Professor Steve Keen recently took time to answer a series of questions on everything from the sustainability of the US economic ‘recovery’ to house prices. Here is the interview in full, where he explains why we’re heading for another ‘financial crisis’.
Chris Menon: In your book ‘Debunking Economics” you predicted that the US economy isn’t likely to make a genuine full economic recovery but that the US is likely to be trapped in a never-ending sequence of ‘double dips’, just as Japan has been in the last two decades. Do you stand by that prediction?
Steve Keen: Yes. I recently commented that, so far as the Anglo nations are concerned, the “Global Financial Crisis” is over (see ‘Closing the door on the GFC’) but qualified this by the expectation that the next period of deleveraging will be not too far away, given that private debt is still in record territory (see ‘Why the US can’t escape Minsky’)
Chris Menon: Does that mean that the current ‘recovery’ is in fact illusory and will soon peter out?
Steve Keen: It could last half a decade or so, but I think it will fall over much sooner than the last boom, which really lasted from the end of the 1990s recession till 2007.
Chris Menon: As I understand it, the reason you think it isn’t sustainable it because of the recovery is driven by increasing private debt in an economy already saturated by private debt? Can you explain the importance of private debt and provide evidence of this saturation?
Steve Keen: Aggregate spending in the economy is financed out of both income and new debt. Mainstream economists ignore the latter source, on the fallacious argument that debt merely transfers spending power from one person to another. This proposition was rubbished recently by the Bank of England in an excellent publication: ‘Money creation in the modern economy’ where the Bank observed that lending creates new money—rather than allocating existing money between savers and borrowers—and the repayment of debt destroys money. This phenomenon means that the change in debt each year plays an integral role in changing the level of demand. A rising level of debt means a rising level of demand; a falling level the reverse.
The dangers are of course that debt has to be serviced, and repaid, and the ventures funded by debt have to succeed for both these conditions to be fulfilled. Debt can also be used to fund pure speculation rather than new investment or working capital, and speculation (while it can be individually profitable) doesn’t increase an economy’s productive capacity. When debt grows much faster than GDP for an extended period, it can lead to bubbles and an accumulation of failed ventures that ultimately lead to a financial crisis.
This is what happened in 2008, when private debt reached an unprecedented level—both in absolute terms and in terms of the annual change in debt as a percentage of GDP—and then dropped as the economy went into deleveraging.
The increase in public debt which politicians and the media obsess about began after the rate of growth of private debt collapsed, and in response to it.
Chris Menon: Is this also the case in the UK?
Steve Keen: Yes—though the debt levels are actually higher and more volatile than in the USA. Recent data implies that the change of debt is trending down for both government and the private sector, which implies that the current recovery won’t persist.
Chris Menon: Here in the UK we hear politicians talking about public debt being too high but they rarely focus on private debt. Why do you think this is?
Steve Keen: It’s a version of the Animal Farm “Four legs good, two legs bad” fairy tale. Conventional economics fantasizes that private individuals are always sensible in what they do, and therefore private debt is good, while governments are reckless, hence government debt is bad. The politicians latch onto this simplistic tale and also appeal to the electorate on the basis of being “responsible”.
Politicians also latch on to the simple but false analogy of a government to a household or a business—and mainstream economics, with its equilibrium fetish and non-monetary analysis, does nothing to disavow them of this analogy.
In reality, a better analogy for the role of the government is a bank, and the economy in which we live is not in equilibrium but is normally growing. The government is one of three ways in which new money can be created into this growing economy—the other two being by banks creating more money via new loans than they cancel via repayment of old ones, and by running a current account surplus. The government does its bit by running a deficit.
If the government instead runs a surplus, then the only way that the money supply can grow is by having a current account surplus—which isn’t possible for all countries since that is a zero sum game on the planet as a whole—or by private sector debt expanding.
That’s what we had in spades during the so-called Great Moderation, and the majority of that money wasn’t used for productive purposes but in speculation on rising share and property prices.
If politicians could appreciate that the alternative to them running a surplus is a private sector debt bubble that will ultimately burst and cause an economic crisis, then they might be willing to run a small deficit most of the time instead—which would lead to a stable ratio of government debt to GDP, not a ballooning one.
Chris Menon: What would the governments in the US and UK have to do to avoid a long period of stagnation?
