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Edition 01 :22 July, 2013.

(VERSION EN FRANÇAIS PAS DISPONIBLE)

Summaries of monetary reform papers by L.F. Manning published at http://www.integrateddevelopment.org.

Analysis of Jackson, A., Dyson, B., Hodgson, G. The Positive Money Proposal – Plan for Monetary Reform,

Capital is debt.

Chicago Plan Revisited Version II: An insufficient response to financial system failure. (Posted 11 May, 2013.)

Comments on the (Jaromir Benes and Michael Kumhof) Chicago Plan Revisited Paper.

Debt bubbles cannot be popped : Business cycles are policy inventions.

DNA of the debt-based economy.

General summary of all papers published.(Revised edition).

How to create stable financial systems in four complementary steps. (Revised edition).

How to introduce an e-money financed virtual minimum wage system in New Zealand. (Revised edition) .

How to introduce a guaranteed minimum income in New Zealand. (Revised edition).

Interest-bearing debt system and its economic impacts. (Revised edition).

Manifesto of 95 principles of the debt-based economy.

Manning plan for permanent debt reduction in the national economy.

Missing links between growth, saving, deposits and GDP.

Measuring Nothing on the Road to Nowhere : The Myths of Inflation and Growth Measurement.

Savings Myth. (Revised edition).

There’s no such thing as affordable housing.

Unified text of the manifesto of the debt-based economy.

Using a foreign transactions surcharge (FTS) to manage the exchange rate.

(The following items have not been revised. They show the historic development of the work. )

Financial system mechanics explained for the first time. “The Ripple Starts Here.”

Short summary of the paper The Ripple Starts Here.

Financial system mechanics: Power-point presentation.

This work is licensed under a Creative Commons Attribution-Non-commercial-Share Alike 3.0 Licence

DEBT BUBBLES CANNOT BE POPPED:

BUSINESS CYCLES ARE POLICY INVENTIONS.

By Lowell Manning,

Sustento Institute,

www.sustento.org.nz .

Version 3 for distribution.

18 July 2013, 3000 words.

EXECUTIVE SUMMARY.

Figure 1 : Model systemic inflation v. GDP : New Zealand 1968-2013.

Figure 2 : Debt Model and Bubble Size for New Zealand 1978-2013.

Figure 3 : Systemic inflation and GDP growth in New Zealand 1986-2013.

Attempts to deflate debt bubbles deflate the economy not the bubbles.

Not even the Great Depression of the 1930’s destroyed all the debt that had built up prior to the worldwide crash. Nor has the present “Global Financial Crisis” deflated the current debt mountain. The debt mountain has instead increased in the US as this article shows must be so. Debt cannot be destroyed without also destroying the capitalist economy.

Bubbles are largely a figment of macroeconomic imagination. Just like business cycles. Wrecking the world economy to de-leverage structural debt is like trying to shovel lava from an erupting volcano.

This article traces the origin and growth of exponential debt growth, bubbles and business cycles.

In the absence of structural financial reform orthodox economic theories and policies cannot stop the impending implosion of the world financial system because they do not offer a mechanism for appropriate macroeconomic action.

INTRODUCTION.

There is a long history of attempts to explain business cycles and debt bubbles. The economists involved include a who’s who of the world’s most prominent academics that is far too long to list here.

From Irving Fisher’s “The Debt-Deflation Theory of Great Depressions” of 1933, to Hyman Minsky’s “ The Financial Instablility Hypothesis” of 1992, many of those writers have recognized that business cycles and bubbles relate to changes of ....surprise, surprise ...... debt. For example, as long ago as 1951 Arthur Burns wrote:

“The problem of how business cycles come about is therefore inseparable from the problem of how a capitalist economy functions.” (A. F. Burns, in Wesley C. Mitchell, What happens during business cycles: A progress report. New York, National Bureau of Economic Research, 1951, Introduction.)

