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A Simple Explanation of the Great Recession and Why It Has Years To Go

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August 31, 2010 – Comments (13)

Yelnick has an excellent new post up. He draws upon Steve Keen's work putting GDP + private sector debt into perspective as a measure of the magnitude of the problem that is faced. The current macro environment for the US (and many advanced economies) is highly deflationary. The Fed has thus far been crediting and shoring up bank reserves hoping they will lend (which they haven't) in order to spur more consumption. What the Fed has also done is go around the banking system to monetize private debt directly. So while crediting banks is inflationary only if the banks lend, taking over private sector debt directly is highly inflationary. I would expect (or at least seriously consider) the Fed to attempt more of this in the future to spur 'aggregate demand'.

I continue to stand by the idea that we will not get either monolithic inflation or monolithic deflation. We are going to get something far uglier and far more mixed. Something akin to stagflation. But whereas 70's stagflation was caused by an oil shock + out of control deficits, this one will be much more sinister. Because it is not some 'exogenous' event, but rather a homegrown balance sheet recession which the economy has not faced in over 70 years.

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A Simple Explanation of the Great Recession and Why It Has Years To Go
Tuesday, August 31, 2010

http://yelnick.typepad.com/yelnick/2010/08/a-simple-explanation-of-the-great-recession-and-why-it-has-years-to-go.html#more

From 1987 when Greenspan took over the Fed until 2009 when the US hit Peak Debt, the US private sector added $34T of debt while US GDP only went up by $9T. Rather than seeing this as a classic Ponzi Scheme, economists praised it as financial innovation. Steve Keen, an economist out of Australia, writes a trenchant essay on this topic entitled What Bernanke Doesn't Understand About Deflation that explains why this Ponzi Scheme is the greatest failure of the Fed and central banks around the world.

His point can be understood this way: what an economy produces (GDP) plus the increase in private debt equals the aggregate demand for stuff. The increase in debt ahead of GDP means the country is living beyond its means, consuming more than it produces. At some point this cannot go on, and the debt begins to shrink. As it shrinks, GDP less the change in private debt equals aggregate demand. As debt shrinks the drop literally sucks demand out of the economy.

    * At the peak of our credit bubble, new debt drove US demand to an astounding $18T, $4T beyond GDP of $14T
    * By 2010, the decrease in debt turned GDP of $14T into demand of $12T - an absolutely brutal turnaround of -$6T in two years

From $18T to $12T in two years means a third of the wind got sucked out of the sails of the US economy. In 2010 alone demand is headed to a drop of 17% - about what happened in 1930.

The next two years (1931 and 1932) saw drops of 27% and 24%.

While our recent massive increase in govt debt cushioned our drop, it cannot overcome it, especially with State governments now facing a estimated $1T shortfall over the next three years, and political pressure rising against taking on any more massive Federal debt.


... [more at the link above]

but the end is great. Here it is:

Somewhere Bernanke is making a huge mistaken presumption. His critique does not comport with the real world. Steve points the finger to Bernanke maintaining that presumption of equilibrium. In an irony of history, the presumption of equilibrium which Fisher abandoned has crept back into modern economic thinking. Steve's conclusion is priceless:

    We might not be in such a pickle now if economics had started to become more of a science and less of a religion by following Fisher’s lead, and abandoning key beliefs when reality made a mockery of them. But instead neoclassical economics completely rebuilt its belief system after the Great Depression, and here we are again, once more experiencing the disconnect between neoclassical beliefs and economic reality.

13 Comments – Post Your Own

#1) On August 31, 2010 at 2:14 PM, outoffocus (23.49) wrote:

The current macro environment for the US (and many advanced economies) is highly deflationary.

Buy Gold

 What the Fed has also done is go around the banking system to monetize private debt directly. So while crediting banks is inflationary only if the banks lend, taking over private sector debt directly is highly inflationary. I would expect (or at least seriously consider) the Fed to attempt more of this in the future to spur 'aggregate demand'.

Buy Gold

I continue to stand by the idea that we will not get either monolithic inflation or monolithic deflation. We are going to get something far uglier and far more mixed. Something akin to stagflation. But whereas 70's stagflation was caused by an oil shock + out of control deficits, this one will be much more sinister. Because it is not some 'exogenous' event, but rather a homegrown balance sheet recession which the economy has not faced in over 70 years.

Are you buying gold yet?

(Apologies to Family Guy)

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#2) On August 31, 2010 at 2:16 PM, binve (< 20) wrote:

outoffocus ,

>>(Apologies to Family Guy)

LOL! I don't think Seth would mind :) Thanks!..

