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Can we avoid another financial crisis?

Nils Zimmermann
October 26, 2017

Economist Steve Keen specializes in researching how private and public debt mountains arise and generate financial crises. In an interview with DW, he explains how the ECB could solve the problem — but probably won't.

UK London | Skyline des Londoner Finanzzentrums "The City"
Image: picture alliance/dpa/D. Kalker

DW: You've just written a new book, entitled "Can we avoid another financial crisis?" So, what's the verdict? Can we?

Steve Keen: The answer is: Yes and no. It's "yes" for some countries which have recently already had one — the "walking dead of debt," I like to call them. They'll avoid another crisis, at least in the near-term, if they avoid excessively reinflating their debt bubbles, but also avoid deflating their money supply by paying down too much debt too fast.

China Ordos Geisterstadt
Ordos in northern China has stood mostly empty for years. Chinese savers have invested in a vast speculative housing bubble Image: picture-alliance/dpa/H. Hwee Young

And it's "no" for those countries which managed to avoid a severe downturn after 2008 by continued massive private-sector borrowing, thereby overexpanding their private debt mountains. They're the zombies-to-be. At some point, their net credit creation will see a sudden swing from a large positive to a large negative amount, and they'll have financial crises as a direct result.

Fresh credit is an essential part of demand. When a country's net credit creation goes negative, i.e. when its private and public sectors combined are trying to pay down debt on a net basis, the supply of circulating money shrinks. This can set off a "debt deflation" cycle, involving a sudden drop in aggregate spending on goods and services, a contagious wave of bankruptcies, and a severe recession, or even a depression.

Symbolbild Deutschland Export
In 2016, Germany's goods and services exports added up to 1,209 billion euros, and imports to 955 billionImage: picture-alliance/dpa/C. Charisius

Which category does Germany fall into?

There's a tiny set of countries I call "the immune," and Germany is one of them. These countries are living off enormous trade surpluses that they shouldn't be allowed to have in the first place. When one country runs a persistent trade surplus, that means its trading partners are running persistent trade deficits. It's a zero-sum game.

Germany is virtually the only country in the world with falling levels of both public and private debt. But this is only possible because of its huge trade surplus. Trade deficits must be financed by borrowing. Germany's trading partners are getting deeper into debt in order to buy German goods. In essence, Germany is offshoring the creation of its money supply. That can't go on forever, because it eventually results in overindebtedness in trade deficit countries.

Germans tend to think their country is doing well by their economy running trade surpluses, their government running budget surpluses, and private citizens having a high savings rate, avoiding overspending or too much debt. They think other Europeans should emulate them. Are they wrong?

Yes. The problem is that people reason by analogy with private households. It may be virtuous for private households to be frugal, to save money for a rainy day, to pay down debt and tighten their belts. But since your spending is your neighbor's income, your failure to spend is your neighbor's lack of income. If too many people save rather than spend, economic activity slows down. The economy deflates. Money needs to circulate in order for real goods and services to be produced and exchanged. Saving is a microeconomic virtue and a macroeconomic vice.

Also, it's an accounting truism that the global sum of all countries' current-account surpluses and deficits is necessarily zero. It's impossible for most other countries to follow the German surplus model. What we need is everyone spending lots of money back and forth, but the financial flows have to roughly balance out over time, otherwise problems arise in deficit countries.

Steve Keen, Edinburgh
Economist Steve Keen Image: DW/N. Zimmermann

Where are financial crises likely to arise next?

First, it's important to understand that bank lending creates new credit and new debt in equal measure, by keystroke entry in double-entry spreadsheets. The British and German central banks have both published papers and videos in recent years explaining how this works. Banks don't on-lend deposits they take in from depositors. Banks create money — and debt  — whenever they extend credit to a client, whether it's by means of credit cards, mortgages, or business loans.

In most countries, the bulk of credit creation is mortgage lending. And when bigger and bigger mortgage loans are made in an environment of fast increases in house prices, i.e. in countries or cities where there's a major real estate bubble inflating, like Sydney in Australia or Vancouver in Canada, you get bigger and bigger private debt mountains.

When real estate prices stop rising, banks reduce the scope of their mortgage lending, and debtors start trying to pay down their debts. They cut back all their other expenditures and focus on trying to keep up with their monthly debt obligations. This causes an economic slowdown, reducing incomes further, and so on, in a self-reinforcing spiral.