Steve Keen: Writing off much of the private debt, and changing laws relating to mortgages and share ownership would be a good start. A certain amount of debt-financed investment and consumption is actually desirable in a growing economy, but while debt levels are as high as they are now thanks to the Ponzi Schemes of the last four decades, that debt-financed investment and consumption will be weak. They should also realize that a government deficit is a sensible policy most of the time in a growing economy.
Chris Menon: Can you explain how official economic statistics on employment and inflation both here in the UK and in the US have been compromised?
Steve Keen: The rot began in the early 1970s, when the first major economic slowdown began—not because of the oil crisis, but because a speculative debt bubble burst in 1973. Unemployment, which had been very low by historical standards from 1950 till 1970, rose suddenly. The response of politicians was in part to paper over the problem, and that affected the definition of unemployment.
It used to be that if you were out of work and looking for work, you were classified as unemployed. Now the ILO definition requires that you have not done an hour’s paid or unpaid work in the previous two weeks, that you are available to start immediately, and many other extraneous points. The USA even drops you off their main measure—known as U3—if you have been unemployed for more than a year. All these factors make modern unemployment statistics misleading, and hard to compare to historical statistics.
Chris Menon: As you forecast, Europe appears to be slipping into deflation. What affect do you think this will have on the heavily debt-laden European economies?
Steve Keen: Deflation amplifies the burden of debt, because prices and incomes fall due to deflation, but debt levels remain the same—the bank doesn’t reduce your debt because prices have fallen. This phenomenon was one of the major reasons that the Great Depression was so severe, because for 2 years the rate of inflation was minus ten per cent, and the private debt level rose compared to GDP even though the nominal level of debt was actually falling.
So deflation will further depress economies that have already been artificially depressed by the EU’s public austerity policies. In retrospect I think this period will be seen as one of the greatest public policy failures ever: Europe did not have to have a worse crisis than the Great Depression, because the much larger State sector now than then could have attenuated the downturn—as it did in America. Instead public austerity made the private sector decline worse.
Chris Menon: Is the break-up of the Euro likely?
Steve Keen: I thought so, and still believe it is possible, but one striking thing about the European situation is the political inertia compared to the Great Depression—and it’s probably in part due to the memories of how bad the political turmoil was back then. We’ve had over half a decade of pain now, but there has been no successful popular campaign to break out of the Euro—which as Wynne Godley accurately foresaw back in 1992 (see ‘Maastricht and All That’) would turn a recession into a depression.
It seems that for the Euro to break up, it will take a political party in one country unilaterally abandoning it—and that is only likely to be done by an extreme right or left party. To date no such party has come to power. But since unemployment in Spain and Greece still exceeds 25 per cent of the population (and twice that for youth), and Italy and France have rates well over 12 per cent, such a political development could still occur.
Chris Menon: How is deflation in Europe likely to affect the UK economy?
Steve Keen: It will make it harder for the UK to export its way out of trouble, since European prices will fall relative to UK ones, and European demand will remain suppressed.
Chris Menon: In the UK we’ve annual house price inflation officially running at 9.1%, with London going up almost 18%. Can you explain why this isn’t sustainable?
Steve Keen: The basic reason is the in the short run house prices are determined by leverage: the higher the loan to valuation ratio allowed by banks, the higher house prices will be. But in the long run house prices have to be financed by income: a permanent bubble in which higher house prices are financed by ever-rising debt can’t happen because ultimately the debt servicing cost exceeds available income, defaults become widespread and the price bubble ends.
However bubbles can go on much longer in markets where prices are not determined by local incomes—which is your next question.
Chris Menon: What do you think of the argument that London is a special case, as the global rich are investing here and there is also a shortage of property?
Steve Keen: That is a reality for global cities like London, New York, and Sydney, especially where governments don’t apply controls to ensure that the majority of properties are sold to residents.
Chris Menon: Can you foresee UK house prices dropping substantially within the next 5 years?
Steve Keen: It could happen, but the determination of the government to keep house prices high means that you can’t rely on market dynamics alone determining the outcome. My basic argument is that the main determinant of the level of house prices is the level of mortgage lending, which leads to the proposition that accelerating mortgage debt is needed for rising house prices. Since acceleration can’t go on forever, house prices that are solely driven by local leverage do eventually burst—as happened in the USA, Spain and Ireland to name a few.
But in international cities like London, especially ones dominated by the finance sector both economically and politically, the rise in house prices can go on past the point when the capacity of local buyers to lever is exhausted.
