Academic journal article Journal of Australian Political Economy

The Global Financial Crisis, Credit Crunches and Deleveraging

Academic journal article Journal of Australian Political Economy

The Global Financial Crisis, Credit Crunches and Deleveraging

Article excerpt

Speaking at a conference of Business Economists in December 2008, the Governor of the Reserve Bank of Australia, Glenn Stevens, remarked:

I do not know anyone who predicted this course of events. This should give us cause to reflect on how hard a job it is to make genuinely useful forecasts. What we have seen is truly a 'tail' outcome--the kind of outcome that the routine forecasting process never predicts. But it has occurred, it has implications, and so we must reflect on it (Stevens 2008: 7).

The proposition that the crisis was inherently unpredictable is a recurrent theme amongst those charged with preventing such events. It is also a convenient untruth. A Netherlands academic did a rather better survey of the literature than Governor Stevens, to identify 12 economists and market analysts who did foresee this crisis--of whom I was one (Bezemer 2009: Table 1). More importantly, he identified common elements to the analyses that led these researchers to foresee what neoclassical economists in particular failed to anticipate. Bezemer noted that though we came from varied intellectual backgrounds, we shared four common factors:

a concern with financial assets as distinct from real-sector assets, with the credit flows that finance both forms of wealth, with the debt growth accompanying growth in financial wealth, and with the accounting relation between the financial and real economy (Bezemer 2009: 8).

My own analysis extends Hyman Minsky's 'financial instability hypothesis' (Minsky 1977; Keen 1995), using a theory of monetary dynamics known as Circuit Theory, which originated in Europe (see Graziani 2003). Both perspectives played a key role in helping identify that a crisis was imminent. Minsky emphasised the importance of the debt to GDP ratio as the key indicator of financial fragility; while the Circuit School's insights enabled the development of a purely monetary model of the economy in which changes in debt play a crucial role in determining the level of aggregate demand.

The debt to GDP ratio--which effectively shows how many years it would take to reduce debt to zero if all of GDP were devoted to debt repayment--has been in danger territory ever since the Stock Market Crash of 1987. As the long term data shown in Figure 1 reveals, Australia's debt ratio in late 1980s exceeded the deflation-driven peak it reached during the Great Depression. (1)


Had central banks around the world not intervened in 1987, it is quite possible that we would have had a mild depression back then--a depression because de-leveraging would have depressed economic activity, and a mild one because inflation would have helped reduce the debt burden. Instead, the rescues encouraged financial institutions across the globe to move from one debt-financed bubble to another, with the consequence that for most of the OECD, private debt has risen substantially faster than GDP for the past 3 decades, as shown in Figure 2 below.


Australia's overall debt to GDP ratio fell slightly during the recession of the 1990s--from 85 to 79 per cent--as deleveraging by businesses more than offset the increase in mortgage debt from the comparatively low base of 20 per cent of GDP. This deleveraging of business investment is shown in Figure 3. But as Australia's housing bubble went into overdrive, the mortgage to GDP ratio increased fourfold and the aggregate debt ratio reached 165 per cent of GDP--100 per cent above the level at the end of 1929, and two-thirds higher than the previous record level set in 1892 during the 1890s depression. The unwinding of this huge debt burden, coupled with an inflation rate that is now falling towards zero, will cause a deleveraging-led economic downturn that could rival the Great Depression in severity.


Leverage and Economic Activity

One of the many false assumptions that blinded neoclassical economists to the approaching crisis was the proposition that money has no long-lasting impact on the real economy. …

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