A comprehensive view of how economic theory and policy need to be reformed to make sense of the real world and allow rational to prevent future crises. This is adapted from Steve Keen's Debtwatch Manifesto.

Preventing a future crisis will require a redefinition of financial claims upon the real economy which eliminates the appeal of leveraged speculation.

Three primary objectives:

  1. To develop a realistic, empirically based, dynamic monetary approach to economic theory and policy;
  2. To develop and promote a "modern Jubilee" by which private debt can be reduced while doing the minimum possible harm to aggregate demand and social equity; and
  3. To develop and promote new definitions of equity and property ownership that will minimize the destructive instabilities of capitalism and promote its creative instabilities.

[Steve Keen w/Alan Harvey]

Michael Hudson’s simple phrase  “Debts that can’t be repaid, won’t be repaid” sums up the economic dilemma of our times. This does not involve sanctioning “moral hazard”, since the real moral hazard was in the behavior of the finance sector in creating this debt in the first place. Most of this debt should never have been created. All it did was fund disguised Ponzi schemes that inflated asset values without adding to society’s productivity. The irresponsibility—and Moral Hazard—clearly lay with the lenders rather than the borrowers.

The question we face is not whether to repay this debt, but how to go about not repaying it?

The standard means of reducing debt—personal and corporate bankruptcies for some, slow repayment of debt in depressed economic conditions for others—could have us mired in deleveraging for one and a half decades, given its current rate. That would be one and a half decades where the boost to demand that rising debt should provide—as it finances investment rather than speculation—is absent. Growth is too slow to absorb new entrants into the workforce, innovation is muted, and political unrest rises--with all the  social consequences. Just as it did in the Great Depression.

So it is incumbent for society to reduce the debt burden sooner rather than later, so as to reduce the period spent in the damaging process of deleveraging. Pre-Capitalist societies instituted the practice of the Jubilee to escape from similar traps, and debt defaults have been a common experience in the history of Capitalism too. So a prima facie alternative to 15 years of delever­ag­ing is an old-fashioned debt Jubilee.

But a Jubilee in modern Capitalism faces two dilem­mas. Firstly, a debt Jubilee would paral­yse the finan­cial sec­tor by destroy­ing bank assets. Sec­ondly, in our era of secu­ri­tized finance, the own­er­ship of debt per­me­ates soci­ety in the form of asset based secu­ri­ties (ABS) that gen­er­ate income streams on which a mul­ti­tude of non-bank recip­i­ents depend. Debt abo­li­tion would inevitably destroy both the assets and the income streams of own­ers of ABSs, most of whom are inno­cent bystanders to the delu­sion and fraud that gave us the sub­prime xri­sis, and the myr­iad fias­cos that Wall Street has per­pe­trated in the 25 years since the 1987 stock mar­ket Crash.

We there­fore need a way to short-circuit the process of debt-deleveraging, while not destroy­ing the assets of both the bank­ing sec­tor and the mem­bers of the non-banking pub­lic who pur­chased ABSs. One fea­si­ble means to do this is a “Mod­ern Jubilee”, which could also be described as “Quan­ti­ta­tive Eas­ing for the public”.

Quan­ti­ta­tive Eas­ing was under­taken in the false belief that this would “kick start” the econ­omy by spurring bank lending. Barack Obama put it:

And although 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 is our bailout?,” they ask – 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. (Obama 2009)

Instead, QE's main effect was to dra­mat­i­cally increase the idle reserves of the bank­ing sec­tor while the broad money sup­ply stag­nated or fell (see figure). There is already too much pri­vate sec­tor debt, and nei­ther lenders nor the pub­lic want to take on more debt.

A Modern Jubilee would cre­ate fiat money in the same way as QE, but would direct that money to the bank accounts of the pub­lic with the require­ment that the first use of this money would be to reduce debt. Debtors whose debt exceeded their injec­tion would have their debt reduced but not elim­i­nated, while at the other extreme, recip­i­ents with no debt would receive a cash injec­tion into their deposit accounts.

