Can We Avoid Another Financial Crisis? (The Future of Capitalism)

1. Private debt, not public debt, caused the 2008 financial crisis

The crisis will be preceded, as indeed it was, by a 'Great Moderation' in employment and inflation.

Debt-fueled boom: The 2008 financial crisis was primarily caused by excessive private debt, not government deficits. In the years leading up to the crisis, private debt levels in many countries reached unprecedented heights, often exceeding 150% of GDP. This debt accumulation created a false sense of prosperity and economic stability.

Credit collapse: When the rate of debt growth slowed, it triggered a sharp contraction in aggregate demand. The subsequent deleveraging process led to a severe economic downturn, as falling asset prices and reduced spending created a negative feedback loop. Government deficits, often blamed for the crisis, were largely a consequence of the downturn rather than its cause, as tax revenues fell and social spending increased.

2. Mainstream economics failed to predict the crisis due to flawed models

Macroeconomics was born as a distinct field in the 1940s, as a part of the intellectual response to the Great Depression. The term then referred to the body of knowledge and expertise that we hoped would prevent the recurrence of that economic disaster.

Model limitations: Mainstream economic models, particularly Dynamic Stochastic General Equilibrium (DSGE) models, failed to predict the crisis because they ignored crucial factors such as:

• Private debt levels
• The role of banks in money creation
• The inherent instability of financial markets

Misplaced confidence: These models led economists and policymakers to believe that major economic crises were a thing of the past. This overconfidence contributed to the lack of preparedness when the crisis hit.

3. The "Great Moderation" was a precursor to crisis, not economic stability

Stability – or tranquility – in a world with a cyclical past and capitalist financial institutions is destabilizing.

False sense of security: The period of low inflation and stable economic growth known as the "Great Moderation" was misinterpreted as a sign of successful economic management. In reality, it was a precursor to the crisis, masking the buildup of unsustainable private debt levels.

Minsky's insight: Economist Hyman Minsky argued that periods of stability encourage greater risk-taking and leverage, ultimately leading to financial instability. This "stability is destabilizing" concept explains why seemingly calm economic periods can breed the conditions for major crises.

4. Credit creation by banks plays a crucial role in economic cycles

Whenever a bank makes a loan, it simultaneously creates a matching deposit in the borrower's bank account, thereby creating new money.

Money creation: Banks create money when they make loans, contrary to the common belief that they simply intermediate between savers and borrowers. This process of credit creation has a significant impact on economic cycles and aggregate demand.

Credit-driven demand: Total demand in the economy is the sum of GDP plus credit (change in debt). During credit booms, this additional spending can drive economic growth and asset price inflation. Conversely, when credit contracts, it can lead to severe economic downturns.

5. Rising inequality is a symptom and contributor to debt-fueled crises

Rising inequality is therefore not merely a 'bad thing' in this model: it is also a prelude to a crisis.

Debt and inequality: As private debt levels rise, a larger share of income goes to debt servicing, primarily benefiting the financial sector and wealthy individuals. This process contributes to rising income inequality.

Feedback loop: Increasing inequality can fuel further debt growth as lower-income households borrow to maintain their standard of living. This creates a vicious cycle that increases financial fragility and the likelihood of economic crises.

6. Political misattribution of economic success and failure perpetuates debt cycles

Debt thus plays a pernicious role in our political system, as well as in our economy.

False narratives: Politicians in office during debt-fueled booms often receive undue credit for economic success, while those in power when the bubble bursts are blamed for the ensuing crisis. This misattribution of cause and effect perpetuates harmful economic policies.

Policy consequences: The political dynamics surrounding debt cycles can lead to:

• Continued support for deregulation and easy credit during booms
• Misguided austerity measures during busts
• Neglect of underlying structural economic issues

7. Future debt crises are likely in countries with high private debt levels

The only way to avoid a substantial decline in aggregate demand (and therefore a recession) from private sector behaviour alone is for private debt to continue rising faster than GDP.

Debt-dependent growth: Many countries currently rely on continued private debt growth to sustain economic activity. This trend is unsustainable and sets the stage for future crises.

Vulnerable economies: Countries with high private debt levels (over 150% of GDP) and significant credit growth in recent years are particularly at risk. These include:

• China
• Australia
• Canada
• South Korea
• Several European countries

8. Reducing private debt is essential but challenging in the current economic paradigm

Market-driven mechanisms alone are unlikely to reduce the debt to GDP ratio, for the reason that Irving Fisher identified during the Great Depression: 'Fisher's Paradox' that, in a deleveraging and deflationary environment, 'The more the debtors pay, the more they owe'.

Debt reduction dilemma: Reducing private debt levels is crucial for long-term economic stability, but it's challenging to achieve without causing economic pain. Traditional methods of debt reduction often lead to:

• Reduced aggregate demand
• Deflationary pressures
• Potential economic contraction

Policy limitations: Current economic paradigms and political constraints make it difficult to implement effective debt reduction policies. This leaves many economies trapped in a cycle of debt-dependent growth.

9. A "Modern Debt Jubilee" could reset the economy without unfairly favoring debtors

I suggest a melding of the two approaches, in what I have called a 'Modern Debt Jubilee': make a direct injection of money into all private bank accounts, but require that its first use is to pay down debt.

Debt relief mechanism: A Modern Debt Jubilee would involve creating new money and distributing it equally to all citizens, with the requirement that it first be used to pay down existing debts. This approach would:

• Reduce overall debt levels
• Boost aggregate demand
• Avoid moral hazard by not favoring debtors over savers

Implementation challenges: While theoretically promising, implementing a Modern Debt Jubilee faces significant practical and political hurdles, including:

• Legal complexities surrounding debt contracts
• Resistance from the financial sector
• Public misconceptions about money and debt

10. Reforming banking and monetary policy is necessary for long-term economic stability

We have to stop bank lending causing asset bubbles, while making it profitable for banks to lend to companies and entrepreneurs.

Banking reform: Key elements of a more stable financial system could include:

• Limiting property lending to a multiple of rental income
• Allowing banks to make "Entrepreneurial Equity Loans" that create money and give banks an equity stake in ventures
• Treating the private debt to GDP ratio as a key economic indicator

Monetary policy: Reforms to monetary policy could involve:

• Recognizing the government's role in money creation
• Using the state's money-creating power to manage private debt levels
• Implementing a "Modern Debt Jubilee" during severe crises

Implementation barriers: Despite the potential benefits, these reforms face significant obstacles due to:

• Entrenched economic orthodoxy
• Political resistance
• Public misunderstanding of monetary systems

Last updated: October 12, 2024