Steve Keen, associate professor of economics at the University of Western Sydney, is becoming something of a superstar. He has been acknowledged as one of a handful of economists to have predicted the global financial crisis and now is a regular speaker at high-profile conventions around the world.
He is a consultant for the United Nations’ Economic and Social Commission for the Asia Pacific and in April he is speaking alongside George Soros and Nobel Prize-winning economists Joseph Stiglitz and Paul Krugman at the Institute for New Economic Thinking where he has been asked to give a speech on “taming financial market instability”.
The same organisation has given Keen almost $250,000 to develop software capable of predicting an economic crisis before it happens.
Last November he was interviewed on the BBC’s Hardtalk program, which attracts a worldwide audience of almost 300 million, in which he “went public” about his idea for a “debt jubilee”, where private debts are written off “en masse” to avoid “two decades” of economic stagnation.
Yet in his home country, this renegade economist is regarded as something of a quack. His outspoken views about Australia’s housing market, which he maintains will fall by 40 per cent over the next 10-15 years, have caused many to dismiss him as an attention-seeking alarmist.
Ironically, it’s a label that Keen does not mind wearing. “Somebody has to tell people the bad news,” he says. “When I saw the signs of the financial crisis back in 2005, I didn’t want to see what I was seeing.
“It was an accident, stumbling across the data while preparing to appear as an expert witness in a court case. It showed an exponential rise in private debt in Australia, and in the US, that was clearly unsustainable and was going to lead to a collapse in asset prices.
“When you see something like that, you have a responsibility to ring the alarm bell.”
While Keen was right about the crash in much of the northern hemisphere, the Rudd government’s stimulus prevented a similar crash here (although Keen says this is temporary). Consequently, within these shores, Keen is still known as the man who got it wrong.
Overseas, he is often given obsequious receptions by hedge fund managers and fellow economists who flock to meet one of the few that they think has a credible record at predicting what is going to happen next.
Yet it is not as if Keen has invented an entirely new science to predict economic behaviour. It is simply that he has taken a commonsense view of economics and quantified it into a modern theory, one that acknowledges the importance of debt in determining demand in an economy.
“Traditional economists do not take any account of debt in their modelling,” he says. “In their world, debt simply doesn’t matter.”
Keen quotes Nobel Prize winning economist Paul Krugman to illustrate the point. In his 2010 paper entitled Debt, Deleveraging and the Liquidity Trap, Krugman said: “. . . looking at the world as a whole, the overall level of debt makes no difference to aggregate net worth – one person’s liability is another person’s asset.”
Yet Keen argues that, while this is empirically true, it is also irrelevant.
“That view is fine if you have money being lent from one person to another, because the lender has less money and the borrower has more and everything ends up equal,” he says. “But this completely ignores the role of banks.
“If somebody goes to a bank and wants to borrow money, the bank effectively creates that money out of nothing. It doesn’t have to take cash out of somebody’s savings to get it. And by doing so it injects extra cash and potential demand into the economy without subtracting spending power from anywhere else. In that way, overall demand is boosted and things can get out of kilter.”
Keen says things are made worse when that money is invested in speculative assets such as property or shares because it raises both the level of debt and the level of asset prices without adding anything to the economy or boosting economic growth: it just results in higher asset prices and higher debt, which inevitably ends up reducing demand.
“This is how bubbles grow and burst and ignoring debt in this way is one of the great fallacies of modern economics,” says Keen.
It is worth understanding this argument in more detail because this measure of demand – the changing levels of debt as a ratio of GDP – appears to explain the depths of the crisis far more clearly than simple measures of economic growth.
In 2008, private debt in the US grew $4.1 trillion but in 2010 shrunk $2.85 trillion as banks decreased their lending as a result of the housing crash.
When subtracted from GDP, this fall in debt equated to a 38 per cent reduction in aggregate demand, leading directly to the “great recession” and unemployment hitting its highest level in almost 30 years.
“This is what people find so confusing,” says Keen. “When you look at GDP numbers in the US, they’re not bad. At the beginning of 2008, US GDP was $14.25 trillion and today it has GDP of $14.75 trillion. That’s stagnant growth but doesn’t explain the enormous depths of the US downturn. It only begins to makes sense when you look at the fall in aggregate demand.”
In Australia, our aggregate demand has not yet even turned negative. Over the same period as the US, Australia’s private borrowing fell from $260 billion in 2008 to $37 billion in March 2010 but because GDP has been rising, thanks to the resources boom, aggregate demand has fallen by only 6.5 per cent, peak to trough.
“However, credit growth is low and getting lower, running at just 3 per cent a year, which is a level associated with the depths of recessions, not boom times.”
He says cutting interest rates will hardly help.
“A couple of years ago people were borrowing to invest in rising asset prices but that isn’t happening now,” Keen says. “Even the healthy borrowing by the resources sector may turn down and that means aggregate demand in Australia will turn negative.
“As that happens, we will fall into recession – a recession we should have had two or three years ago – and house prices will continue to fall for years to come.”
THAT FAMOUS BET
| Nick Gardner
In 2008, Keen bet Macquarie strategist Rory Robertson that house prices would fall by 40 per cent. The forfeit was to walk from Canberra to the top of Mount Kosciuszko and as house prices continued to rise, Keen did just that in 2010.
There is some confusion over the bet and if you listen to the recording of the conversation during which the bet was made, it’s clear that the timescale Keen was talking about was over 10 to 15 years while even Robertson agrees to give him five years for it to drop. Keen says he did it anyway because he thought he might get bad publicity if he didn’t but he got lots of bad publicity anyway and riled many mainstream economists. That doesn’t mean they don’t respect him.
The chief economist at AMP Capital, Shane Oliver, says Keen’s work on highlighting the inefficiencies of markets and opposing deregulation has been valuable.
“He always said that markets are not inherently efficient in that they do not always price assets correctly and that is now largely accepted as true.
“He has also been right to point out the ballooning private debt issues in many countries and his forecasts about what this would do for house prices were right in places such as the UK and US. Just because Australia’s house prices haven’t crashed doesn’t mean we don’t have too much debt. We do. So he has played an important role in bringing these issues into the spotlight.
“When you come out with views as extreme as his, and even sell your flat to avoid a price slump, you will get negative publicity when your predictions don’t come true.”
Saul Eslake of Merrill Lynch Bank of America disagrees with many of Keen’s views but says Keen works hard to back up claims. “Keen’s reading of data leads him to conclusions that I would not necessarily reach but he doesn’t make forecasts without basis. He looks for evidence to support his views. The fact he has been at an extreme end of views about house prices does not make him a bad economist. We all make bad calls from time to time.”
KEEN’S CALLS
| Nick Gardner
WHAT HE’S GOT RIGHT
The global financial crisis. Keen warned of a global recession back in 2005, which he said would occur when the rate of credit growth slowed. He was awarded the Revere Award for Economics in the US for this prediction.
WHAT HE’S GOT WRONG
Unemployment hitting 10 per cent in Australia as a result of the GFC.
WAIT AND SEE?
House prices falling 40 per cent by 2023. Despite reports that Keen said prices would crash – and an ill-advised bet on prices falling in a shorter time scale – his initial predictions were always for Australian property prices to fall by 40 per cent over the next 10 to 15 years. Time will tell.