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#3) On August 31, 2010 at 2:18 PM, portefeuille (99.66) wrote:

The current macro environment for the US (and many advanced economies) is highly deflationary.

many? maybe a few, probably none ...

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#4) On August 31, 2010 at 2:43 PM, Dow3000 (< 20) wrote:

If one defines deflation as a decrease in money + credit...we are deflating at a massive and increasing pace.  I do not belive any actions by the Fed can affect this until the majority of all current outstanding credit (so many trillions it makes me want to cry) defaults or is paid back.  At that point, our government may try to hyperinflate...it is my hope that the tea parties and other fiscally conservative groups have taken control of the house & senate by then....call me optimistic.  Also, a complete breakdown of our banking system (if you think this isn't coming you're crazy) is hugely deflationary.

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#5) On August 31, 2010 at 2:57 PM, binve (< 20) wrote:

Dow3000 ,

I agree with your comment. There are a few nuances that we differ on, but largely that is the story (deflationary private balance sheet debt deleveraging) as the driver of this crisis.

>>Also, a complete breakdown of our banking system (if you think this isn't coming you're crazy) is hugely deflationary.

I am probably not that dire in my prediction, but I think the odds are certainly not zero. The rebuttal might be "the Fed will save the financial system at all costs", and that might be the answer (all costs) if things get really bad. I am optimistic that cooler heads will come out of the woodwork and prevail while we are in the midst of the next crisis, which will come about because the root causes of the first crisis were not fixed, much less even properly addressed...

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#6) On August 31, 2010 at 3:56 PM, Starfirenv (< 20) wrote:

Binve- "Somewhere Bernanke is making a huge mistaken presumption." 
  I am wondering if the mistaken presumption is that these guys really want to turn this around. The notion of "Public Service" has, shall we say, morphed.
  Also, did you see the moral of the Bullish Tale? Usual +1

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#7) On August 31, 2010 at 4:11 PM, binve (< 20) wrote:

Starfirenv,

Hey man!

>>The notion of "Public Service" has, shall we say, morphed.

:) exactly.

>>Also, did you see the moral of the Bullish Tale?

LOL! yep :) Thanks man!..

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#8) On August 31, 2010 at 9:59 PM, Tastylunch (29.40) wrote:

yep that about says it all really.

Next decade=teh suck japanese style until proven otherwise.

let's hope it's not the next two-three decades.

I sincerely hope the Japanese finally break the cycle soon. Looking at their path is depressing.

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#9) On September 01, 2010 at 9:40 AM, binve (< 20) wrote:

Tastylunch ,

Hey man, I agree. It will likely be Japanese-style with a side of American Fed surprises.

>>I sincerely hope the Japanese finally break the cycle soon. Looking at their path is depressing.

Me too...

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#10) On September 01, 2010 at 12:00 PM, leohaas (31.21) wrote:

"While our recent massive increase in govt debt cushioned our drop..."

I guess that fans of the Austrian School have not read this, or we would have had a dissertation on how this cannot be true!

But yes, years more of unwinding of the leverage (yes 3000, that IS deflation) resulting in slow economic growth seems what we are heading for.

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#11) On September 01, 2010 at 12:34 PM, binve (< 20) wrote:

leohaas ,

>>"While our recent massive increase in govt debt cushioned our drop..."I guess that fans of the Austrian School have not read this, or we would have had a dissertation on how this cannot be true!

leo, I wouldn't be antagonistic here. While the government spending did 'cushion our drop', did it fix anything?

I say no. Which means the ramifications of spending inherently unproductive endeavors (helping out banks) instead of targeting small/med business job creation (creating the environment in which that could happen) will be seen as a huge gaffe and one of the largest blunders made during the crisis after it is over (and yes I do believe it will be over in a few years).

The play for bailing out banks is a) from old school playbook at did work during the last similar crisis (1930s) and b) was obvious because bankers in power will look after their own in the 'private' sector.

Is all government spending bad? No.
Was this government spending bad? You bet

>>But yes, years more of unwinding of the leverage (yes 3000, that IS deflation) resulting in slow economic growth seems what we are heading for.

Don't forget that that the 'no growth' and 'negative growth' options are still very much on the table..

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#12) On September 01, 2010 at 10:04 PM, RootnToot (30.37) wrote:

For being double parked in an exogenous zone, +1.

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#13) On September 02, 2010 at 9:11 AM, binve (< 20) wrote:

RootnToot,

LOL! :) Thanks man!..

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