Major Causes
Simplistic Models
It's easy for non-Economists to fall into the trap of over-simplifying what is actually a very complex system experiencing complex problems. But we are not the only one's who over simplify economics. In fact economists do it as well. When economists are talking about the economy as a whole the discipline is called macroeconomics. When they refer to subsets such as the movements of particular commodities through the economy they refer to microeconomics. This introduction is about macroeconomics.
The economy is a complex non-linear system. If we want to compare it to anything we can compare it to the climate and weather. Even ordinary people know how difficult it is to predict the weather for next week. In the UK almost anything is possible. Non-linear systems are inherently unstable and sensitive to small changes, a property known popularly as The Butterfly Effect. Scientists have been studying the dynamics of non-linear systems such as weather, turbulence or ecologies for many years now and have modelled them mathematically. Lay people often refer to this branch of knowledge as Chaos Theory.
To get around the complications involved in predicting complex systems economists simplify their models. For instance they make use of the Supply and Demand curve which is so useful in microeconomics. This curve is typically linear, simple and tends towards an equilibrium where supply and demand are equal. Mainstream economists treat the macro-economy like it was a big micro-economy. But changes in scale are important. Chemistry, for example, is not simply scaled up physics. Chemistry requires new observations about how very large numbers of molecules behave. New laws are required to describe Chemistry that can't simply be derived from physics (though they may in retrospect be explainable in physics terms). So economic models are simple, linear, and assume a tendency towards equilibrium, whereas the real economy is complex, non-linear, and inherently unstable. In short the models hardly relate to the real economy at all.
Economists also assume that banks play no active role in the economy, only being passive conduits for money flowing around the system. This of course is nonsense. Banks create money when they lend beyond their reserves. If they lend a business £1 million they have created an extra £1 million of spending power. Yes, it gradually get's paid off, but that can take many years, and in the meantime we treat it like real money: buying goods and services with it. If a business is profitable then wealth has been created by that investment. So banks are far from passive players.
Bizarrely economists also leave debt out of the picture because the sum of credit and debit is (almost) zero. It is very far from zero at the moment because many debtors are defaulting on their loans and not paying them back! An analogy for this condition would be to consider that rain is equal to the amount of water vapour sent into the air by evaporation and transpiration, and to create a weather prediction model that did not include water.
The models that inform mainstream economics are defective. They did not predict the Global Financial Collapse in 2007. And they have not successfully pulled us out of the mess.
Poor Predictions
In 2005 Steve Keen was giving evidence in a court case. When he consulted the date he noticed that private sector debt in Australia had been rising exponentially for some decades. Data from the USA showed the same trend. We see exponential curves when the rate of change of the quantity being measured is accelerating. Not only was debt increasing, but the rate of increase was increasing. It's a bit like the way an ocean swell travelling towards the shoreline is pushed up by the rising sea bed. At some point the water peaks and because water is not a strong material it begins to collapse, the forward momentum of the water causes it to collapse forwards creating a wave. Steve saw that the collapse of the wave was coming and began to warn everyone who would listen. Not many people listened. And the global economy began to collapse two years later. No one can say there was no warning, only that they weren't listening to the warnings.
Banks make money from debt. We borrow and we pay back the original amount + interest. So banks always want to lend more. Our grandparents knew that debt was bad. Banks started to convince us that debt was good. They made it easy and cheap to borrow money. Credit cards became ubiquitous. Home loans of 95% or even 100% of the value of the house became available.
But at the same time banks began lending money to the finance sector so it could gamble on asset prices. For instance they began to gamble on house prices. And here supply and demand does work. The debt fuelled rise in demand was not able to be met by supply. We could not build houses fast enough. Britain has a rising population, and more people are living alone. So ordinary demand for housing was high anyway. When demand exceeds supply prises rise. In a normal market this increases supply and/or reduces demand. But the gamblers could borrow as much money as they liked, and as long as the market was rising there were short term profits to be made. So house prices continued to rise. Economists told us that this was good as people's investments were appreciating value, but what was really happening was that prices were being artificially inflated. Now the gamblers experienced cashflow problems and so borrowed to pay of creditors, confident that they would continue to win at gambling. Effectively it was a giant ponzi scheme.
When the wave peeked and investors started to sell assets in order to pay off debt, the market slumped overnight. A lot of the ponzi went bankrupt overnight, including several major financial institutions. This caused a further slump as demand dropped precipitously, and it gradually gained momentum. We've had to spend trillions of pounds to prop up the financial system that almost drove us to the wall.
And main stream economists saw none of this coming. They experienced the calm period leading up to the storm as a vindication of their ideas and policies, and ignored anyone who suggested otherwise. Remember some time ago, the Queen asked why no one saw this coming? Part of the reason they didn't see it coming, was that their models are defective. But there was hubris and arrogance on a staggering scale as well. They said it could not have been predicted and blamed external factors. And has the Global Financial Collapse moderated their opinions of themselves? No. It has not. And the same people are still driving economic policy. But is was predicted, and it was not primarily caused by external factors.
Private Debt
Most of the effort to ameliorate the problems we face focus on government borrowing, aka sovereign debt or public debt. In the UK our public debt is around 80% of GDP. This is certainly high, but not as high as other European countries. However our household debt is about 100% of GDP which is very high (for private individuals do not have a nation state backing them up!). But UK private sector dent is a massive 450% of GDP.
