“Why did nobody notice it?” Queen Elizabeth asked the London School of Economics in 2008, about the size of the toxic debt that led to the collapse of banks around the world.
Actually, socialists and other “fringe” economists did, but nobody with the power to stop the train wreck was listening. Mainstream economists (MSE) ex-post attempts to explain the Great Financial Crisis (GFC ) range from a global savings glut, to regulatory failure (typically advanced by the same people who usually urge less regulation), to feckless buyers using the U.S. Community Reinvestment Act to force otherwise reluctant bankers to grant mortgages.
All these responses share one trait: they blame the 2007/08 GFC on anything but the economy—you know, capitalism. According to Steve Keen’s analysis in a little-noticed but compelling book, Can We Avoid Another Financial Crisis?, they are all wrong for exactly that reason.
Keen argues that an explanation of the GFC and the way to avoid another one must be based on a model of the economy that roots a financial crisis in the functioning of the economy.
Now, this may seem obvious to readers, but it’s not obvious to your friends, neighbors, relatives, and elected officials.
Problems with MSE Models
The first third of this short book explains why MSE models did not and could not foresee the GFC. Keen identifies two fundamental flaws in MSE models. First, these models treat the economy as a whole (macroeconomy) as if it were comprised of one household and one firm. The firm triers to maximize profits and the household buys goods and services. Keen argues that complex entities like the macro economy exhibit characteristics and dynamics resulting from the interaction of its parts, not from the traits of the individual parts.
The second, perhaps more remarkable, flaw in the MSE models is the absence of the financial sector – banks, money, and debt. You may ask, how is this possible? It flows from the Econ 101 picture of banks as money warehouses: money comes in from depositors and goes out when the bank subsequently makes a loan, drawing on the new deposits. In fact, banks no longer function primarily in that way.
What Caused the GFC?
Banks seek to maximize profits; they do so by charging interest on the money they lend. Where does that money come from? Banks create it in the very process of making a loan: the new borrower now has money to spend, invest, speculate, and the bank has a source of profit (assuming the borrower will repay). The expansion of credit though bank lending is the expansion of private debt. Banks are money factories; private lending is essential to economic growth but also drives financial crises.
Keen’s analysis follows Hyman Minsky’s financial instability argument. As the pool of the most credit-worthy mortgage borrowers became exhausted, banks (and other lenders) did not step back from lending, because this would have reduced their profits and market share. Instead, they moved down the credit-risk hierarchy, moving from what Minsky called hedge financing to speculative and, often, to Ponzi financing. In the latter case, which drove the GFC, the borrower would be able to repay the loan only if asset prices (houses) continued to rise enough to cover loan repayments. When that didn’t happen, borrowers began to default. Facing financial ruin, many mortgage borrowers tried to sell their house. House prices collapsed, forcing more mortgage borrowers to try to sell.
But Keen goes further than Minsky.
First, he argues that the increased private debt/gross domestic product ratio also drives increased inequality. As lenders get more, workers get less. An acceleration in the process of credit creation results in a change in the distribution of income in favor of creditors and against debtors, or in favor of rentiers and against producers.
Second, and most important, Keen argues that not only the level of private debt but also the rate of change is key to understanding financial crises. When the private debt-to-GDP ratio exceeds 150%, the precondition for financial crisis is in place. But it is the rate of change in the private debt/GDP ratio that triggers the crisis: when that ratio grows significantly over a five-year period, a financial crisis is inevitable.
Can We Avoid Another Financial Crisis?
In large part, the answer to this question depends upon the outcome of the previous financial crisis. The United States went for more than six decades without a financial crisis. However, after 1980 the private debt/GDP ratio began to rise. From 2000 to the onset of the GFC, the ratio went from 133% to 170%, an acceleration of rate of debt/GDP growth of more 30%.
After the GFC, the process reversed itself, with debt/GDP ratio falling below the 150% mark in 2014-2016. However, since then, the process has stalled. The U.S. debt/GDP ratio has remained at the 150% level for the past three years. But the composition of private debt has shifted. At the onset of the GFC, household debt/GDP ratio reached 99% (primarily mortgages), and corporate debt/GDP ratio was only 70%. Since then, the household sector has deleveraged, with debt/GDP ratio dropping to 75%. But corporate debt has resumed its upward trend and is now also 75% of GDP.
Does this mean another financial crisis is imminent? Not by Keen’s analysis. Although the debt/GDP ratio remains high, it is not growing at a significant rate. But it does mean slow growth. We are just about to finish our thirteenth consecutive year of real GDP growth below 3%. Keen would argue that this is likely to continue.
What can be done? Here Keen is less clear. He argues that, although financial crises may be inevitable, the impact of such crises can be significantly reduced. First, central banks’ economic models must pay close attention to the private debt/GDP ratio. Second, post-crisis, the state can undertake economically expansive programs – think Green New Deal – to counter the constraints on economic growth imposed by the overhang of excessive private debt. Keen doubts this will occur, leaving our economy stuck in first gear.
Important political ramifications follow: if the economic pie grows more slowly, there will be more conflicts over its distribution. These could produce class conflict, but equally possible are nativist-driven conflicts, such as we experience today. More than ten years on, our politics are still defined by the GFC. It’s time to change the narrative – and that is what the 2020 presidential election should be about.