Spanien Immobilien Boom
The collapse of Spain's real estate bubble drove the country's financial crisis (2009 photo)Image: AP

This is how financial crises arise. Mortgage overlending and real-estate bubbles in particular are very often the main cause. So, look for crises to happen in any country which has excessive private debt, and especially countries which have big mortgage bubbles that are nearing their peak, but have no big trade surpluses in their favor to offset the growing domestic debt burden. An environment of low commodity prices combined with already-inflated real estate bubbles is a nasty combination, and both Australia and Canada are at risk for that reason.

How could crises be resolved or prevented in countries which already have huge debt burdens?

The challenge is to reduce the accumulated debt mountain, especially the private debt mountain, in an elegant way. The best way, in my view, is actually fairly simple in principle: Central banks could distribute debt-free money in appropriate amounts to citizens on a per capita basis, with a stipulation that they have to use the money to pay down existing debts first. In effect, the central bank would take excessive debt onto its own balance sheet, and then write it off.

Harvard graduation ceremony, 2008
US college graduates owe some $1.45 trillion in debt, due to sky-high tuition fees. In Germany, universities don't charge tuition.Image: picture alliance/epa/Matt Campbell

They could do this because central banks are the only banks that can legally run negative net asset balances, i.e. whose liabilities are allowed to exceed their assets.

So for example, if the European Central Bank were to set up an account for every adult eurozone citizen and credited each of those accounts with 10,000 euros, overindebtedness would suddenly decline. People who were debt-free before getting their 10,000 euros would be free to spend the money on consumer goods, stimulating real-economy demand and employment.

Or alternatively, people could be required to use the money to buy newly issued corporate shares, with corporations in turn required to use the money to pay down their debts.

People assume new money creation automatically creates inflation, but that's nonsense. New money is created by the banking system on a vast scale every day. It only creates inflation in an environment of full employment and fast-rising wages.

Today, there's a lot of slack in the economy, a lot of half-empty factories and millions of unemployed people, so significant inflation is very unlikely to result from the creation and distribution of a moderate amount of new central bank money. The ECB could pay out a few thousand euros per citizen, wait and see what happens, and then spend a little more. The downside risk of doing this is minimal.

The ECB is prohibited by law from directly funding governments by its money-creation powers, but as far as I know, there's no law that prohibits the central bank from distributing money to private citizens.

So is this a plausible scenario?

Unfortunately not. Instead, for the past few years, the ECB has chosen to use its money-creation powers to implement what's called "quantitative easing." This involves creating new central bank money to buy enormous volumes of already-issued government and corporate bonds from private banks and investment funds. A couple of trillion euros of new money has been created and sluiced into financial markets this way since 2015.

ECB President Draghi gives a speech during Lindau Nobel Laureate Meetings in Lindau
The ECB's Mario Draghi is not keen on resolving Europe's debt crisis by providing dollops of fresh money directly to householdsImage: Reuters/A.Wiegmann

The result of quantitative easing is to inflate the prices of existing assets, like real estate and stock prices. That's because the flood of new money in the accounts of the banks or investment funds who sold those bonds to the ECB has to be invested somewhere. QE causes the effective interest rates on bonds to drop, making them unattractive investments, so the banks and investment funds buy stocks or real estate instead.

What this doesn't achieve, to any significant extent, is an increase in economic activity in the real economy. Banks don't spend investment money on consumer goods, and they aren't venture capital funds either. So the money mostly just spins around in the financial economy, inflating asset prices.

Adair Turner, Chairman of the Institute for New Economic Thinking
Lord Adair Turner was Britain's chief financial regulator (2008 - 2013). He too proposes using the central bank's balance sheet to flush away excessive debt Image: Oli Scarff/Getty Images

Since it's the already wealthy who own real estate and stocks, inequality increases. The rich get richer, but the rich mostly save their money, rather than spending it. You only need so many yachts, right? So not much real economic stimulus results. Instead, ownership titles to existing assets get shuffled around at ever-higher prices.

Everyone would be much better off if the ECB had given out a few hundred billion euros directly to European households instead. It could still do this  there's no good reason not to. But don't hold your breath.

Steve Keen is an Australian-born, British-based economist and author, a professor at Kingston University in London, and an innovator in crowd-funded economic research