If You Don't Understand Private Debt, You Don't Understand Economics

If you don't understand private debt, you don't understand economics, and ironically that means that all mainstream economists don't understand economics. In 2004, Ben Bernanke, who was soon to become chairman of the Federal Reserve, declared that mainstream economists like him had tamed the business cycle. Looking back on economic performance since 1979, when Vockler as chairman of the Fed dramatically increased interest rates to try to break the back of inflation, Bernanke said that there'd been a decline in economic volatility ever since then, and he basically took credit for it. So he said the low inflation era, inaugurated by Vockler, has seen a marked reduction in economic volatility, a phenomenon that has been dubbed the Great Moderation. He argued that improved control of inflation had contributed to this welcome change in the economy, as he put it. Following up on that, in July of 2007, given the annual report to Congress on behalf of the Federal Reserve, he told Congress to expect growth of about 2.75% for the United States in 2008. He was a bit wrong, it was actually minus 2.5%. Now at the same time that he was predicting smooth waters ahead, I was predicting a recession. I was one of a handful of economists who saw the global financial crisis coming, not because I was clairvoyant or anything like that, but because the approach that I take to economics leads me to look at a couple of numbers that the economics profession in general has trained itself to ignore, and those are the level of private debt and its rate of growth. Now if you don't understand their significance, you don't understand a single financial crisis in history, including the one that is building right now. This is the data that Bernanke was looking at to be so cheerful about 2008. It's the rate of inflation and the level of unemployment from 1979 forward, and you can see the high inflation that Bockler tried to fight by putting up interest rates, which plunged, as you can see, inflation was almost 15% in 1980, about 7% in 1990, about 4% in 2000. The trend was obviously down. Equally, unemployment, it peaked at about 11% in Bockler's recession, it peaked in about 7.5% in Bush's recession, the one that clipped him to get into office. After the 2000 Berman bust, it peaked at about 6%, so the trend in both cases was obviously going down, and fundamentally Bernanke just extrapolated that forward and thought we were going to head to permanent stability in the future. Now what actually happened was an explosion in unemployment, and inflation briefly turned into deflation. This is now taking the same data and going a few years ahead, and you can see that the unemployment rate bottomed out a bit of 4%, it went to 10%. If we were using the same definitions in the 2000s to be used back in the 1980s, this unemployment rate would have been a couple of percent higher. It was the highest rate of unemployment since the Great Depression. Now, this is the data he ignored and that I take seriously. It's the ratio of private debt to GDP, and if you go back to the early 1950s, the level of private debt compared to GDP was under 50%. By the time we hit the global financial crisis, the ratio of private debt to GDP had risen to about 170%. I took this data seriously, and I predicted a crisis because of it starting from December of 2005, and in May of 2007, writing about the Australian data, but it was very similar for America as well, I said that at some point the private debt to GDP ratio must stabilise, and on past trends, it won't simply stop at stabilising. When that inevitable reversal of the unsustainable occurs, we will have a recession. And the crisis that I expected, and Bernanke didn't see coming, began in August of 2007. So what I expected to happen did occur. Credit, which is the annual change in private debt, plunged from 15% of GDP in 2006 to minus 5% of GDP in 2009. When you take a look at the correlation of the level of credit with the level of unemployment, the correlation is simply off the charts. Taking a look at credit between 1990 and 2010, the correlation was minus 0.92. That's simply off the scale in terms of a correlation, particularly when Bernanke, when commenting on Irving Fisher's explanation of the Great Depression, argued that what he called pure redistributions, in other words credit, should have no significant macroeconomic effects. Well, bollocks to that. The correlation is minus 0.92. That's slightly different to zero, which is the correlation that Bernanke was largely expecting. So why would you ignore something like that? Why wouldn't you look at data like this to see why something you didn't expect to see happen actually took place? Well, the basic reason is mainstream economists have a model of banking in which debt is irrelevant to macroeconomics. And that's what Bernanke used when he rejected Irving Fisher's explanation of the Great Depression as being due to what he called debt deflation. Bernanke, on the other hand, said that pure redistributions, which is lending from one person to another, should have no significant impact on the macroeconomy. He didn't even look at the comparable data for the 1930s, and they normally don't look at the data today either. So why not? Well, it's fundamentally because all academics look at the