Despite the mountains of learned work over more than half a century since that was written, nobody until now has properly described “how a capitalist economy functions” even though the underlying mechanisms have been staring the world in the face all along.

This article refers to a debt model of the economy that “connects the dots” to demonstrate the mechanics of the debt-based financial system.

The model is used first to discuss what “bubbles” really are, and then to show how macroeconomic policy itself creates business cycles in a futile attempt to “manage” systemic debt growth and inflation.

Finally the article considers the consequences to the world financial system as it becomes saturated with systemic inflation arising from the exponential increase of interest-bearing debt.

THE DEBT MODEL.

The author’s debt model of the economy is most recently summarised in a paper “Measuring Nothing on the Road to Nowhere : The Myths of Inflation and Growth Measurement.”

In contrast to orthodox economic work, the author’s modified Fisher Equation of exchange fully satisfies the basic accounting equation, which is : Assets=Liabilities + Net Worth.

For the M3 banking institutions and the central bank , the basic accounting equation is expressed as DC+D_nfca= M3+ R.

DC_m =(GDP)/V_y+M_s +D_ni +D_b+R - D_nfcb +N_b (1)

Where:

DC = Domestic Credit.

DC_m = Domestic Credit plus secondary debt N_bborrowed through non-bank lending institutions (NBLI).

GDP/V_y = The debt and cash used to create GDP (D_my= D_mt+M0_y).

GDP = Gross Domestic Product.

V_y = The speed of circulation of productive transaction accounts.

D_my = The productive transaction account balance used to generate GDP.

D_mt = The portion of D_my arising from bank debt.

D_ni= Debt supporting non-inflationary economic growth.

M0_y = The portion of D_my contributing to the non-inflationary cash transactions M0_y* V_y included in GDP.

M_s = Accumulated systemic inflation arising from net after tax deposit interest paid on the total system debt DC_{m .}

D_nfca = Net foreign currency assets (NFCA) resulting from the current account and capital transfers from the rest of the world.

D_b = Bubble debt (debt in excess of the systemic debt requirements).

R = Bank residual retained profits and paid up share capital not being part of the money supply M3.

N_b = Secondary non-bank debt.

Surprisingly, this is the only model of the debt-based economy that fully satisfies the basic financial accounting equation, though some other economists like Steve Keen in Australia have recently recognised the importance of doing so.

The unique features of the debt model are that:

(a) It separates the debt needed to fund the productive economy (GDP)/V_yfrom the remaining terms on the right hand side of equation (1) that together make up the investment sector of the economy, and

(b) It separates the exponential systemic inflation component M_s from the other investment sector terms on the right hand side of equation (1).

Only a small amount of debt is used to physically generate the economic output GDP. In developed economies, the investment sector funding is dominated by the systemic inflation component M_s which itself depends on the existing debt level and the interest rate paid on deposits. Since the investment sector itself does not produce any goods and services that contribute to GDP other than taxable services like brokerage and consultancy provided by financial sector service companies, M_s must be wholly funded by the productive economy through inflation in the productive sector.

M_s funding creates an exponential feedback loop that cannot be stopped unless the interest rate on deposits is reduced to zero.

Figure 1 : Model systemic inflation v. GDP : New Zealand 1968-2013.

Figure 1 plots the components of GDP shown in equation (2).

GDP = M_s+ D_ni+R (2)

Figure 1 shows that accumulated non-inflationary GDP growth D_ni has all-but disappeared in New Zealand. Errors in the model calibration affect the relationship between M_s and GDP but they do not affect the trend. The likely result in New Zealand when (M_s+R) becomes equal to GDP is debt default and destruction of GDP as is already happening in some parts of Europe. Figure 1 is calculated on the assumption NFCA (D_nfca, negative for NZ) is funded directly through the current account.

Figure 1 shows that systemic inflation increased by NZ$150 billion between 1988 and 2013 while nominal GDP increased by NZ$140 billion over the same period. The systemic inflation M_scurve closely follows the GDP curve. All New Zealand’s nominal GDP increase over that period has been absorbed by systemic inflation M_s.

