt matters, not its level or rate of change.

US Federal Reserve Chairman Ben Bernanke provided precisely this rationale to explain why neoclassical economists ignored Irving Fisher’s “debt-deflation” explanation of the Great Depression (Fisher 1933), and he also asserted that the differences in behaviour between saver and borrower could not be large enough to explain the Great Depression:

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… (Bernanke 2000, p. 24)

Similarly, Nobel Prize winner Paul Krugman argued recently that the aggregate level of private debt was not a factor in the GFC: only its distribution could be. He therefore developed a model in which the distribution of debt, rather than its level, was the causal factor:

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…

In what follows, we begin by setting out a flexible-price endowment model in which “impatient” agents borrow from “patient” agents, but are subject to a debt limit. If this debt limit is, for some reason, suddenly reduced, the impatient agents are forced to cut spending… (Krugman and Eggertsson 2010, p. 3)

He reasserted this analysis in a recent blog, arguing that the level of debt doesn’t matter, because most debt is “money we owe to ourselves”:

People think of debt’s role in the economy as if it were the same as what debt means for an individual: there’s a lot of money you have to pay to someone else. But that’s all wrong; the debt we create is basically money we owe to ourselves, and the burden it imposes does not involve a real transfer of resources.

That’s not to say that high debt can’t cause problems — it certainly can. But these are problems of distribution and incentives, not the burden of debt as is commonly understood. (Krugman 2011)

Bizarre as it may sound, these arguments by leading economists ignore decades of empirical research into and practical knowledge on banking, which have established that their fundamental premise is false: a new debt is not a transfer from one bank customer’s account to another’s—which is effectively what Krugman models and Bernanke assumes above—but a simultaneous creation of both a deposit and a debt by the bank. A bank loan thus gives a borrower additional spending power without forcing savers to reduce their spending power to compensate. As Joseph Schumpeter put it during the Great Depression:

‘It is always a question, not of transforming purchasing power which already exists in someone’s possession, but of the creation of new purchasing power out of nothing…’ (Schumpeter 1934, p. 73; see Keen 2011 , pp. 154-157, for more detail on this issue)

From this empirically confirmed perspective (Holmes 1969; Moore 1979; Kydland and Prescott 1990; Carpenter and Demiralp 2010), the change in debt therefore does have serious macroeconomic consequences, since an increase in debt adds to aggregate demand—and it is the primary means by which both investment (Fama and French 2002) and speculation (Minsky 1982, pp. 28-30) are funded.

In a credit-based economy, aggregate demand is therefore the sum of income plus the change in debt, with the change in debt spending new money into existence in the economy. This is then spent not only goods and services, but on financial assets as well—shares and property. Changes in the level of debt therefore have direct and potentially enormous impacts on the macroeconomy and asset markets, as the GFC—which was predicted only by a handful of credit-aware economists (Bezemer 2009)—made abundantly clear.

If the change in debt is roughly equivalent to the growth in income—as applied in Australia from 1945 to 1965, when the private debt to GDP ratio fluctuated around 25 per cent (see Figure 1)—then nothing is amiss: the increase in debt mainly finances investment, investment causes incomes to grow, and the economy moves forward in a virtuous feedback cycle. But when debt rises faster than income, and finances not just investment but also speculation on asset prices, the virtuous cycle gives way to a vicious positive feedback process: asset prices rise when debt rises faster than income, and this encourages more borrowing still.

The result is a superficial economic boom driven by a debt-financed bubble in asset prices. To sustain a rise in asset prices relative to consumer prices, debt has to grow more rapidly than income—in other words, if asset prices are to rise faster than consumer prices, then rather than merely rising, debt has to accelerate. This in turn guarantees that the asset price bubble will burst at some point, because debt can’t accelerate forever. When debt growth slows, a boom can turn into a slump even if the rate of growth of GDP remains constant.

