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Catching a Falling Financial Knife

Global Debt Bubble, Steve Keen on Causes and Solutions

Interest-Rates / Credit Crisis 2009 Aug 24, 2009 - 03:59 AM GMT

By: Mike_Shedlock

Interest-Rates

Best Financial Markets Analysis ArticleAustralian economist Steve Keen is one of the very few who have called this economic crisis correctly. What distinguishes Keen is that his economic forecasts are based on levels of debt and changes in levels of debt as opposed to money supply, output capacity and other things that led most economists astray.


The following video is about 19 minutes long but very much worth listening to in entirety, improving as it goes along. The video may take a while to load but it's well worth it. Everything below in quotes, until the next bold title is a partial transcript from the video.

Steve Keen:

"If you have a sane economy, and by sane economy I mean one which is not addicted to debt, not a Ponzi economy, then the change in debt each year should contribute a minor amount to demand. Therefore, if you tried to correlate debt to the level of unemployment you would not find much of a correlation. Unfortunately that is not the economy we live in."

"The red line shows the percent contribution that debt contributes to demand and the blue line which is inverted is the unemployment rate."

"There should be no correlation if the economy is operating sensibly. Correlation is now at the level of 83%. Because we have a debt driven economy, the change in debt levels each year is the major determinant in the change in economic performance."

"Neoclassical economic theory is dangerous. Neoclassical economists completely missed this crisis. My favorite statement comes from the OECD in its June 2007 report"

" A recent survey trying to find economists who predicted this found 12. And there are 10,000-15,000 economists in the US alone which is why I don't particularly accept their assurances that everything is OK from now on."

"Now why are economists so ignorant? Two major reasons. First of all the type of modeling they do is static where you ignore time, or if you have dynamics you assume they are converging to some nice stable situation in the future. And they ignore almost completely the role of credit and debt."

"I probably win the Dr. Doom award around the planet these days now that Nouriel Roubini is expecting the recession will end in about 6 months time. I think it's got a lot longer to go than that."

"What we are going through is a deleveraging crisis and we haven't experienced one of those since 1930. Last time it took 10 years and a world war to get rid of it, and this time we are staring up with 1.7 times the level of debt in America, not even mentioning the derivatives catastrophe that is also there."

"And deleveraging which is the attempt by the private sector to reduce its debt level can overwhelm the government's stimulus. The whole problem was caused by irresponsible lending and the only way out of this ultimately is to eliminate that debt. The debt has to be written off"

Powerpoint Presentation

The above text is a partial transcript from his presentation and the slides are two of many slides from the accompanying Powerpoint presentation. You can download the presentation on Steve Keen’s Debtwatch Blog. You will need to listen to the video to understand some of the slides.

Australian readers will want to pay particular attention as Australia is certainly not out of the woods.

Keen's Proposed Solutions

Steve Keen has some interesting proposals for solutions. He spoke of nationalizing banks which I have sided against. However, Keen also wanted to wipe out the shareholders and repudiate the bondholders by turning the assets over to the bondholders in a bankruptcy process. That is something I certainly do agree with. The problem here is probably the word "nationalization"

One thing is certain, US taxpayers got the worst of all worlds by nationalizing Fannie Mae and Freddie Mac, and taking over the liabilities (at taxpayer expense) while making the bondholders whole. To top off the madness, Fannie and Freddie increased lending limits, putting taxpayers at further risk. This is exactly the wrong "nationalization" approach and I am sure Keen would agree.

Keen has an interesting idea that mortgages on houses ought to be based on what rent they could fetch. Clearly the credit bubble never would have escalated to the point it did if lenders had the common sense to lend based on how much rent a house could fetch.

As it was, debt upon debt upon debt piled up until we had the Collapse Of The "Ownership Society".

Supposedly no one saw this coming. A chart in the preceding link proves otherwise.

Fed and Fractional Reserve Lending at Heart of the Issue

In regards to Keen's solutions, I believe the free market should make these decisions, not government bureaucrats. And in that regard, Keen never touched on what I think are the two root causes of this mess:

1) Micro-mismanagement of interest rates by central bankers in general and the Fed in particular.
2) Fractional reserve lending gone mad.

Free Market Forces Should Decide

It was not lack of regulation that got us into this mess, but rather regulation, going back to 1913 and the creation of the Fed. Making matters worse, Congress authorized Fannie Mae and Freddie Mac and hundreds of "affordable housing" programs all designed to pressure people into buying houses.

Let's not forget the misguided regulation that created FDIC.

Inquiring mind will want to consider As of Friday August 14, 2009, FDIC is Bankrupt and followup Emails from a Bank Owner regarding FDIC and Under-Capitalized Banks.

If we eliminate FDIC, Fannie Mae, Freddie Mac, and all the housing subsidies authorized by Congress and the states, then the free market may very well decide that Keen's model of pricing houses is the correct one.

As it sits, there are too many factors other than rent that affect home prices, such as federal income tax deductions, affordable housing programs, proposition 13 in California, Fannie and Freddie, etc . Attempting to control those forces with more regulation is the wrong way to go. However, there is no reason why banks could not and should not (on their own accord) start making lending decisions based on rental values.

When it comes to the writeoff of debt and the need to prevent another debt bubble, I certainly side with Keen vs. Krugman, Mankiw, and even Roubini who all prescribe variations of "Neoclassical Nonsense" hoping to spur more bank lending and consumer borrowing by throwing money at the problem.

My own theory on credit and debt is contained in Fiat World Mathematical Model. Thanks go to Steve Keen for helping me finalize that model.

I have some emails from Steve Keen regarding my model, Keynesian clowns, and other things. I will share some of those emails later this week.

By Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com

Click Here To Scroll Thru My Recent Post List

Mike Shedlock / Mish is a registered investment advisor representative for SitkaPacific Capital Management . Sitka Pacific is an asset management firm whose goal is strong performance and low volatility, regardless of market direction.

Visit Sitka Pacific's Account Management Page to learn more about wealth management and capital preservation strategies of Sitka Pacific.

I do weekly podcasts every Thursday on HoweStreet and a brief 7 minute segment on Saturday on CKNW AM 980 in Vancouver.

When not writing about stocks or the economy I spends a great deal of time on photography and in the garden. I have over 80 magazine and book cover credits. Some of my Wisconsin and gardening images can be seen at MichaelShedlock.com .

© 2009 Mike Shedlock, All Rights Reserved


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Catching a Falling Financial Knife