5 December 2020
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It's hard being a bear (part five): rescued?

It's hard being a bear (part five): rescued?

Steve Keen
22 September 2009

I’m happy to admit that I underestimated how strongly governments would respond to this financial crisis. Dramatic reductions in interest rates, huge fiscal stimuli and—in the USA and UK—expansion of government-created money, have all had a positive impact on the economy and asset markets (both shares and houses).

In his recent essay, Australian Prime Minister Kevin Rudd estimated that the rescues were the equivalent of roughly 18 percent of global GDP over a three-year period, which is an unprecedented level of expenditure by governments.

Eichengreen and O’Rourke’s comparison of today to the Great Depression gives the most balanced assessment of how effective these policies have been at the global level.

They have clearly turned around stock markets. Six months ago, world stock markets were 50 per cent below their peak, a far worse performance than during the Great Depression when, at the same time after the peak, they had only fallen 10 per cent. By the beginning of September, markets had recovered to be only a couple of per cent below the comparable 1930 position of a 30 per cent fall.

Industrial output has also turned around. Six months ago this was 13 per cent below the peak level, worse than the 1930s position of an 11 per cent decline. Since then it has risen to be only 10 per cent below, while at the equivalent time in the 1930s, industrial output had fallen 20 per cent from its 1929 high.

So has the government cavalry ridden to the rescue? If the crisis were one simply of liquidity, the answer would be yes. A government stimulus can overwhelm the impact of a credit crunch, and the innate dynamic of a productive economy can re-assert itself after such a crisis, leading to renewed growth.

But this not merely a crisis of liquidity. It is one of excessive private debt, on a scale that is also unprecedented: the USA is carrying US$41.5 trillion in debt on the back of a US$14 trillion economy, proportionately 70 per cent more debt than it had at the start of the Great Depression. In December 2007, the private sector swung from ramping up debt levels as it chased speculative gains on asset markets, to retreating from debt as the asset bubbles burst.

In the space of a year, private debt went from adding US$4 trillion to aggregate demand, to subtracting US$165 billion from it. Private debt had ceased being the economy’s turbocharger and had instead become its flooded engine.

While economic outsiders like myself, Michael Hudson, Niall Ferguson and Nassim Taleb argue that the only way to restart the economic engine is to clear it of debt, the government response, has been to attempt to replace the now defunct private debt economic turbocharger with a public one.

In the immediate term, the stupendous size of the stimulus has worked, so that debt in total is still boosting aggregate demand. But what will happen when the government stops turbocharging the economy, and waits anxiously for the private system to once again splutter into life?

I am afraid that all it will do is splutter.

This is especially so since, following the advice of neoclassical economists, Obama has got not a bang but a whimper out of the many bucks he has thrown at the financial system.

In explaining his recovery program in April, President Obama noted that:

“There are a lot of Americans who understandably think that government money would be better spent going directly to families and businesses instead of banks – ‘where's our bailout?,’ they ask”.

He justified giving the money to the lenders, rather than to the debtors, on the basis of “the multiplier effect” from bank lending:

“The truth is that a dollar of capital in a bank can actually result in eight or ten dollars of loans to families and businesses, a multiplier effect that can ultimately lead to a faster pace of economic growth”. (page 3 of the speech)

This argument comes straight out of the neoclassical economics textbook. Fortunately, due to the clear manner in which Obama enunciates it, the flaw in this textbook argument is vividly apparent in his speech.

This “multiplier effect” will only work if American families and businesses are willing to take on yet more debt:

“A dollar of capital in a bank can actually result in eight or ten dollars of loans”.

So, the only way the roughly US$1 trillion of money that the Federal Reserve has injected into the banks will result in additional spending is if American families and businesses take out another US$8-10 trillion in loans.

What are the odds that this will happen, when they already owe more than they have ever owed in the history of America? The next chart inverts the usual portrayal of America’s debt to GDP ratio by inverting it: the top of the graph represents zero debt, the bottom, a debt to GDP ratio of 300 per cent—which is just shy of the current ratio of 292 per cent.

If the money multiplier was going to “ride to the rescue”, private debt would need to rise from its current level of US$41.5 trillion to about US$50 trillion, and this ratio would rise to about 375 per cent—more than twice the level that ushered in the Great Depression.

This is a rescue? It’s a “hair of the dog” cure: having booze for breakfast to overcome the feelings of a hangover from last night’s binge. It is the road to debt alcoholism, not the road to teetotalism and recovery.

Fortunately, it’s a “cure” that is also highly unlikely to work, because the model of money creation that Obama’s economic advisers have sold him was shown to be empirically false over three decades ago.

The first economist to establish this was the American Post Keynesian economist Basil Moore, but similar results were found by two of the staunchest neoclassical economists, Nobel Prize winners Kydland and Prescott in a 1990 paper Real Facts and a Monetary Myth.