This process is easily illustrated in a numerical example. Consider an economy with a GDP of $1 trillion that is growing at 10% per annum, with real growth of 5% and inflation of 5%, and in which private debt is $1.25 trillion and growing at 20% p.a. Total spending on both goods & services and financial assets is therefore $1.25 trillion: $1 trillion is financed by income, and $250 billion is financed by the 20% increase in debt.

In the following year, if the growth of debt simply slows down to the same rate at which nominal GDP is growing (without affecting the rate of economic growth), then the growth in debt will be $150 billion (10% of the $1.5 trillion level reached at the end of the previous year). Total spending will therefore be exactly the same as the year before: $1.25 trillion, consisting of $1.1 trillion in GDP plus a $150 billion growth in debt. However, since inflation is running at 5%, this amounts to a 5% fall in the real level of economic activity—which would be spread across both commodity and asset markets.

If instead the growth of debt stopped, then total spending the next year will be $1.1 trillion, a 15% fall from the level of the previous year in nominal terms, and 20% in real terms. This would cause a massive slump in demand for goods & services, assets, or both, even without a slowdown in the rate of growth of GDP.

This hypothetical example is not far removed from the actual experience of the GFC. As the US experience illustrates most clearly, the switch from rising to falling private debt ushered in the biggest economic downturn since the Great Depression, a prolonged period of high unemployment, and sharp falls in asset markets—all of which are plotted in Figure 3.

Figure 3

This is why the shift from the Age of Leverage to the Age of Deleveraging was so dramatic, and yet so unforeseen by conventional economists: it was caused by a huge reduction in aggregate demand from a factor they ignore. This debt-induced reduction in aggregate demand will persist as long as private debt levels are falling—as they still are in the USA, though at a much reduced rate from the peak rate of fall in early 2010.

Until private debt levels are substantially reduced, the economy will always tend towards what Richard Koo called a “balance sheet recession” (Koo 2009), where the desire of the private sector to reduce its leverage will suppress aggregate demand, causing both recessions and falling asset prices. The Western OECD is thus “turning Japanese”—replicating the crisis that led to Japan’s “Lost Decade”, which is now two decades old.

Koo argues that whether the world experiences the relatively minor decline in Japanese economic performance or achieves something much worse depends in part on whether the world mimics Japan’s policy response or not. But whereas conventional wisdom argues that Japan has failed by running huge government deficits, Koo argues that without these deficits, Japanese GDP would have fallen far more.

His reasoning is that, just as private sector borrowing spends additional money into existence, so too does a government deficit. But if the private sector is deleveraging—as it has done in Japan since 1991 and is now doing in the USA—then the change in private debt is actually subtracting from demand. Japan’s public sector deficits therefore attenuated the decline in aggregate demand:

Although this fiscal action increased government debt by … 92 percent of GDP during the 1990–2005 period, the amount of GDP preserved by fiscal action compared with a depression scenario was far greater. For example, if we assume, rather optimistically, that without government action Japanese GDP would have returned to the pre-bubble level of 1985, the difference between this hypothetical GDP and actual GDP would be over 2,000 trillion yen for the 15-year period. In other words, Japan spent 460 trillion yen to buy 2,000 trillion yen of GDP, making it a tremendous bargain. And because the private sector was deleveraging, the government’s fiscal actions did not lead to crowding out, inflation, or skyrocketing interest rates. (Koo 2011, p. 23)

On the other hand, Koo cautions that if the government attempts to run a surplus while the private sector is deleveraging, there will be two factors reducing economic activity at the same time. He therefore argues that deficits are sensible when the private sector is deleveraging, while attempting to run surpluses will make a bad situation worse:

Although shunning fiscal profligacy is the right approach when the private sector is healthy and is maximizing profits, nothing is worse than fiscal consolidation when a sick private sector is minimizing debt. (Koo 2011, p. 27)

However, fiscal consolidation is the policy prescription that is being applied in the Euro zone and the UK, and supported by politicians in both Australia and the USA. The likely outcome of public austerity is thus a further decrease in the growth rate of countries practicing it. Given that most of the Western OECD is already under severe economic stress, the pain that austerity inflicts upon already stressed societies is likely to mean drastic political change.