The broad effects of a Mod­ern Jubilee would be:

  1. Debtors would have their debt level reduced;

  2. Non-debtors would receive a cash injection;

  3. The value of bank assets would remain con­stant, but the dis­tri­b­u­tion would alter with debt-instruments declin­ing in value and cash assets rising;

  4. Bank income would fall, since debt is an income-earning asset for a bank while cash reserves are not;

  5. The income flows to asset-backed secu­ri­ties would fall, since a sub­stan­tial pro­por­tion of the debt back­ing such secu­ri­ties would be paid off; and

  6. Mem­bers of the pub­lic (both indi­vid­u­als and cor­po­ra­tions) who owned asset-backed-securities would have increased cash hold­ings out of which they could spend in lieu of the income stream from ABS’s on which they were pre­vi­ously dependent.

Clearly there are numer­ous and com­plex issues to be con­sid­ered in such a policy:

  • The scale of money cre­ation needed to have a sig­nif­i­cant pos­i­tive impact (with­out exces­sive neg­a­tive effects. [There will obvi­ously be such effects, but their impor­tance should be judged against the alter­na­tive of continued delever­ag­ing.]
  • The mechan­ics of the money cre­ation process itself (which could repli­cate those of Quan­ti­ta­tive Eas­ing, but may also require changes to regulation prohibitiing Reserve Banks from buy­ing gov­ern­ment bonds directly from the Trea­sury).
  • The basis on which the funds would be dis­trib­uted to the pub­lic;
  • Man­ag­ing bank liq­uid­ity prob­lems (since though banks would not be made insol­vent by such a pol­icy, they would suf­fer sig­nif­i­cant drops in their income streams);
  • Ensur­ing that the pro­gram did not sim­ply start another asset bubble.

Reducing the size of the financial sector

Finance per­forms gen­uine, essen­tial ser­vices in a Cap­i­tal­ist econ­omy when it lim­its itself to

  • Pro­vid­ing work­ing cap­i­tal to non-financial cor­po­ra­tions;
  • Fund­ing invest­ment and entre­pre­neur­ial activ­ity, whether directly or indi­rectly;
  • Fund­ing hous­ing pur­chase for strictly res­i­den­tial pur­poses, whether to owner-occupiers for pur­chase or to investors for the pro­vi­sion of rental prop­er­ties;
  • Pro­vid­ing finance to house­holds for large expen­di­tures such as auto­mo­biles, home ren­o­va­tions, etc.

It is a destruc­tive force in Cap­i­tal­ism when it pro­motes lever­aged spec­u­la­tion on asset or com­mod­ity prices, and funds activ­i­ties (like lev­ered buy­outs) that drive debt lev­els up and rely upon ris­ing asset prices for their suc­cess. Such activ­i­ties are the over­whelm­ing focus of the non-bank finan­cial sec­tor today, and are the pri­mary rea­son why finan­cial sec­tor debt has risen from triv­ial lev­els of below 10 per­cent of GDP before the 1970s to the peak of over 120 per­cent in early 2009.

Return­ing Cap­i­tal­ism to a finan­cially robust state must involve a dra­matic fall in the level of pri­vate debt and the size of the finan­cial sec­tor, policies that return the finan­cial sec­tor to a ser­vice role to the real economy.

The per­cent­age of total wages and prof­its earned by the FIRE sec­tor (as defined in the NIPA tables) gives another guide. America’s period of robust eco­nomic growth coin­cided with FIRE sec­tor prof­its being between 10 and 20 per­cent of total prof­its, and wages in the FIRE sec­tor being below 5 per­cent of total wages. Finance sec­tor prof­its peaked at over 50% of total prof­its in 2001, while wages in the FIRE sec­tor peaked at over 9 per­cent of total wages.

Since finance sec­tor prof­its are pri­mar­ily a func­tion of the level of pri­vate debt, this implies that the level of debt needs to shrink by a fac­tor of between three and four, while employ­ment in the finance sec­tor needs to roughly halve. At the max­i­mum, the finance sec­tor should be no more than 50% of its cur­rent size.