world through a paradigm. It's an intellectual framework they use to try to understand the data. And as well as trying to understand it, the paradigm also tells you which data to take seriously and which data to ignore. Now, the neoclassical paradigm basically treats capitalism as a barter system. They fundamentally regard money as a surface-level phenomenon. And if you remove the monetary system from your analysis of the economy, according to neoclassical economists, you'll actually understand the economy better. So in their bottle, it is part of this model of the economy where banks are irrelevant. They basically treat banks as credit rating agencies. Rather than lending money, they claim that banks tell savers, who are depositors with banks, which borrowers, who are also depositors with banks, that they should actually lend money too because these guys are safe and these other ones aren't particularly safe. So on the textbook model, banks don't actually lend money. I know that sounds crazy, and it is, but this is the sort of thing which has become part of mainstream economics. So Bernanke and all the neoclassicals fundamentally treat banks as what they call financial intermediaries, meaning they're the channel through which one group of people, savers, lend to another group of people, borrowers. But the banks themselves are fundamentally passive. They shuffle around existing money. They don't create new money. Now, this model is completely false. Banks do lend new money into existence, but because of this false belief, neoclassical economists don't even look at this data, and if they ever do, they misunderstand it. Now, of course, the financial crisis caused them to look at the possibility that maybe the financial crisis was caused, I don't know, by the financial system. If they do look at the data, they misunderstand it. Now, on the other hand, I come from a tradition of economics following non-mainstream economists. People like Irving Fisher developed what's called the debt deflation theory of Great Depressions. Hyman Minsky, who developed what's called the financial instability hypothesis, and Basil Moore, who developed what he called the endogenous money theory. And all of these people treat banks as money creators, and I follow in their footsteps. So Basil Moore, writing back in 1979, said banks are essentially in the business of selling credit. Bank assets and liabilities both expand when they do, and therefore, because bank assets are predominantly bank loans, loans make deposits. Now, that was ignored by the mainstream until 35 years later, when the Bank of England, of all groups, came out and said that Basil Moore was right and the textbooks are wrong. So in this night, in a paper in 2014, the Bank of England said in 2014 that whenever a bank makes a loan, it creates a matching deposit in the borrower's bank account, thereby creating new money, which is precisely the argument you can see from Basil Moore above. So rather than banks lending out deposits that are placed with them, which is what the textbooks will teach you, the Bank of England said, just like Basil Moore, the act of lending creates deposits. And that's the real world. As the Bank of England pointed out, it's the reverse of the sequence typically described in textbooks. So textbooks are wrong, and the mainstream is wrong as well. But despite this, the mainstream still ignores the Bank of England and the Bundesbank, and rebels like myself have been arguing this case for virtually a century. Now, none of this analysis or data will ever get into mainstream economics textbooks, and that's exactly why I left the university sector, so I could teach this material directly to everybody. If you want to see the analysis my arguments are built upon, if you want to work through the data yourself rather than just taking my word for it, then come and join the many others in my online community. I don't just tell you what data matters, I teach you a far more realistic way to think about economics using system dynamics. And this approach is the deep reason that I saw the crisis coming, and the links to my online course are in the description below. Now here's a classic example of why mainstream economics is worse than useless, because this is a paper by a leading neoclassical trying to explain the global financial crisis, called The Economic Crisis from a Neoclassical Perspective, published in one of the leading journals in the profession. And you can download a copy for yourself, which I recommend, to see what passes for economic analysis above what you see in the textbooks. Now, he rejected the credit crunch explanation for the crisis. Just watch the language here. The financial explanation also argues that the 2007 to 2009 recession became much worse because of a significant contraction of intermediation services. That's some economic jargon for lending. He said, but for some measures of intermediation have not declined substantially. Figure four shows that bank credit relative to nominal GDP rose at the end of 2008 to an all-time high. And while this declined by the first quarter of 2010, bank credit was still at a higher level at this point than any time before 2008. Well, that sounds definitive, doesn't it? Until you take a look at the data and see what the hell he's done. This is the chart that he was talking about, figure