The most obvious location for political turmoil is Europe, where the Maastricht Treaty’s rules force countries to attempt to restrain fiscal deficits to 3% of GDP. This was always a bad idea, predicated on the belief that severe economic crises could not occur. Though the treaty was applauded by neoclassical economists, I was far from the only non-neoclassical economist to observe that this treaty could lead to the breakup of Europe when a recession hit, since “Europe’s governments may be compelled to impose austerity upon economies which will be in desperate need of a stimulus” (Keen 2001, pp. 212–13; see also Keen 2011, pp. 2-3).

Though continental Europe is the most obvious location for economically inspired political instability in 2012, another dark horse may also be the UK. As Figure 1 shows, its private debt level is staggeringly high—one and a half times the peak level of the USA’s—and yet it did not suffer as severe a downturn as the USA when the crisis began because, as Figure 2 indicates, it did not fall as deeply into deleveraging. The maximum decline in aggregate demand caused by falling private debt in the UK was only 6 percent of GDP, versus 20 percent in the USA.

However the rate of deleveraging in the UK has again hit this level, while the USA has recovered from the worst of the initial downturn and is deleveraging at a rate of only 3% of GDP. Governments in both the USA and the UK are favouring austerity policies, but the UK is already imposing them—with thus far negative results—and is far more likely to be able to maintain them than the politically hamstrung USA. This means that private sector deleveraging and public sector austerity may coincide in the UK in 2012, which from a “balance sheet recession” perspective indicates that the UK could fall into recession from an already depressed level of economic activity. This is especially likely if the rate of private sector deleveraging accelerates.

What could the future hold for Australia? To date, sangfroid has dominated Australian attitudes towards the GFC—based partly on our avoidance of a deep downturn in 2008, which was unique amongst OECD nations, and partly on our lucky dependence on China. At the beginning of 2011, the RBA expected to be raising rates to restrain inflation in a booming economy, while Treasury expected unemployment to fall towards full employment levels. Economic policies proposed by the major political parties were based on expectations of managing a boom, and the only debate was over how quickly the Budget should return to surplus.

Figure 4: Treasury forecasts (& projections of a return to equilibrium) in the 2011-12 budget

Unfortunately, recent economic data hasn’t followed the sangfroid script. Inflation—as measured by the RBA’s preferred indicators, the weighted and trimmed means—has fallen rather than risen, while unemployment has risen from a low of 4.9% to 5.3% (versus expectations of 4.75% in June 2012) and appears likely to trend up rather than down in coming months.

If this does happen, it will not be an indication that Government deficits are the problem—or even that they have failed to stimulate the economy—but a caution that Australia is not so different after all. Though it was delayed by policy and the mining boom, Australia is now on the cusp of a balance sheet recession too.

To see this, we need to take a closer look at the Australian private debt level. Figure 5 considers both the level (compared to GDP) and rate of change of Australian private debt since 2000.

Figure 5

After initially falling in 2008, Australia’s private debt to GDP ratio actually rose from mid-2009 till mid-2010; so Australia re-levered while the USA in particular de-levered. This rising debt boosted aggregate demand after its initial fall during the GFC, but the growth of debt is now at levels well below the pre-GFC peak.

Anticipating what might happen from now on involves considering one of the trickiest aspects of debt, its acceleration. Since aggregate demand is income plus the change in debt, the change in aggregate demand is the change in income plus the acceleration of debt. I define the “Credit Accelerator” (initially called the “Credit Impulse” by Biggs and Mayer 2010; Biggs, Mayer et al. 2010) as the ratio of the acceleration of debt to GDP, and use this as an indication of how strongly the dynamics of private debt are going to impact upon economic performance and asset markets.

Figure 6 illustrates why the “GFC” (which Americans call the “Great Recession”) was so much more devastating in the USA than Australia: the deceleration of debt was far more extreme, and lasted for much longer.

Figure 6

Figure 7 shows the relationship between credit acceleration and change in employment in Australia since 2000. Though the difference between the mild Australian and the severe American downturn was due to the much more severe deceleration of debt in America, private debt is now decelerating in Australia, and the level of employment is falling as a result.