Such a large con­trac­tion in the size of the sec­tor means that the major­ity of those who cur­rently work there will need to find gain­ful employ­ment else­where. Indi­vid­u­als who can actu­ally eval­u­ate invest­ment proposals—generally speak­ing, engi­neers rather than finan­cial engineers—will need to be hired in their place. Many of the stan­dard prac­tices of that sec­tor today will have to be elim­i­nated or dras­ti­cally cur­tailed, while many prac­tices that have been largely aban­doned will have to be reinstated.

Tam­ing the Credit Accelerator

Capitalism’s crises have always been caused by the finan­cial sec­tor fund­ing spec­u­la­tion on asset prices rather than fund­ing busi­ness and inno­va­tion. This allows finan­cial sec­tor prof­its to grow far larger than is war­ranted, on the foundation of a far larger level of pri­vate debt than soci­ety can sup­port. This lend­ing causes a feed­back loop between accel­er­at­ing debt and ris­ing asset prices, lead­ing to both a debt and asset price bub­ble. The asset price bub­ble must burst—because it relies upon accel­er­at­ing debt for its maintenance—but once it bursts, soci­ety is still left with the debt.

The under­ly­ing cause is the rela­tion­ship between debt and asset prices in a credit-based econ­omy. Aggre­gate demand is the sum of income plus the change in debt , and this is expended on both newly pro­duced goods and ser­vices and buy­ing finan­cial claims on exist­ing assets.

Some accel­er­a­tion of debt is vital for a grow­ing econ­omy. Change in debt is the main source of funds for invest­ment, and as Josef Schum­peter explained, the inter­play between invest­ment and the internal ("endoge­nous") cre­ation of spend­ing power by the bank­ing sys­tem ensures that this will be a cycli­cal process. Debt accel­er­a­tion dur­ing a boom and decel­er­a­tion dur­ing a slump are thus essen­tial aspects of capitalism.

How­ever this rela­tion also implies that the accel­er­a­tion of debt is a fac­tor in the rate of change of asset prices (along with the change in income) and that when asset prices grow faster than incomes and con­sumer prices, the motive force behind it will be the accel­er­a­tion of debt. At the same time, the growth in asset prices is the major incen­tive to accel­er­at­ing debt: this is the pos­i­tive feed­back loop on which all asset bub­bles are based, and it is why they must ulti­mately burst.. This is the foun­da­tion of Ponzi finance, and it is this aspect of finance that has to be tamed to reduce the destruc­tive impact of finance on Capitalism.

It is not likely that reg­u­la­tion alone will achieve this aim, for two reasons.

  • Minsky’s propo­si­tion that “sta­bil­ity is desta­bi­liz­ing” applies to reg­u­la­tors as well as to mar­kets. If reg­u­la­tions actu­ally suc­ceed in enforc­ing respon­si­ble finance, the rel­a­tive tran­quil­lity that results from that will lead to the belief that such tran­quil­lity is the norm, and the reg­u­la­tions will ulti­mately be abol­ished. This is what hap­pened after the last Great Depression.
  • Banks profit by cre­at­ing debt, and they are always going to want to create more debt. This is sim­ply the nature of bank­ing. Reg­u­la­tions are always going to be attempt­ing to restrain this ten­dency, and in this struggle between an “immov­able object” and an “irre­sistible force”, I have no doubt that the force will ulti­mately win.

Relying on reg­u­la­tion alone to tame the finan­cial sec­tor, then it will be tamed while the mem­ory of the cri­sis it caused per­sists, only to be over­thrown by a resur­gent finan­cial sec­tor some decades hence.

There are thus only two options to limit Capitalism’s ten­den­cies to finan­cial crises: to change the nature of either borrowers or lenders in a fun­da­men­tal way.

Reducing the appeal of leveraged speculation on asset prices:

As already noted, the key deter­mi­nant of prof­its in the finance sec­tor is the level of debt it can gen­er­ate. So the prospects of a fundamental change in behavior are dim. In whatever way it is organized and with whatever limits are placed on it, the finance sector will want to create more debt.