There has been no “real” GDP increase in New Zealand over the past 25 years or more though many other countries have fared better because their interest rate structure has been lower.

The recent debt de-leveraging in 2009 and 2010 has made the situation worse, not better, just as it did following the 1987 share market crash. The two events can be seen clearly in Figure 1 for 1987 (spike in inflation) and Figure 2 (below) for 2007 (spike in bubble debt D_b).

Equation (2) is derived in the “Measuring Nothing on the Road to Nowhere : The Myths of Inflation and Growth Measurement.”

While some of the capital investment supporting the productive sector has been destroyed through debt default in recessions like those of the early 1990’s and 2009-2010, M_s continued to expand, as it must do as long as deposit interest rates exceed zero. Orthodox measurements of “growth” and “inflation” entirely miss the crucial structural processes taking place in the debt-based economy. For more information refer to the DNA of the debt-based economy which shows that in a debt based financial system GDP equals the outstanding principal on capital investment.

BUBBLES.

Bubbles evolve when banks create and lend more debt than the financial system needs. It really is that simple, despite a century of misplaced research.

The bubble debt can be easily calculated by solving equation (1) for D_b since all the other terms are either known or can be independently calculated. To get the bubble size B_u, the secondary debt N_b has to be added onto D_bin Figure 2.

That equation is: M3= (D_my+M_s+D_ni+D_b).

The bubble history for New Zealand is shown in Figure 2.

Figure 2 : Debt Model and Bubble Size for New Zealand 1978-2013.

Figure 2 is plotted for DC_m(=DC+N_b) whereas D_b is calculated from M3 that does not include N_b. Therefore, to plot the size of the bubble in Figure 2: B_u=D_b + N_{b .}

The two major New Zealand events (1987 and 2007) are structurally different. The 1980’s share market collapse was led by the investment sector while the more recent recession that began in 2007 was led by the productive sector.

In the lead up to the 1987 share market crash, policy was guided by the Friedman money rule that allowed the money supply to expand to match nominal GDP growth. The high inflation that resulted from the monetary policy was accompanied by substantial “real” economic growth as it is currently measured under the current System of National Accounts (SNA). That is clearly shown by the increase in D_ni (refer to the text box in Figure 1). Interest rates were progressively increased to try to manage the debt expansion, generating even more systemic inflation M_s. Debt continued to expand until the productive sector could no longer fund the escalating share prices in the investment sector. Share prices collapsed because investors’ profit growth expectations could no longer be satisfied. Many highly leveraged businesses failed, including (in New Zealand) large speculative investment and development companies operating in the secondary debt market.

Following the 1987 collapse, orthodox macroeconomic policy was switched from targeting the money supply following the Friedman money rule to inflation targeting following a Taylor type rule. The changes were initiated in New Zealand in 1988-89 followed by the passing of the Reserve Bank of New Zealand Act (RBA) in 1989 and the implementation of the Basel I accords in 1991. Under the RBA interest rates would be increased when measured CPI inflation rose above a target level (3%/year in New Zealand). The author’s paper “Measuring Nothing on the Road to Nowhere : The Myths of Inflation and Growth Measurement” shows that the use of the CPI figure as an economic stabilisation guide is fatally flawed because a CPI rise of, say, 3%/year, represents only a 1.5% increase in the measured “value” of GDP. Orthodox inflation targeting has been repeatedly imposed even when (according to orthodox theory itself) there is very little CPI inflation.

Higher interest rates increase systemic inflation instead of reducing it.

The demand for new debt then falls but the need for new debt rises because debt servicing costs in the productive sector increase.

