Transcription
Right now, it feels like the world is on fire. War, oil shocks, inflation, people worried about jobs, rent, groceries, and whether the global economy is falling apart.
We desperately need a realistic economics. The advice that textbooks give to politicians is disastrous because it tells them to ignore the fact that actually causes financial crisis. Meet Steve Keen, the economist who predicted the 2008 financial crash before it happened. He says everything you learned about banks and money is wrong. So you can't ignore the banking sector when you understand that the banks actually create money to provide the things the private sector doesn't do well, like public services. That's what we should be using the money for. Instead, because of this obsession about reducing the level of government debt, we haven't cut back on military, but we've cut back on health, welfare, education, infrastructure maintenance.
My video on Kama's resignation focused on the reasons that he lost office that are the same as he shares of all his predecessors, right back to Maggie Thatcher. Of course, he had plenty of his own reasons for folding, but I wanted to focus on the extent to which politicians are basically puppets of economists to explain why there have been so many political failures in the last 10 or 15 years.
Now, then that was the reason that I included a quote from Paul Samuelson because in one of the teaching guides to one of his textbooks, and he wrote the textbook that defined how economists think the economy actually operates. All modern textbooks are basically poor copies of Paul Samuelson's original. Uh, in a guide to using his textbook, he wrote at one point, "I don't care who writes a nation's laws if I can write its economics textbooks."
Now, why did he say that? The reason that Samson made that statement is he knows that if you get an 18-year-old male, of course, most economists are male for fairly obvious reasons, they will believe what they're taught at university, most of them, obviously I didn't. And that therefore means that once you teach them, they reproduce what your economic textbooks tells them is good policy. Samus put this very eloquently. He said, "The first lick is a privileged one, impinging on the beginner's tabular rasa at its most impressionable state."
Now, if you don't know what tabular rasa is, Latin for blank slate. So the basic concept Samson had that students will arrive with some ideas of their own, but they'll learn in the economics textbook, and what they learn in the textbook is what they will put into practice when they become politicians, and that's exactly what happens. Now, that wouldn't be a problem if economic textbooks were like engineering textbooks or physics textbooks where they said about the real world was actually accurate. Unfortunately, it's not. All the policies that have been imposed on western governments for the last 50 years spring from textbook economics, and what they teach, to quote the old American humorist Henry Menchkin, is neat, plausible, and wrong.
Now, a handful realize that that's where I came from, obviously, but most politicians don't realize that. So they take the textbooks as gospel, and when they get into power, they implement what the textbook tells them is good economic policy. Now, the trouble is, unfortunately, textbooks are wrong about virtually everything, but they're especially wrong about money and banking. And economists actually have a quite a childish model of what banks actually do. Believe it or not, they actually pretend that banks do not lend money.
Now, that is crazy. Okay, but that's what textbooks teach. And because you have 18-year-old students coming in, they don't necessarily know that this is a crazy notion. Now, what the textbooks will teach students is that banks are what they call financial intermediaries. And the idea is they're simply an agency that enables one group of non-banks, savers, normally normally households, to lend to another group of non-banks, borrowers, normally firms. And all the banks really do is assess whether the borrowers are trustworthy or not.
So, this is Ben Bernani writing back in 1983. And after this contribution, he was ultimately became chairman of the Federal Reserve, and he also received the Nobel Prize in economics in 2022. And in writing back in 1983, he made this argument about banking. He said, "The real service before by the banking system is differentiation between good and bad borrowers, not actually lending you money." Effectively, it's a model which says that banks are like credit agencies. And he said that what banks do is uh charge a small fee for working out which borrowers are worth sending money to, and they tell the savers that makes for a larger level of lending.
Now, this is nonsense. This is basically describing banks as credit rating agencies. They're far more than that. Banks actually create money. They're the ones who you get a loan from. You don't get a loan from a saver when you go to a bank. You get a loan from the bank itself because they they learn lend money. They also create money, and none of this turns up in mainstream economics. It completely ignores it and sticks with a mythical model in which banks actually don't lend money.
