Can We Avoid Another Financial Crisis?
By Steve Keen
Polity Cambridge UK, 2017
In 2009, economist Steve Keen walked from Canberra to Mount Kosciuszko after losing a bet that the Australian housing market would crash 40% after the Global Financial Crisis (GFC).
However, he had been one of the few economists who actually predicted the coming of the GFC. And he still maintains that a crash in the Australian housing market is coming.
In Can We Avoid Another Financial Crisis?, he looks at why the GFC happened and argues that the conditions that caused it are still with us.
As in his earlier work, Debunking Economics, he pulls apart mainstream neoclassical economics. In particular, he criticises its obsession with idealised models that show how the economy will always naturally find its way to equilibrium.
Rather, he argues, credible models of the economy ought to be able to explain recurrent crises. In this, he especially makes use of the economics of Hyman Minsky and his account of the financial system and its role in crises.
The main risk factors for a financial crisis involve credit and debt. The rising debts of the US and other governments loom large in discussions of potential economic problems.
However, as Keen points out, governments are uniquely placed when it comes to debt. They have their own bank, the central bank, which can purchase their bonds and create money without any necessary restraint to pay it back.
Think how easily Australia turned from the “debt and deficit disaster” that Tony Abbott cried incessantly about to being almost silent about government debt, even while it continued to increase — as if it never really mattered that much anyway.
The real danger, Keen argues, is in non-government debt. Yet private debt owed by corporations and households (largely in the form of home mortgages) rarely features in mainstream economic models and thinking.
Global debt has grown exponentially in recent decades, with private debt accounting for the bulk.
Although GDP has also been growing, it has been considerably outstripped by the growth in private debt.
As a result, much of this excess credit has been ploughed into bidding up the prices of assets such as stocks and housing. This led to the bubbles we’ve seen growing and sometimes bursting.
Keen’s analysis is based on the idea “that aggregate expenditure in the economy [is] roughly the sum of GDP plus credit [that is, growth in debt], and that this sum generate[s] both income (through purchases of goods and services) and realised capital gains (via net purchases of assets — predominantly property and shares).”
GDP tends to be relatively stable, but credit is much more volatile. It is capable of adding demand to the economy or, when it turns negative, subtracting demand.
Keen illustrates how with lower levels of private debt, a slowdown in the growth of debt can be relatively benign.
But at a higher level of debt, the effect of a slowdown in the growth of debt is amplified. Even with a growing GDP, if debt grows at a slower rate this can be enough to cause total demand in the economy to contract and trigger a crisis.
Keen cites the empirical regularity identified by Richard Vague that has featured in every economic crisis in the past 150 years: a debt-to-GDP ratio of more than 150% and a rise in that ratio of more than 17% over a five year period.
The Japanese economy is a clear example. After seemingly remarkable post war growth, with private debt at 208% of GDP and a five-year debt growth of 17.5%, its bubble economy burst in 1990.
Its debt has dropped to 167%, but it has remained high ever since and its economy has remained in the doldrums for almost three decades. It is one of what Keen calls the Debt Zombies, joined since 2008 by Denmark, Ireland, the Netherlands, New Zealand, Portugal, Spain, Britain and the US.
Using criteria similar to Vague, Keen plots several countries on a chart with their levels of private debt and the growth of that debt.
Those with the highest levels of both are the strongest candidates for membership of the Debt Zombies club. Outstanding on the chart are China, Hong Kong and Ireland. Also in the danger zone are Belgium, Canada, South Korea, Norway, Sweden and Australia.
In the US, private debt, which stood at 37% of GDP after World War II, peaked at 170% in 2009. Through the GFC, credit turned from plus 15% to minus 5%, draining demand out of the economy – from $16 trillion in 2008 to $13.5 trillion in 2010.
Yet, in spite of this crash, debt was almost back to 150% of GDP by 2016 — putting the risk of another crisis back on the horizon.
Australia’s economy stood out by passing through the GFC without going into recession. This was through a combination of luck — its links to the still expanding Chinese economy — and the Kevin Rudd government’s stimulus package.
However, Keen says avoiding the crisis has merely put it off until later.
The GFC pegged back US debt levels, albeit to a fairly limited extent, but by 2016 Australia’s private debt to GDP was 208%, 22% higher than when the GFC hit.
The effect of this contrast is especially evident in the housing market. The bursting of the US subprime bubble sent inflation-adjusted housing prices back to 1.2 times their 1986 level.
Australia’s 2016 inflation-adjusted housing prices were 2.8 times their 1986 level, leaving plenty of scope for a significant downward movement.
In the time since the book was written, Australia’s private debt to GDP ratio has eased slightly to 207% — well within the danger zone for its debt level though safer in terms of the growth of that debt.
Australian housing prices, according to CoreLogic, have dropped 2.7% in the year to the end of September, 6.1% in Sydney — a decline but not yet a crash.
Since the book was written, we have also seen the banking royal commission.
Among the numerous dodgy practices highlighted by the commission are “liar loans” — mortgages created on the basis of fanciful information as regards to borrowers’ ability to pay — and implausible calculations of borrowers’ household expenses. These loans can be likened to the now notorious subprime mortgages that triggered the GFC in the US.
This is already sending a chill through the banking sector, making banks more nervous about providing easy credit.
It could even result in stricter regulation that might tighten credit. (Though history would tell us not to expect too much from the government when it comes to putting the reins on their big business backers.)
We are also coming to the point where the interest-only period expires on the interest-only mortgages that were widely issued in recent years. Many borrowers will face a sudden leap in home loan repayments in the near future.
In the context of Keen’s analysis, this definitely appears as a potential tipping point.