Imagine you are blowing up a balloon. When it get's to about the right size, you just keep on pumping air into it until the rubber is stretched about as far as it can go. It's so thin that it's almost transparent. Not another single breath could go in or it would burst. This is the image for the private sector. Of course in real life there are businesses who need investment money, and the media love to trot these people out. And make no mistake banks investing in business are vital to our economy. But taken as a whole the private sector is massively over indebted. The only way to pump in more debt is to wait for some to seep out. We all know that a balloon is slightly porous, and will gradually deflate over time. And so it is with debt. We slowly pay off debts, or go bankrupt which brings down the overall level of indebtedness.
But consider that if the private sector paid of 10% of it's debts ( = 45% of GDP) each year for ten years the level of indebtedness would have dropped to 175% of GDP. This is the level of debt in the USA just before the First Great Depression. That's how bad things are at present.
Now there's no doubt that the banks are evil bastards who have caused this crisis, drunk on profit, they went on a lending bender and have woken up with a hangover. Unfortunately we can't expect them to ramp up lending. In effect the balloon analogy breaks down because it has already burst. So as much as we rightly vilify banks for causing this crisis, we have to be morons to expect them to just keep pumping debt into the system. It really won't matter how much money we give them. All they can do is invest the money and wait for private debt to come down, or they will make things a lot worse.
Why don't governments understand this? Because they all studied mainstream economists (most of them has the same teachers at Oxford) and their advisers are all mainstream economists. They are completely blind to private sector debt. So they act like morons and keep throwing money at the banks. This does wonders for the banks as they appear to be making money, and this is good for shareholders. And it helps to pay the large salaries and bonuses that these failed business-people get.
Now What?
How long will it take?
It's been five years already. Given the current plans how long will it take for us to get back to prosperity. Steve Keen says look at Japan. Twenty years ago their debt financed demand bubble burst. At present they have falling population and rising unemployment. Take into account how long it took to recover from the First Great Depression. Steve reckons on at least ten, but more like twenty years. Call it a generation. That's if we wait for the private sector debt to gradually dissipate through paying back loans and bankruptcy. Given that policy makers are still listening to the guys who do not understand the crisis, maybe even longer.
And that's just the UK. As I write Europe is melting down. Greece is about to be bailed out again, but it won't make any difference. Spain, Portugal, Ireland and Italy are all on the brink for the same reasons and taking the same failed approach. The USA is experiencing the full effects of the Second Great Depression. China is a bubble about to burst. Steve Keen predicts another credit crunch on the scale of Lehman Brothers in the UK, which the government are trying to ameliorate by giving the banks yet more money, and swapping good debt for bad without doing anything to the overall level of indebtedness. It simply cannot work, and it won't work.
So unless we can convince our politicians to start listening to the economists who understand what's going on, who predicted the Global Financial Collapse presided over by the current economic geniuses, we're in for a generation of economic depression. Private debt has to come down, one way or another. What will be left of the UK by the time it does remains to be seen.
What are the Consequences if we Don't Act?
If you look at the aftermath First Great Depression two things stand out: widespread civil unrest, and the rise of fascism. Part of the reason that Hitler was successful in gaining a powerbase in Germany was because he reversed the economic thinking of the time and rescued Germany from hyper-inflation and mass unemployment. Of course he did this by building a war machine, and then went on a rampage. And the irony of Germany lobbying to take control of the fiscal policy of Europe is not lost on Britain, especially British comedians!
In Britain we had some pretty large scale riots in 2011. I suspect that they will seem tame in comparison with what is to come in Greece alone. Just as I write the rise of the extreme Right-wing groups in the UK seems to have stalled. In the last local body elections the BNP lost all of the council seats they had taken in the previous elections when immigration from Eastern Europe was one of the big issues. France has once again voted Socialist. But the far right is active in Europe still, and when this depression lingers for another 5, 10, 15, 20 years or more, they may well find favour with a disgruntled population.
What to do about it?
We urgently need to start listening to Steve Keen and other non-orthodox economists and investigating other approaches to the crisis. It's time for Plan B. I've tried to summarise what this might look like under the heading Modern Debt Jubilee. Steve is more eloquent and his thinking more rigorous. It is a complex problem, but it's not so hard to understand what Steve is saying. He's logical and systematic. So watch the YouTube videos. The recent batch of interviews are excellent. Read his blog Debt Watch. Read Steve's book: Debunking Economics: The Naked Emperor Dethroned?
Think it through for yourself. If you are an economist then start reading outside the mainstream. We need to get our politicians interested in these ideas. Write to your MP. Go and see them. We need to organise and lobby. The Occupy Movement may well be a conduit, though they have many competing voices and priorities. I think Modern Debt Jubilee will be a good rallying cry!
I see this problem as being on a par with Global Warming. It's urgent, misunderstood, and the consequences for the planet could be catastrophic if we don't turn it around and learn from our mistakes. I also see Steve Keen's model as a viable alternative to the current options: free market capitalism has drive us into a ditch, but socialism stifles growth and innovation and means we run out of gas. Rational capitalism, with periodic jubilees, is our best bet for a sustainable future.
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Keep is seemly & on-topic. Thanks.