When inflation targeting imposed rising interest rates in New Zealand from 2006 to 2009 the “new” debt needed to cover the higher systemic inflation M_s had to be supplied from somewhere, somehow. Initially, households took on more debt, but once the (more or less “forced”) Kiwisaver savings scheme was implemented in tandem with higher interest rates, disposable incomes dropped sharply, causing a recession. The recession reduced demand for new investment, particularly housing, as well as for consumption goods. That led to the failure of many second tier mortgage lenders and speculative development companies followed inevitably by other business failures.

The New Zealand banks were only moderately affected because there were few loan defaults. Individual non-bank investors bore much of the investment losses while the government also lost money through its finance company guarantee scheme.

In the present financial system debt de-leveraging typically “hits” the banking sector first, rendering it quickly insolvent as happened in the US and is happening in some parts of Europe. Nevertheless, under current macroeconomic mismanagement in New Zealand as elsewhere, the public bears the brunt of systemic losses through unemployment and suppression of incomes.

The New Zealand economy has not yet recovered from the 2009-2010 recession because systemic inflation is still increasing by more than 4% of GDP/year despite historically low interest rates, while incomes are rising more slowly and Kiwisaver savings (and the “Cullen” superannuation fund) continue to draw more money out of consumption. New government contributions to the fund were deferred in 2009 and have yet to be resumed. It could make sense to deduct NFCA from the bubble size B_u in Figure 2 but further research on B_u would be advisable before doing so.

The recent primary over-funding of debt since 2002 shown in Figure 2 as the bubble size B_uin New Zealand has continued unabated. It appears to be the direct result of the surplus debt that funds the Net Foreign Currency Assets (NFCA). Attempting to eliminate that debt using orthodox tools would cut New Zealand’s GDP by more than 35%! (Bubble size Bu = NZ$77b/GDP NZ$210b as at March 2013 = 36.7%).

BUSINESS CYCLES.

Business cycles are similar to bubbles except that they are typically of shorter duration and they are non-structural, being caused directly by the application of very poor macroeconomic policy options, especially inflation targeting that has continually suppressed “real” economic growth (D_ni). No sooner than non-inflationary growth D_ni has got started, it has been destroyed by flawed central bank monetary policy as can be seen in Figure 3.

As shown in “Measuring Nothing on the Road to Nowhere : The Myths of Inflation and Growth Measurement” the use of CPI inflation as the trigger for interest-rate intervention is not only wildly mis-measured, it bears no relation to the structural exponential systemic inflation occurring in the economy. Astonishingly, interest costs are not included in the CPI, so the effects of interest rate changes are not taken into account when monetary policy is used to “control inflation”. In New Zealand, as of March 2013, a 1% increase in interest rates represented an annual loss of about 1.3% of GDP, the equivalent of a decrease of 2.6% in the CPI as it is presently used. [Total debt about NZ$350 b *1%/GDP NZ$210 b* (1-0.23) where the average final tax rate on deposits is 23%.]

Lower systemic inflation would mean that available productive resources could be utilised better. More “growth” could occur simply because income earners would keep more of their incomes. There are no complex theories or equations involved.

Figure 3 : Systemic inflation and GDP growth in New Zealand 1986-2013.

The business cycle comprises the following sequence:

(a) Since all debt must be funded from the productive economy, higher interest rates increase the gross unearned income of deposit holders while reducing aggregate disposable incomes in the productive sector by the same amount.

(b) Reduced incomes in the productive sector lead to reduced demand (consumption) there, higher unemployment, and default on household and business debt.

(c) At the same time, those same households and businesses are forced to take on yet more M_s debt to fund higher systemic inflation created by the higher interest rates. That is a classic “double hit” on the productive sector.

(d) The government receives more taxation from the higher taxes it receives on unearned income but that extra tax is offset by lower business profits that reduce the government’s company tax receipts. The government also has to “pick up the pieces” as unemployment and associated social transfer costs rise.

(e) When households and businesses cannot take on more debt some of them default, slightly reducing the rate of increase of total debt DC_m. Some of the vast majority who do not default choose to repay debt instead of consuming. Others try to “save” by hoarding part of their incomes and reducing their consumption that way.