Chris Menon: What advice would you offer to those in the UK thinking of mortgaging themselves to the hilt to buy a property?
Steve Keen: That is a tricky question! The only advice I’d give there depends on where you’re buying. In London, the disconnect between incomes and house prices caused by the high level of non-resident purchases means that prices could well continue to rise; but on a simple comparison of house prices to rents, renting appears a more viable option if the alternative is a “to the hilt” debt.
Outside of London, the dynamics of mortgage debt play a more defining role. There I’d keep an eye on the rate of growth of mortgage debt: if that is falling then a price drop is imminent and waiting makes sense.
Ultimately, though, I think these questions are posing individual solutions to a collective problem: the extent to which we’ve allowed finance to dominate the economy, and speculation to determine the cost of housing.
Chris Menon: You’ve proposed that the valuation of both shares and property should be based on prospective earnings rather than capital gain, which would avoid speculation that damages the economy and misallocates capital. Can you explain how this might work in each case and the benefits of so doing?
Steve Keen: The simple problem with banking is that banks profit by creating debt, and the process of doing so is essentially costless to them—so they are always going to want to create more debt than society actually needs to finance investment and consumption. The limit on bank debt has to come from the demand side, and when we borrow for consumption—via credit cards for example—that limit works moderately well: though some people get into difficulty, in the aggregate unsecured personal debt has been fairly stable when compared to income.
The problem comes with debt used to buy assets—shares and property—because the extra demand that generates drives up their prices, which in turn encourages people to borrow more than they would do if they were buying assets strictly for the income streams they generate—dividends and rents. Figure 5, which compares credit card debt in Australia to mortgage debt, makes that point nicely: mortgage debt exploded from 15% to almost 90% of GDP between 1985 and 2015, while credit card debt was 1% of GDP in 1985 and is 3% now.
That gives banks a vested interest in Ponzi Schemes: lending people money to buy assets which makes those assets more expensive, encouraging others to take out yet more debt to buy those assets off the first purchasers. It works until debt reaches levels where the asset price to income ratio is too high for new entrants, so the demand stops, the bubble bursts, and we have an economic crisis.
Regulators have been useless in controlling this: they either loosen regulations over time—under the influence of vested interests, lobbying, and conventional economic theory which believes that the market is always right—or banks circumvent them.
So my proposals are to limit lending for asset purchases to some multiple, not of the buyer’s income as at present, but to the income stream expected from the asset being purchased.
That’s relatively easy to do with property: what I call the ‘PILL’ (Property Income Limited Leverage) would limit mortgages to (for example) ten times the annual rental income of the property being purchased. This would remove one enticement that borrowers currently have to actually want higher leverage: if two people with the same income are competing for a property these days, the one who wins will be the one who takes out higher leverage.
If, instead, neither could get an advantage that way because the maximum loan would be set by the property’s expected rental income, the winner would be the one who had a larger deposit. So there would be negative feedback between leverage and house prices, rather than the current positive feedback loop that leads to property bubbles.
Shares are more complicated. My original proposal here is what I called ‘Jubilee Shares’. Shares would exist as now and trade as now, but after a set number of trades (enough to allow genuine price discovery for an IPO and some waxing and waning of an established company’s valuation over time) they would convert into Jubilee Shares that would have a lifetime of another 50 years.
Another possibility would be similar to the PILL: a limit on margin lending related to the dividend stream expected from a share rather than the current free-for-all where margin debt is based on the share value.
Chris Menon: Do you regard gold as a ‘barbarous relic’ or is it likely to prove a sound investment when the “dollar turns to confetti”?
Steve Keen: It’s a speculative asset that does well in times of currency turbulence. It is not money, which is the attitude a lot of gold bugs have to it, but clearly it does well when credit-based monetary crises occur.
Chris Menon: Every investor needs to understand more about economics. Can you recommend three books for the non-academic layperson?
Steve Keen: I’ll recommend four: my own, ‘Debunking Economics’, ’23 Things They Don’t Tell You About Capitalism’ by Ha-Joon Chang, Ann Pettifor’s ‘Just Money’, and Jim Stanford’s ‘Economics for Everyone: A Short Guide to the Economics of Capitalism’.
Steve Keen is Head of the School of Economics, History and Politics at Kingston University in the UK. Kingston will be offering undergraduate and postgraduate courses that are pluralist – teaching economics ‘warts and all’, including different schools of thought rather than just the Neoclassical dogma.