Looking at the timing of economic variables, they found that credit money was created about four periods before government money. However, the “money multiplier” model argues that government money is created first to bolster bank reserves, and then credit money is created afterwards by the process of banks lending out their increased reserves.

Kydland and Prescott observed at the end of their paper that:

Introducing money and credit into growth theory in a way that accounts for the cyclical behavior of monetary as well as real aggregates is an important open problem in economics.

I couldn’t agree more, but unfortunately they—and neoclassical economists in general—did bugger all about it. On the other hand, the Post Keynesian group, of whom I am one, have continued to try to construct models of the economy in which credit plays an essential role.

I’ve recently developed a genuinely monetary, credit-driven model of the economy, and one of its first insights is that Obama has been sold a pup on the right way to stimulate the economy: he would have got far more bang for his buck by giving the stimulus to the debtors rather than the creditors.

The following figure shows three simulations of this model in which a change in the willingness of lenders to lend and borrowers to borrow causes a “credit crunch” in year 25. In year 26, the government injects $100 billion into the economy—which at that stage has output of about $1,000 billion, so it’s a pretty huge injection, in two different ways: it injects $100 million into bank reserves, or it puts $100 billion into the bank accounts of firms, who are the debtors in this model.

The model shows that you get far more “bang for your buck” by giving the money to firms, rather than banks. Unemployment falls in both case below the level that would have applied in the absence of the stimulus, but the reduction in unemployment is far greater when the firms get the stimulus, not the banks: unemployment peaks at over 18 percent without the stimulus, just over 13 per cent with the stimulus going to the banks, but under 11 per cent with the stimulus being given to the firms.

The time path of the recession is also greatly altered. The recession is shorter with the stimulus, but there’s actually a mini-boom in the middle of it with the firm-directed stimulus, versus a simply lower peak to unemployment with the bank-directed stimulus.

Why does this model show that it’s better to give the money to the debtors than the lenders, in contrast to the case that Obama was sold, that it’s better to give it to the bankers?

Because the “money multiplier” model is effectively a mechanical, static, equilibrium model of the economy. Give the banks excess reserves, and they will lend them to the public, which will happily take on the debt. Once the reserves are fully lent out, the economy is back to equilibrium again.

In contrast, my model is a dynamic, non-equilibrium one, where the “circular flow” of money and goods is properly accounted for. In this system, you can think of the different bank accounts in the system as like dams with pipes connecting them of vastly different diameters.

When a credit crunch strikes, the pipes pumping the bank reserves to the firms shrink dramatically, while the pipe going in the opposite direction expands, and all other pipes remain the same size.

If you then fill up the bank reserves reservoir—by the government pumping the extra $100 billion into it—that money will only trickle into the economy slowly. If however you put that money into the firms’ bank accounts, it would flow at an unchanged rate to the rest of the economy—the workers—while flowing more quickly to the banks as well, reducing debt levels.

So giving the stimulus to the debtors is a more potent way of reducing the impact of a credit crunch—the opposite of the advice given to Obama by his neoclassical advisers.

This could also be one reason that the Australian experience has been better than the USA’s: the stimulus in Australia has emphasised funding the public rather than the banks (and the model shows the same impact from giving money to the workers as from giving it to the firms—and for the same reason, that workers have to spend, so that the money injected into the economy circulates more rapidly.

This model can explain some aspects of the current US data that are inexplicable from the conventional, neoclassical point of view—the key paradox being that while base money (“M0”) has been increased dramatically, there has been almost no movement in broader measures of money (“M1” and “M2”). If the money multiplier argument were correct, the increases in M1 and M2 would have been multiples of the increase in M0, as Obama was led to expect.

In fact, the expansion in M0 has been met by a fall in the credit-generated component of the money supply: since M2 includes all of M1 and M1 includes all of M0, this is clearer when we subtract the double-counting out. M1 has actually contracted almost as much as M0 has expanded, while the expansion in M2 has been less than a third the size of the growth in M0.

The “money multiplier” has also collapsed—a mystery from a neoclassical point of view, but entirely predictable from the “endogenous money” perspective.


Obama has been sold a pup by neoclassical economics: not only did neoclassical theory help cause the crisis, by championing the growth of private debt and the asset bubbles it financed; it also is undermining efforts to reduce the severity of the crisis.

This is unfortunately the good news: the bad news is that this model only considers an economy undergoing a “credit crunch”, and not also one suffering from a serious debt overhang that only a direct reduction in debt can tackle. That is our actual problem, and while a stimulus will work for a while, the drag from debt-deleveraging is still present. The economy will therefore lapse back into recession soon after the stimulus is removed.

Important information:This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.


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