This is why they didn't see the global financial crisis coming because, according to their thinking, it doesn't really matter whether savers or borrowers have the money. So the toy model of banking that economists teach in textbooks is actually believed by economists as well. And this is why they didn't see the global financial crisis coming from their point of view. If savers are lending, then they've got less money to spend, but borrowers have more. If borrowers repay, then the borrowers have less, but spenders but savers have more. So the whole thing balances out, and you can basically ignore the banking system in your models of the macroeconomy. Crazy, but that's what economists believe. And they also from the same advice end up telling politicians what to do about government spending, which is equally extremely bad advice.
What textbooks do is use supply and demand diagrams to allegedly explain the functions of the banking system. But there's a slight problem there. Banks do not use supply and demand diagrams to make loans. They use double-entry bookkeeping. Now, I invented Ravel to show what banks actually do using double-entry bookkeeping. And the reason Ravel does this, it includes a feature I call a godly table, which lets me show the banking system using the standards of accounting.
So this is Ravel. And what I'm showing here is a model of the way that the textbooks think banks actually operate. So you have households having accounts at the banks, firms having accounts at the banks as well. Households lend money to firms, and firms pay interest back. That's effectively the model that the textbooks teach about what banks actually do. Now, Ravel lets you see it not just from the point of view of the banks, but also from other agents in the system.
So, we have banks. So, we have so we have households reducing the amount of money in their deposit account. Why is that? Well, they're giving it to firms. Why do they do it? Because they by lending the money to the firms, they get an asset which is the debt that is owed by the firms. So in this model, lending reduces the amount of money in the uh household deposit accounts, but it increases the value of the debts that the firms now owe back to the households, and then when the firms pay interest, that is increasing the net worth of the household sector, and that's why they do the lending. Now, from the point of view of the firm sector, the debt becomes a liability, and so their liability rises, and they pay interest back to the households, and that reduces their net worth overall. So that, in a nutshell, is the textbook model of bank lending.
So having now placed the flows and the stocks in this model on the canvas, I can now start defining a model. And the simplest, the most obvious part is so if we multiply the interest rate by the level of outstanding debt, we get interest payments. That's fairly obvious. I'm going to use a basic monetary model here and say that the amount of money in the economy is the sum of the money in the household sector bank accounts and the money in the firm sector bank accounts. That's now the money supply. Very simple model. I'm going to argue that GDP is simply the money in existence multiplied by the velocity of money. So how often money turns over determines GDP. Give it a value of two and a bit of a range. So I can play with different values. So you multiply velocity by money, you therefore get GDP. So I model the lend frack by GDP, I get the amount of lending.
So now let's see how this model behaves. And if there's no lending, of course, nothing happens. But if there's lending, the amount of money in the accounts changes. Obviously, private debt ratio rises. Nothing happens to GDP. Now, if we go in the opposite direction, so lending uh goes negative instead, equally nothing happens to GDP. So the private debt ratio has no impact upon GDP, upon macroeconomic performance, and you can basically ignore the private debt system, which is what mainstream economists do. I've got the money supply is the total of the amount of money in household accounts and firm accounts. Uh, interest payments are equal to the interest rate multiplied by the level of debt. GDP is the amount of money in existence times how often it turns over per year, and lending is a fraction of GDP.
Now, having done all that, and I model it as you can see, there's no impact for the level of private debt on the economy itself, which means with this model of banking, you're quite justified in ignoring the banking sector when you build mac models of the macroeconomy, and that's exactly what neoclassical economists do. They leave out the banking system, the level of money in the economy, and the level of private debt from their macroeconomic models, and they think they're doing a good job.
Well, if this video has alerted you to the fact that what you thought you knew about economics is wrong, you'll thoroughly enjoy the free book bundle that has been requested by over 5,000 people already. It's worth $50, but it's free right now. Click in the link in the description or go to stevekeen.com and click on the black button and fill in your information. About 60 seconds, you'll get the free book bundle. And after that, if you want to study with me personally and use my proprietary software, Revel, there'll be an invite to join that course as well of modeling the economy.
Now, this is Bernanki explaining why, for example, he didn't look at the level of private debt to explain the great depression. He was criticizing Irving Fischer's argument that the great depression was caused by what Fischer called a debt deflation. Bernanki rejected the advice of Fischer on this front by saying that unless there's very large differences in how fast the different groups, the savers and borrowers spend, what he called a pure redistribution should have no significant macroeconomic effects. And this is showing that if the model of banking that neoclassicals had in their heads was correct, then yes, they'd be correct to ignore the private banking system. But it's a fairy tale.
