LONDON (Reuters Breakingviews) - The late Hyman Minsky described capitalism as an inherently unstable system. The Australian-born economist Steve Keen was a prominent follower of Minsky’s long before the global financial crisis made his unorthodox views fashionable. Thus, we can anticipate the answer to the question posed in the title of Keen’s new book, "Can We Avoid Another Financial Crisis?" A capitalist economy can no better avoid another financial crisis than a dog can avoid picking up fleas - it’s only a matter of time. And, if Keen is correct, we don’t have long to wait before the next blowup arrives.
Mainstream economists notoriously failed to anticipate the subprime debacle. It was not for want of smarts. This group got to pick up most of the Nobel Prizes in their field, dominated the dismal-science departments at the most esteemed universities, sat on the editorial boards of the most prestigious journals and, crucially, dictated monetary policy. Keen, by contrast, is an outsider: he is currently head of the economics department at Kingston University. Yet it was Keen who successfully anticipated the last financial crisis at a time when most academic economists around the world were hailing that chimera known as the Great Moderation.
Why did Keen get it right when the grandees of his profession flunked? Institutional dominance appears to have placed the mainstream economists at an intellectual disadvantage. Long before they were blindsided by the Lehman Brothers bust, many in the economics elite had become a self-regarding bunch, worldly from a careerist perspective, eager to dominate policy discussions but cut off from the real world, inhabiting an echo chamber where only received opinions were entertained.
Last year, one of the clerisy broke ranks. In a withering speech, Paul Romer, the chief economist of the World Bank and a former New York University professor, accused his fellow macroeconomists of forming a monolithic intellectual community, which deferred to authority, disregarded the opinions of those outside of their group and ignored unwelcome facts. They behaved more like cult members than genuine scientists. Romer compared modern macroeconomics to string theory, famously described as “not even wrong.”
The preference for high theory and abstruse mathematical modeling meant that mainstream economics had come to rest on a number of gloriously improbable assumptions. In their models, millions of households were reduced to a single “representative agent," a God-like being, omniscient and immortal. This unreal creature inhabited a world where peace – or equilibrium – ruled. Crises were impossible in such an Eden, unless a mischievous serpent entered from abroad. But such an outcome was naturally impossible to predict.
Both Romer and Keen agree that the most serious error of modern macroeconomics is that it ignores finance. Money is seen as a “veil” placed over the activities of the real economy, a mere contrivance to get around the inconveniences of barter. Minsky, by contrast, saw capitalism as a financial system in which millions of balance sheets and cash flows were intertwined in a highly complex fashion. Money and credit are the essence of capitalism: economic transactions can only take place after financing.
The trouble is that credit is inherently unstable, prone to expand excessively and to inflate asset price bubbles, which in time collapse, causing a cascade of defaults throughout the economy. In Minsky’s world, the tail of finance wags the real economy dog.
Anyone who paid serious attention to credit, as Keen did prior to 2008, could hardly have failed to notice that something was amiss. After all, credit was growing very rapidly in the United States, in Australia and across much of Europe. Keen’s own contribution at the time was to point out that it wouldn’t take a collapse of credit to cause a serious economic downturn – a mere slowdown in the rate of lending would do the job. This prediction was vindicated in 2008, when credit growth slowed sharply but remained positive, sending the U.S. economy into a tailspin.
Keen is now calling for the dominant macroeconomic models to be jettisoned and replaced by ones that take account of credit. In his book, he develops a simple credit-based macro model. The economists at the Bank for International Settlements have constructed a “financial cycle” model along similar lines. In the end, the money-free macro models appear doomed. Yet progress has been painfully slow to date. As Max Planck said, science advances one funeral at a time - failing death, retirement would do the trick.
So what of the next crisis? With his eye on credit growth, Keen sees China as a terminal case. The People’s Republic has expanded credit at an annualized rate of around 25 per cent for years on end. Private-sector debt exceeds 200 per cent of GDP, making China resemble the over-indebted economies of Ireland and Spain prior to 2008, but obviously far more significant to the global economy. “This bubble has to burst,” writes Keen unequivocally.
Nor does he have much hope for his native Australia, whose credit and housing bubbles failed to burst in 2008, thanks in part to government measures to support the housing market, lower interest rates and massive mining investment to meet China’s insatiable demand for raw materials. Last year, Australian private-sector credit nudged above 200 per cent of GDP, up more than 20 percentage points since the global financial crisis. Australia shows, says Keen, that “you can avoid a debt crisis today only by putting it off till later.”
Keen doesn’t have much to say about post-crisis America, where household credit has contracted (relative to GDP) since 2008. Yet in the era of unconventional monetary policy, the growth of U.S. corporate credit has picked up and its quality has deteriorated. As economist and former Treasury Secretary Larry Summers has pointed out, America’s economy only seems to thrive nowadays during bubble periods. The current value of U.S. financial assets is more inflated relative to GDP than at any time in the country’s history. As Minsky said, it is only a matter of time before the next crisis arrives.