If This Analysis Is Correct, A Great Depression Is All But Inevitable
George Monbiot

I stumbled out into the autumn sunshine, figures ricocheting around in
my head, still trying to absorb what I had heard. I felt as if I had
just attended a funeral: a funeral at which all of us got buried. I
cannot claim to have understood everything in the lecture:
Sonnenschein-Mantel-Debreu Theory and the 41-line differential equation
were approximately 15.8 metres over my head {1}. But the points I
grasped were clear enough. We’re stuffed: stuffed to a degree that
scarcely anyone yet appreciates.

Professor Steve Keen was one of the few economists to predict the
financial crisis. While the OECD and the US Federal Reserve foresaw a
“great moderation”, unprecedented stability and steadily rising wealth
{2, 3}, he warned that a crash was bound to happen. Now he warns that
the same factors which caused the crash show that what we’ve heard so
far is merely the first rumble of the storm. Without a radical change of
policy, another Great Depression is all but inevitable.

The problem is spelt out at greater length in the new edition of his
book Debunking Economics {4}. Like his lecture, it is marred by some
unattractive boasting and jostling. But the graphs and figures it
contains provide a more persuasive account of the causes of the crash
and of its likely evolution than anything which has yet emerged from
Constitution Avenue or Threadneedle Street. This is complicated, but
it’s in your interests to understand it. So please bear with me while I
do my best to explain.

The official view, as articulated by Ben Bernanke, chairman of the
Federal Reserve, is that both the first Great Depression and the current
crisis were caused by a lack of base money. Base money, or M0, is money
that the central bank creates. It forms the reserves held by private
banks, on the strength of which they issue loans to their clients. This
practice is called fractional reserve banking: by issuing amounts of
debt several times greater than their reserves, the private banks create
money that didn’t exist before. Conventional economic theory predicts
that when the central bank raises M0, this triggers a “money
multiplier”: private banks generate more credit money (M1, M2 and M3),
boosting economic growth and employment.

Bernanke, echoing claims by Milton Friedman, believed that the first
Great Depression in the US was propelled by a fall in the supply of M0,
which, he said, “reinforced … declines in the money multiplier” {5}.
But, Keen shows, there is a weak association between M0 money supply and
depression. There were six occasions after World War Two when M0 money
supply fell faster than it did in 1928 and 1929. On five of these
occasions there was a recession, but nothing resembling the scale of
what happened at the end of the 1920s {6}. In some cases unemployment
rose when the rate of M0 growth was high and fell when it was low:
results which defy Bernanke’s explanation. Steve Keen argues that it’s
not changes in M0 which drive unemployment, but unemployment which
triggers changes in M0: governments issue more cash when the economy
runs into trouble.

He proposes an entirely different explanation for the Great Depression
and the current crisis. Both events, he says, were triggered by a
collapse in debt-financed demand {7}. Aggregate demand in an economy
like ours is composed of GDP plus the change in the level of debt. It is
the sudden and extreme change in debt levels that makes demand so
volatile and triggers recessions. The higher the level of private debt,
relative to GDP, the more unstable the system becomes. And the more of
this debt that takes the form of Ponzi finance – borrowing money to fund
financial speculation – the worse the impact will be.

Keen shows how, from the late 1960s onwards, private sector debt in the
US began to exceed GDP. It built up to wildly unstable levels from the
late 1990s, peaking in 2008. The inevitable collapse in this rate of
lending pulled down aggregate demand by fourteen per cent, triggering
recession {8}.

This should be easy enough to see with the benefit of hindsight, but
what lends weight to Keen’s analysis is that he saw it with the benefit
of foresight. In December 2005, while drafting an expert witness report
for a court case, he looked up the ratio of private debt to GDP in his
native Australia, to see how it had changed since the 1960s. He was
astonished to discover that it had risen exponentially. He then did the
same for the United States, with similar results {9}. He immediately
raised the alarm: here, he warned, were the conditions for an economic
crisis far greater than those of the mid-1970s and early 1990s. A
massive speculative bubble was close to bursting point. Needless to say,
he was ignored by policy-makers.

Now, he tells us, a failure to address these problems will ensure that
this crisis will run and run. The “debt-deflationary forces” unleashed
today “are far larger than those that caused the Great Depression” {10}.
In the 1920s, private debt rose by fifty per cent. Between 1999 and
2009, it rose by 140%. The debt-to-GDP ratio in the US is still much
higher than it was when the Great Depression began {11}.

If Keen is right, the crippling sums spent on both sides of the Atlantic
on refinancing the banks are a complete waste of money. They have not
and they will not kickstart the economy, because M0 money supply is not
the determining factor.

President Obama justified the bailout of the banks on the grounds that
“a dollar of capital in a bank can actually result in $8 or $10 of loans
to families and businesses. So that’s a multiplier effect” {12}. But the
money multiplier didn’t happen. The $1.3 trillion that Bernanke injected
scarcely raised the amount of money in circulation: the 110% increase in
M0 money led not to the 800 or 1000% increase in M1 money that Obama
predicted, but a rise of just twenty per cent {13}. The bail-outs failed
because M0 was not the cause of the crisis. The money would have
achieved far more had it simply been given to the public. But, as Angela
Merkel and Nicholas Sarkozy demonstrated over the weekend {14},
governments have learnt nothing from this failure, and seek only to
repeat it.

Instead, Keen says, the key to averting or curtailing a second Great
Depression is to reduce the levels of private debt, through a unilateral
write-off, or jubilee. The irresponsible loans the banks made should not
be honoured. This will mean taking many banks into receivership {15}.
Otherwise private debt will sort itself out by traditional means: mass
bankruptcy, which will generate an even greater crisis.

These are short-term measures. I would like to see them leading to a
radical reappraisal of our economic aims and moves to develop a
steady-state economy, of the kind proposed by Herman Daly and Tim
Jackson {16}. Governments and central bankers now have an unprecedented
opportunity to learn from the catastrophic mistakes they’ve made. It is
an opportunity they seem determined not to take.

www.monbiot.com.

References:

1. Professor Steve Keen, 6th October 2011. Alternative theories of
macroeconomic behaviour: a critique of neoclassical macroeconomics and
an outline of the alternative Monetary Circuit Theory approach. Nuffield
College, Oxford.

2. Ben Bernanke, 20th February 2004. The Great Moderation.
http://www.360doc.com/content/11/0402/23/67028_106822017.shtml

3. Jean-Philippe Cotis, May 2007. Achieving further rebalancing. OECD
Economic Outlook.
http://findarticles.com/p/articles/mi_m4456/is_81/ai_n27271380/

4. Steve Keen, 2011. Debunking Economics: revised and expanded edition.
Zed Books, London.

5. Ben Bernanke, 2000. Essays on the Great Depression, page 153.
Princeton University Press. Quoted by Steve Keen, as above.

6. Steve Keen, page 302.

7. Page 300.

8. Page 341.

9. Pages 336 & 337.

10. Page 349.

11. Page 348.

12. Barack Obama, 14th April 2009. Remarks on the economy.
http://www.whitehouse.gov/the-press-office/remarks-president-economy-geo...

13. Page 306.

14.
http://www.guardian.co.uk/business/2011/oct/09/france-germany-agree-plan...

15. Page 355.

16. http://www.monbiot.com/2011/08/22/out-of-the-ashes/