There are, however, prospects for alter­ing the behav­iour of the non-financial sec­tor towards debt because, fun­da­men­tally, debt is a bad thing for the bor­rower: the spend­ing power of debt now is an entice­ment at the outset, but it comes with the burden ser­vic­ing in the future. For that rea­son, when either invest­ment or con­sump­tion is the rea­son for tak­ing on debt, bor­row­ers will be restrained in how much they will accept. Only when they suc­cumb to the entice­ment of lever­aged spec­u­la­tion will bor­row­ers take on a level of debt that can become sys­tem­i­cally dangerous.

Regard­less of the end­less induce­ments from the finance sec­tor to enter into per­sonal debt, data show that com­mit­ments by the pub­lic to per­sonal debt are gen­er­ally related to and reg­u­lated by income. Com­mit­ments to debt for the pur­chase of assets, on the other hand, are related not to income, but to expec­ta­tions of lever­aged prof­its on ris­ing asset prices—when the fac­tor most respon­si­ble for caus­ing growth in asset prices is accel­er­at­ing debt.

This rela­tion­ship between debt accel­er­a­tion and change in asset prices is espe­cially appar­ent for mort­gage debt. Though debt accel­er­a­tion can enable increased con­struc­tion or turnover, the far greater flex­i­bil­ity of prices, and the treat­ment of hous­ing as a vehi­cle for spec­u­la­tion rather than accom­mo­da­tion, means that the brunt of the accel­er­a­tion dri­ves house price appre­ci­a­tion. The same effect applies in the far more volatile equity markets. Accel­er­at­ing debt leads to ris­ing asset prices, which encour­ages more debt acceleration.

The link between accel­er­at­ing debt lev­els and ris­ing asset prices is there­fore the basis of capitalism’s ten­dency to expe­ri­ence finan­cial crises. That link has to be bro­ken if finan­cial crises are to be made less likely—if not avoided entirely. This requires a rede­f­i­n­i­tion of finan­cial assets in such a way that the temp­ta­tions of Ponzi Finance can be eliminated.

Jubilee Shares

The key fac­tor that allows Ponzi Schemes to work in asset mar­kets is the “Greater Fool” promise that a share bought today for $1 can be sold tomor­row for $10. No inter­est rate, no reg­u­la­tion, can hold against the charge to insan­ity that such a fea­si­ble promise fer­ments, and on such a foun­da­tion the now almost for­got­ten folly of the Dot­Com Bub­ble was built.

Jubilee Shares is a rede­f­i­n­i­tion of shares in such a way that the entice­ment of lim­it­less price appre­ci­a­tion can be removed, and the pri­mary mar­ket can take prece­dence over the sec­ondary mar­ket. A share bought in an IPO or rights offer would last for­ever (for as long as the com­pany exists) as now with all the rights it cur­rently con­fers. It could be sold once onto the sec­ondary mar­ket with all the same priv­i­leges. But on its next sale it would have a life span of 50 years, at which point it would terminate.

The objec­tive of this pro­posal is to elim­i­nate the appeal of using debt to buy exist­ing shares, while still mak­ing it attrac­tive to fund inno­v­a­tive firms or star­tups via the pri­mary mar­ket, and still mak­ing pur­chase of the share of an estab­lished com­pany on the sec­ondary mar­ket attrac­tive to those seek­ing an annu­ity income.

This basic pro­posal might be refined, while still main­tain­ing the pri­mary objec­tive of mak­ing lever­aged spec­u­la­tion on the price of exist­ing share unat­trac­tive. The ter­mi­na­tion date could be made a func­tion of how long a share was held; the num­ber of sales on the sec­ondary mar­ket before the Jubilee effect applied could be more than one. But the basic idea has to be to make bor­row­ing money to gam­ble on the prices of exist­ing shares a very unat­trac­tive proposition.

“The Pill”

At present, if two indi­vid­u­als with the same sav­ings and income are com­pet­ing for a prop­erty, then the one who can secure a larger loan wins. This real­ity gives bor­row­ers an incen­tive to want to have the loan to val­u­a­tion ratio increased, which under­pins the finance sector’s abil­ity to expand debt for prop­erty purchases.