And I can easily edit this unravel to go back to the real world because banks are the ones who do the lending, not households. So they're the ones for whom debt is an asset, not the households. And what I'm going to do for simplicity uh is just bring in the fact that the banks do the lending, but basically pretend that banks spend all their interest income immediately. So I don't need to make many other changes to the model. I can stick with this simple model and still got the basic facts right.
So here we have the model where there's no impact upon lending, but it's based on a myth. Let's correct the myth. So first of all, it's not true that debt is an asset of the household sector, and it's not true the household lends the money or that it receives interest from firms. Instead, the debt is an asset of the banking sector, and the interest is paid to the banks. And for simplicity here, I'm going to assume that the banks spend their the money they get immediately. I could make it more realistic, but it would just make it a more complicated model with much the same impact. So, I'm going to have spending by the banks going back onto the households and firms. And I'll split it 50/50 between the two. And that spending goes to households, and it goes to firms. All I've done here is get rid of the myth that banks don't lend money to the real world where the banks do lend money.
So what happens now when we vary the level of lending? I'm going to start from zero lending again over here. Run the model. Now, as soon as we have lending in this system, lending is creating money. This is what neoclassical economists leave out. Because it creates money, the GDP grows. So a rising level of debt is associated with a rising GDP until such time as the interest surfacing costs start to weed into the system. So now I'm going to have banks trying to get out of debt and back into it again. And you can easily get to a situation where uh the level of bank lending can overwhelm the capacity of of the non-bank sector to repay the debt. So you can have a crash like in the Great Depression.
So you can't ignore the banking sector when you understand that the banks actually create money. And this is one reason why the advice that textbooks give to politicians is c is disastrous because it tells them to ignore the fact that actually causes financial crisis. So bank lending creates money. Rising debt means rising money supply, which means a rising GDP. The economy can crash if people have taken on too much debt. They can't service it out of their cash flow, and and you can have a debt deflation as we saw during the great depression. Neoclassical economists advised to politicians that they should ignore private debt is completely wrong. And this is why politicians had no idea that the global financial crisis was approaching back in 2007 because they were listening to mainstream economists, and mainstream economists were telling them everything's absolutely hunky dory. Get ready to take credit. What a great year 2008 is going to be.
Now, when you look at the data, this is completely wrong. This is what I looked at before the financial crisis occurred. It's why I saw it coming. I realized the level of private debt was rising so rapidly that there had to be a point where it stopped rising. And when it stopped rising and credit went from positive to negative, I knew that a crisis was going to occur. And that's exactly what happened. Now, Ben Bernani, armed with the neoclassical vision of how banks actually operate, completely ignored the level of private debt. He didn't even look at this information. What he focused upon, if anything, was that there was a stable level of government debt, and therefore thought that meant a stable economy. And that's the advice he gave Congress in 2008, three weeks before the global financial crisis began.
Now, instead of seeing what he expected, which was falling unemployment and rising economic growth, unemployment exploded from 4% of the uh the workforce to 10%. And the driving force behind that was credit went from plus 16% of GDP in 2006 to minus 5% in 2008-2009. So this is why neoclassical economists and the politicians they advise had no idea that they were walking into a debt crisis, whereas somebody who understands the monetary system properly knew that was going to happen.
They're just as clueless about government debt, and this is where they do lasting damage. If the government spends more than it gets back in taxation, runs a deficit, ultimately it's going to go bankrupt. That's the advice they give them. So what I've done in this Ravel model is I've included teach that government's function where the government borrows from households if it runs a deficit, and it taxes and spends on both households and firms, and then it's required by law to sell bonds that are equivalent to the deficit plus the interest on existing bonds. So I've got the same mechanism as I showed for the private sector model beforehand. I've got the government spending a fraction of GDP and taxing a fraction of GDP. And if the spending fraction is larger than the tax fraction, then the government runs a deficit. It has to pay interest on existing bonds, and I'm starting from zero bonds here. There's the operations of the private sector as according to economics textbooks. Uh, then I have taxation, government taxes both households and firms. It spends on households and firms. It then sells bonds to the household sector and it pays interest to the household sector. So that's the mental model that economists and politicians have in their head if they believe what the textbooks teach them.