four. And you notice the numbers over here, 1, 1.2, 1.4. Those are the ratios of what he calls bank credit to GDP. Now, this might look familiar to you because it's a bit like the chart I showed a short while ago to show the ratio of, not of credit to GDP, but of debt to GDP. He was using a slightly different data series than I was, but it's basically the same line. Now, what he's done, he's mistaken debt, which is the amount of money you owe, for credit, which is the change in the amount of money you owe every year. And it's, it's crazy that he missed this because even the numbers make it obvious that it couldn't possibly be what he calls intermediation services and which is otherwise bank lending. Look at the bottom number there, ratio of one. All the data here, he said that he was actually talking about bank credit, which is what's on the chart here. Then what he'd be saying is the annual increase in private debt is greater than GDP itself. Now that would mean the private debt to GDP ratio would be growing by at least a hundred percent every year. It'd be astronomical. So what he's done is that he's mistaken this level here for its rate of change. It's not the level that matters, it's the rate of change of debt. And that's what I call credit. So if you take this data, this is the level of debt, the data that I'm using for the Bank of International Settlements, and it's obvious the level of debt in 2006 was much the same as the level of debt in 2010. And on that basis, neoclassical economists reject the idea that the financial crisis was caused by the financial sector. Now this is his rate of change. It's bloody obvious that the decline was caused by a plunge in credit. So neoclassicals don't even know the data that they're looking at when they look at it. And it isn't just one neoclassical economist getting that wrong, they all do. Ahanian thanked about 20 people in his paper, including one guy who got the Nobel Prize in Economics for his work on business cycles. This is an ex-chairman of one of the Federal Reserve regions. Significant economists who all agreed with this mistake that Ahanian made of mistaking debt for the rate of change of debt. And even after going through the crisis that he didn't see coming, Bernanke did not change his explanation for what the banking system does. So when he was given that Nobel Prize in Economics in his lecture in 2022, he modelled banks as intermediaries. And I'm not expecting you to be excited by this language, I want you to see how boring the thinking of mainstream economists is. But here's his little mathematical model. And he says, assume the entrepreneur initially turns over their wealth endowment to the intermediary. The intermediary adds one minus his wealth units to fund the project. The intermediary then deserves whether the project succeeds or fails. If it succeeds, he pays CS for success units of consumption. If it fails, he pays CU for unsuccessful. This is a toy model, a toy model of an unreal world. And this is the sort of thing which mainstream economists think is leading economics. So there's absolutely no way that the mainstream understands the economy on which they're supposed to be experts. If somebody tells you in the future that the economy is fundamentally sound, just ask them what private debt is doing and see whether they know. And that's private debt, not government debt. Government debt is an issue, but private debt is far more dangerous and it's ignored by the mainstream. A single number will tell you whether the ground is solid or whether it's about to give way beneath you. And in doing my analysis, I don't just tell you what data matters. I also teach a far more realistic way to think about the economy using system dynamics. And that's the deep reason why I saw the global financial crisis coming. Because back in 1992, I built a model of Minsky's financial instability hypothesis. And much to my own surprise, this model predicted that the crisis would be preceded by a decline in volatility, which Bernanke later called the Great Moderation. And I finished up my paper by being surprised about this event and said the chaotic dynamics explored in this paper should warn us against accepting a period of relative tranquility in a capitalist economy as anything other than a lull before the storm. So I wrote that 15 years before the global financial crisis happened. The financial crisis itself reproduced what I was expecting in my model. Now, right now, there's a debt bubble that's being inflated in plain sight with the letters AI stamped all over it. Even though a lot of the AI was begun by what they call private credit, which is money pooled by large institutions, large cash buffers, they're now borrowing. I'm sure there's massive leverage behind these data centers as well. And credit is far lower than it was in 2006. But very dangerously, the income that these investors in AI need to service the debts they're taking on simply isn't happening. Most AI companies are losing money hand over fist, losing roughly five times their level of investment, it seems at the moment. And that at some point, they won't be able to service their debts. Now, I've broken down exactly how that particular bubble ends. And it's the video right here. So please watch this. And I look forward to seeing you at some stage in the near future in my online community.