Since the accel­er­a­tion of debt dri­ves the rise in house prices, we get both the bub­ble and the bust. But since houses turn over much more slowly than do shares, this process can go on for a lot longer. The buildup of mort­gage debt there­fore also goes on for much longer.

Lim­its on bank lend­ing for mort­gage finance are obvi­ously nec­es­sary, but while those con­trols focus on the income of the bor­rower, both the lender and the bor­rower have an incen­tive to relax those lim­its over time. This relax­ation is in turn the fac­tor that enables a house price bub­ble to form while dri­ving up the level of mort­gage debt per head.

PILL (Property Income Limited Leverage) is a propal tying the max­i­mum debt that can be used to pur­chase a prop­erty to the income (actual or imputed) of the prop­erty itself. Lenders would only be able to lend up to a fixed mul­ti­ple of the income-earning capac­ity of the prop­erty being purchased—regardless of the income of the bor­rower. A use­ful mul­ti­ple would be 10, so that if a prop­erty rented for $30,000 p.a., the max­i­mum amount of money that could be bor­rowed to pur­chase it would be $300,000.

Under this regime, if two par­ties were vying for the same prop­erty, the one who raised more money via sav­ings would win. There would there­fore be a neg­a­tive feed­back rela­tion­ship between lever­age and house prices: an gen­eral increase in house prices would mean a gen­eral fall in leverage.

PILL is much sim­pler than Jubilee Shares, and less in need of tin­ker­ing before it could be final­ized. Its real prob­lem is in the imple­men­ta­tion phase, since if it were intro­duced in a coun­try where the prop­erty bub­ble had not fully burst, it could cause a sharp fall in prices. It would there­fore need to be phased in slowly over time—except in a coun­try like Japan where the house price bub­ble is well and truly over (even though house prices are still falling).

There are many other pro­pos­als for reform­ing finance, most of which focus on chang­ing the nature of the mon­e­tary sys­tem itself. The best of these focus on insti­tut­ing a sys­tem that removes the capac­ity of the bank­ing sys­tem to cre­ate money via “Full Reserve Banking”.

Tech­ni­cally, these pro­pos­als would work. But the bank­ing system’s capac­ity to cre­ate money is not the fundamental cause of crises, so much as the uses to which that money is put. As Schum­peter explains so well, the endoge­nous cre­ation of money by the bank­ing sec­tor gives entre­pre­neurs spend­ing power that exceeds that com­ing out of “the cir­cu­lar flow” alone. When the money cre­ated is put to Schum­peter­ian uses, it is an inte­gral part of the inher­ent dynamic of cap­i­tal­ism. The prob­lem comes when that money is cre­ated instead for Ponzi Finance rea­sons, and inflates asset prices rather than enabling the cre­ation of new assets.

Full reserve bank­ing sys­tems would make the endoge­nous expan­sion of spend­ing power the respon­si­bil­ity of the State alone. Although government's counter-cyclical spend­ing is essential, it is doubtful that government agencies or bureaucracies would get the cre­ation of money right at all times. This is not to say that the pri­vate sec­tor has done a bet­ter job—far from it! But the pri­vate bank­ing sys­tem will always be there—even if changed in nature—ready to exploit any slipups in gov­ern­ment behav­iour that can be used to jus­tify a return to the sys­tem we are cur­rently in. Slipups will surely occur, espe­cially if the new sys­tem still enables spec­u­la­tion on asset prices to occur.

Since in the real world, peo­ple for­get and die, the mem­ory of current chaos won’t be part of the mind­set when those slipups occur, espe­cially if the end of the Age of Delever­ag­ing ush­ers in a period of eco­nomic tran­quil­lity like the 1950s. We could well have 100% money reforms “reformed” out of exis­tence once more.

Schum­peter­ian bank­ing also inher­ently includes the capac­ity to make mis­takes: to fund a ven­ture that doesn’t suc­ceed, and yet to be will­ing to take that risk again in the hope of fund­ing one that suc­ceeds spec­tac­u­larly. I am wary of the capac­ity of that mind­set to co-exist with the bureau­cratic one that dom­i­nates government.