And let's now run this model. If if taxation is exactly equal to spending, then of course nothing happens. But as soon as you have even a 1% of GDP deficit in this model, then you see the government debt ratio starts to rise. The amount of money is being distributed between firms and households by the dynamics of paying interest to households and so on. Uh, but the debt ratio just rises exponentially. You can see the curvature down here. It starts at zero. At year 10, it starts to rise. By year 50, it's 140% of GDP. Keep on going for long enough, you're going to get 100,000% of GDP as the debt level. This is clearly going to cause a crisis. And that's what you'll read in all the newspapers. You'll get it from all the normal journalists who write on this issue. The politicians tell you, the economists tell you, and they are all wrong because they've got the structure of the system wrong.
The fallacy in the conventional view is that it's not true that the bonds are sold to the household sector. The bonds are sold to the banks and primary auctions. Just like private debt is an asset of the banking sector and not an asset of households, government bonds are an asset of the of the banking sector and not an asset of households. What happens to the model if I change those details to make them like the real world? Let's find out. So here's the crisis origin as you can see here. Now I'm going to go through using Ravel, change this from the fantasy the textbooks teach to the real world where banks are the ones who own the debt and banks are the ones who own the bonds that the lending is not done by the households or or the purchase of bonds or the interest on bonds. And so I now have bonds are an asset of the banking sector, just like debt is an asset of the banking sector. And then the interest on bonds is paid to the banking sector, just as uh applies with private debt. And it's also not true that the government banks at the private banks. It banks at the central bank. So I now need to put the government account as something that's uh owned by the there's a liability of the central bank, and then all the operations pass through reserves. So interest on bonds increases reserves. Bonds are purchased using reserves. Government spending increases reserves, and taxation reduces reserves.
So all I've done is correct the model so that it's accurate about who buys the bonds. That's literally the entire change that's occurred here. And also for simplicity, I'm going to assume that the banks just basically spend their money, just like I did in the previous model. So take a copy of interest on bonds and interest on debt and include spending by banks and have them spending 50% on households and 50% on firms. So those two sums together now equal to spending by banks, and that spending by banks increases the net worth of households and the net worth of firms. So all I've done is change the accounting structure of the model. Haven't changed the definition of the equations. Haven't changed behavior.
Now let's see what happens when we have a government running a deficit of 1% of GDP. I'll start from the same situation with no deficit. What if the government's runs a deficit? It creates money. Okay, that money is the excess of government spending over taxation turns up in households and firms bank accounts and enables them to take commerce with each other. So GDP rises as well as the level of government debt rising. And then when you divide the level of government debt by the level of GDP, rather than seeing that exponential function you saw earlier where the level of debt was going to overwhelm the economy, it stabilizes. Notice here it's stabilizing at about 50% of GDP.
Now, why is it 50%? That's another uh cute little uh outcome of putting this model together. It depends upon the velocity of money because when the government borrows, the the amount of debt goes in the numerator of the government debt to GDP ratio. So that goes up by the amount of change in debt, but the denominator goes up by the amount of change in the money caused by the government debt, which is identical to the change in debt multiplied by the velocity of money. So overall, the system stabilizes with a government debt ratio uh equal to the one over the velocity of money, which in this case I've got the velocity of money is two, so therefore the government debt ratio is 50%. Now, that applied back in the 50s and 60s before neoclassical economists took over government policy and got governments to uh panic about the level of government debt while ignoring the level of private debt.
Now, when they did that, the private sector ended up borrowing more money to start to speculate on houses and shares and so on. Households and firms are carrying a larger level of debt. And in that situation, certainly households spent more slowly because they were worried if they didn't save some money, they wouldn't be able to service their debt. Now, when households collectively decide to spend less rapidly, they don't create any money. They simply slow down how fast that money circulates. So the velocity of money fell from about two to about one. And if I now increase the velocity of money here, you'll see the same thing happens to the government debt ratio. It rises. But these are the basic changes in the model. Bonds are an asset of the banks, not an asset of the household sector. The sale of bonds occurs. Interest on bonds is paid to the banks, and the banks spend back to the real economy. So when I do that, I get absolutely no crisis coming out of it. There's no government debt crisis. And this is the reason for this. The government deficit creates money at the same time as it creates debt. It creates money. This is left out of the mainstream model because they pretend that banks don't actually lend money.