Figure 7 (Mea culpa–R^2 should be “Correlation Coefficient”)

A similar phenomenon applies to the most important asset class in Australia, housing. Mortgage debt was the only component of private debt to rise during the GFC—under the influence of what I call the First Home Vendors Boost. Mortgage debt is now decelerating, and house prices are falling as a result. As experience has shown in the USA and Japan, this tends to be a runaway process, as falling house prices encourage further falls in debt.

Figure 8 (R^2 should be “Correlation Coefficient”)

Clearly, economic policy is now far more complex than it appeared to be before the GFC. As we enter this Age of Deleveraging, the worst thing we can do is apply policies that appeared to work during the preceding Age of Leverage—but were in fact predicated on ever-rising private sector indebtedness. Politicians should be sceptical of conventional economic advice at this time; it would be much wiser to study the history of the 1930s instead.

Bernanke, B. S. (2000). Essays on the Great Depression. Princeton, Princeton University Press.

Bezemer, D. J. (2009). “No One Saw This Coming”: Understanding Financial Crisis Through Accounting Models. Groningen, The Netherlands, Faculty of Economics University of Groningen.

Biggs, M. and T. Mayer (2010). “The Output Gap Conundrum.” Intereconomics/Review of European Economic Policy

45(1): 11-16.

Biggs, M., T. Mayer, et al. (2010). “Credit and Economic Recovery: Demystifying Phoenix Miracles.”SSRN eLibrary.

Carpenter, S. B. and S. Demiralp (2010). Money, Reserves, and the Transmission of Monetary Policy: Does the Money Multiplier Exist? Finance and Economics Discussion Series. Washington, Federal Reserve Board.

Fama, E. F. and K. R. French (2002). “Testing Trade-Off and Pecking Order Predictions about Dividends and Debt.” Review of Financial Studies

15(1): 1-33.

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1(4): 337-357.

Holmes, A. R. (1969). Operational Constraints on the Stabilization of Money Supply Growth. Controlling Monetary Aggregates. F. E. Morris. Nantucket Island, The Federal Reserve Bank of Boston: 65-77.

Keen, S. (2001). Debunking economics: The naked emperor of the social sciences. Annandale Sydney & London UK, Pluto Press Australia & Zed Books UK.

Keen, S. (2011). Debunking economics: The naked emperor dethroned? London, Zed Books.

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41(3): 147-167.

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58(58): 19-37.

Krugman, P. (2011). “Debt Is (Mostly) Money We Owe to Ourselves.” The Conscience of a Liberal 2012.

Krugman, P. and G. B. Eggertsson (2010). Debt, Deleveraging, and the Liquidity Trap: A Fisher-Minsky-Koo approach [2nd draft 2/14/2011]. New York, Federal Reserve Bank of New York & Princeton University.

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14(2): 3-18.

Minsky, H. P. (1982). Can “it” happen again? : essays on instability and finance. Armonk, N.Y., M.E. Sharpe.

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Steve Keen is Professor of Economics & Finance at the University of Western Sydney, and author of the popular book Debunking Economics, a second edition of which has just been published (Zed Books UK, 2011;

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  1. Anonymous says

    One thing that intrigues me about the UK US and Australian debt is the distribution and how it has affected the deleveraging. In the US it has been the households that were the ones in serious debt. They have been hit by the housing crisis, missed by all the stimulus and rescue efforts, so their debts have been paid down as fast as possible. In the UK the biggest lump of debt is held by the financial sector and they are being giving a lot of support to avoid deleveraging. Yet the lack of credit is impacting house prices as they have fallen for five years now because of a credit shortage. The stickiness of house prices is also slowing that deleveraging. Australia has its debts primarily in the household sector and deleveraging is not as crucial there because the property market has not crashed yet, and so deleveraging is a lower priority right now. 

  2. Dave Holden says

    Nice discussion here with Steve Keen, especially good if you’ve no time to read Graeber, Hudson etc..

Comments are closed.

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