(f) Nominal GDP increases below systemic inflation indicate a recession because existing income, and therefore GDP, is given up to fund the systemic inflation as consumption falls.

(g) There is a cascade effect on GDP as consumer demand falls, forcing the remaining players in the productive economy to discount prices and profits.

(h) As the measured (but wrongly calculated) CPI inflation falls toward the lower end of the inflation target range, the monetary authorities reduce interest rates.

(i) Disposable incomes begin to rise because the rate of change in M_s falls. Households and firms then have more to spend. Some save or continue repaying debt, slowing the recovery process.

(j) GDP growth in excess of systemic inflation is “real” (D_ni) growth.

(k) There is no inflation targeting for the investment sector so there are no controls on debt growth there.

Contrary to orthodox economic theory, the debt model shows there are no multipliers in macroeconomics. The basic financial accounting equation is a one to one relationship between financial assets on the one hand and financial liabilities on the other hand.

Inflation targeting and other applications of orthodox macroeconomic policy destroy inflation-free GDP while increasing systemic inflation.

LIVING WITH THE CONSEQUENCES OF SYSTEMIC INFLATION.

When nominal GDP and M_s grow at the same rate the investment sector expands at the same rate as the productive economy and there can be no economic “growth” (Figure 1).

When M_s increases faster than nominal GDP, (Dni + R) must fall as shown in equation (2).

GDP = M_s+ D_ni+R (2)

Since the banks will not give up their residual R except in the case of debt default by their clients, the debt supporting non-inflationary growth (D_ni) mathematically must shrink when M_s growth is greater than the change in the measured CPI inflation included in nominal GDP. This can be clearly seen in both

Figure 1 and Figure 3.

As D_ni falls towards zero, earlier inflation-free gains in GDP are lost to the systemic inflation that orthodox economics has failed to measure, as shown for New Zealand in Figure 1.

Businesses and income earners are no better off in real terms than they were before the Friedman money rule and Taylor inflation targeting rule were imposed on the economy except for any accumulated unmeasured productivity gains made by previous generations. There appear to have been few, if any, aggregate productivity gains in New Zealand over the past 16 years or more. Official statistics for New Zealand claim 9.5% productivity gain over the past 16 years, but that has been badly mis-measured as discussed in the author’s paper Measuring Nothing on the Road to Nowhere : The Myths of Inflation and Growth Measurement improvements in technology and primary production.

In New Zealand “progress” measured in GDP has therefore been one giant myth as has been the case throughout the developed world.

The vast majority of people, “the 99%”, are financially worse off now in terms of their real purchasing power and quality of life than they were decades ago.

That is why most households must have two incomes to make ends meet and why so many people cannot “afford” their own home.

Chaos erupts once D_ni has been reduced to zero because the banking system then fails as R is also (quickly) eroded toward zero through debt default.

When that happens the monetary authorities have no choice but to “bail out” the banks by creating some form of interest-free money. That is exactly what has happened in Japan over the past 15 years and more recently in US and is now going on in Europe. If the banks fail there can be no modern debt-based economy and therefore no capitalist system.

To avoid global system failure the financial system must be comprehensively restructured to eliminate systemic inflation as far as is possible[1].

In the interim, increases in M_s must be slowed or stopped so that non-inflationary “growth” can resume. And that, again, is what has happened in Japan, in US and in some parts of Europe as deposit interest rates have fallen towards zero.

There is chaos in countries like Greece because high interest rates and “austerity” in the guise of shrinking public expenditure have been applied in an entirely misconceived effort to do the mathematically impossible.

The “impossible” in this context is to try to offset ongoing M_s growth greater than GDP growth against the GDP itself.

According to the author’s debt model that is a theoretical impossibility because it causes a systemic economic collapse that cannot be corrected without fundamental reform first of all to reduce the growth of M_s to close to zero and secondly to control the issue of new credit to avoid bubble formation.

Lowell Manning 18/7/13