Now, of course, they do. Okay? When you take that into account and B banks also buy the bonds at primary auctions, then what happens is it creates fiat money at the same time. The government debt creates fiat money in the same way that private debt creates credit money. Means is that when the government spends more than it takes back in taxation, it actually puts money into private bank accounts. That then enables the private sector to spend with money that doesn't have debt attached to it for it. So it actually makes the private sector feel freer. And this is one of the reasons why the velocity of money was higher back in the 50s and 60s when the private sector, particularly households, had a lower level of debt than they now have.
Now, we've ignored the growth in household debt. That's what caused the subprime bubble. That's what caused the global financial crisis. All this has been ignored because of the neoclassical economist fetish on level of government debt. But I'm going to give them a little clue here. If you want to reduce the level of government debt, reduce the government debt ratio. The way you do it is by increasing the velocity of money. This might sound strange, and it's certainly not what you'll find in the textbooks, but the reason is when the government runs a deficit and sells bonds equivalent to that deficit, it creates additional government debt that goes on the numerator of the government debt to GDP ratio. On the denominator, you have GDP because the government is creating money when it runs a deficit. That money turns over at the velocity of money. And so the increase in the numerator is equal to the velocity of money multiplied by the change in government debt. That means that the government debt ratio is actually one over the velocity of money. So if you want to reduce the government debt ratio, increase the velocity of money.
The same model with the same parameters beforehand, but what I'm going to do now is change the velocity of money. Or that the level of government debt stabilizes at roughly close to 50% of GDP. If you want to reduce the government debt ratio, you increase the velocity of money. But of course, what's happened over the last 50 years is because the private because the government and economists have ignored the level of private debt. Rising level of private debt mean households and firms are carrying a larger level of debt than they used to hold. So their response has been to spend more slowly. Now we reduce the velocity of money, and that increases the private debt ratio. If you get to the stage where the ratio is one, which is roughly what it is right now, then you get a level of government debt roughly equivalent to 100% of GDP. If we could return to the situation of the 50s and 60s, when money turned over roughly 1.8 times per year, then we get a higher GDP and we'd get a fall in the government debt ratio as well.
So, not only are economists wrong about the dangers of private debt, they're wrong about what causes the government debt ratio in the first instance. If you want to reduce the government debt ratio, you have to reduce private debt and then encourage the private sector to spend more rapidly because they're no longer terrified about being unable to service their private debts.
You might think it's bad for the government to be in debt. Many, many people do. And frankly, everybody feels uncomfortable about carrying any debt whatsoever. Households don't like it. Firms don't like it. Neither does the government. But the thing is, the government is the only entity which can cope with that because it creates the money supply. And the money that it borrows should be used to build the infrastructure and develop the economy properly to provide the things the private sector doesn't do well, like public services. That's what we should be using the money for. Instead, because of this obsession about reducing the level of government debt, we haven't cut back on military, but we've cut back on health, welfare, education, infrastructure maintenance. All these things means the economy works less well, and it reduces something that is largely irrelevant so long as the government is issuing bonds in its own currency.
Government should normally run a deficit. And that's the exactly opposite advice that you get out of economic textbooks, but it's based on the real world in which banks create money. We desperately need a realistic economics. And when we don't have realistic economics, we get the results that Kanes himself saw in the 1930s. He said, "The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed, the world is ruled by little else. Practical men, otherwise politicians, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist. Madmen in authority who hear voices in the air are distilling their frenzy from some academic scribbler of a few years back." And Kane's finished up by saying he's sure the power of vested interests is vastly exaggerated compared to the gradual encroachment of ideas. And we've got the wrong ideas, the wrong sort of economics. And that's where a large part of our economic problems come from. We need realistic economics. That's what I teach in my online courses to see how the economy really works. That's why I invented Ravel. Throw away the economics textbooks and start learning how the real world operates.