Post-Keynesian Observations

Understanding the Macroeconomy

7. DEBT, DEBT, and MORE DEBT

with 6 comments

[NOTE: Be sure you have read part 6 before this one! This is part of a series of posts that explain the operation of the macroeconomy and the current crisis and they build on one another.]

Thinking back through the various posts and all the way to part 1, you may have gathered that debt is very important in an industrial, capitalist economy. Consumers need it to buy durables (cars, houses, computers, etc.), firms need it for working capital (cash to pay workers and suppliers), and firms have to have it to undertake physical investment (expand capacity).

The economist Hyman Minsky theorized that all economic agents incur debt with an eye toward how much their current and expected income will allow them to repay. You get in your head, explicitly or implicitly, an idea of the level of debt you can safely carry. In addition, those extending you credit are thinking about the same thing. But, everyone inevitably gets carried away. Remember that spontaneous optimism/animal spirits from part 2? It kicks in again here because as people and firms find that they can repay debt, so they start adjusting their idea of “safe.”

Think about what would happen as we emerge from a recession. At first, everyone is still groggy from the high unemployment, low growth, bankruptcies, and defaults. However, firms (particularly) eventually decide that they want to start working on physical investment again (see part 4 for the explanation). And so the recovery starts.

Debt levels are low since people didn’t take out many new loans during the recession and thus firms and consumers figure they can increase them safely. This is especially true as incomes and profits start to rise. Banks agree with the optimistic appraisals, loans are approved, and debt levels start to rise. Because the economy is growing at a healthy rate, loan payments are met with no problem. “Hey,” people and firms say to themselves as the balance between animal spirts and uncertainty swings towards the former, “I bet I could manage even more debt!!!” Banks are not immune to the spontaneous optimism and they agree and lend even more (and they start thinking about the subprime market and those to whom they haven’t loaned much yet–but I’m getting way ahead of myself!).

Minksy says that this process of reevaluating what “safe” means continues until, inevitably, it isn’t! Remember also that during the expansion we’ll be saturating the market for consumer durables (part 3 of this series) and physical investment (part 4). The recession IS coming, and as debt levels rise so the financial sector puts itself in an increasingly precarious situation. Inevitably, someone defaults. If enough people do, then this can cause a chain reaction as banks and other financial institutions then default, too, since they were counting on that money getting paid back (starting to sound familiar?!). Banks both loan and borrow, and if they don’t get paid back then they can’t make new loans. And the panic begins, with the financial sector desperately trying to get their debtors to pay back while keeping creditors off their backs (creditors who are in exactly the same spot). Animal spirits collapse everywhere, and stock values fall, firms stop investing, and consumers stop buying. The credit crunch makes the last two activities especially difficult.

Of course, everyone now says, “Wow, I guess I was carrying too much debt!” (or the bank version thereof, “Wow, I guess we shouldn’t have loaned to those people!”).

Minsky argues that this cycle happens over and over and over. People take on debt as the expansion starts, find that they can pay it back, and figure they can take on even more. Banks encourage this as they are people, too, and see it through the same animal-spirits colored lenses. This, by itself would lead eventually to unmanageable debt levels. In combination with the saturation of demand for consumer durables and firms’ physical investment over the expansion, and it is a recipe for system collapse.

Next in line: part 8, FINANCIAL CRISES!!!

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Written by rommeldak

January 14, 2009 at 11:22 pm

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6 Responses

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  1. Nice writing. You are on my RSS reader now so I can read more from you down the road.

    Allen Taylor

    Allen Taylor

    January 14, 2009 at 11:45 pm

  2. Does this mean then that when I save to buy a washing machine/car/other durable goods that I’m depriving the economy – rather than making sound financial sense (to me) i.e. I save for lets say 6 months to buy a new washing machine rather than spend more money due to accumulative interest on a loan over 12 months… or is my example on too small a scale to count?

    Quikkie

    January 15, 2009 at 4:43 pm

  3. No, that’s right. It is indeed true that what might be a sound decision for the individual is not necessarily good for the economy. This means that our options are:
    1. Live with the fact that letting people make their own decisions may be bad for the economy;
    2. Force people to spend money when they don’t want to;
    3. Find another economic entity whose job we make it to spend under those circumstances.
    Voila, a role created for the government. The trick then is to make sure that the government is spending with an economic goal in mind and not other political objectives.

    rommeldak

    January 15, 2009 at 7:00 pm

  4. does minsky theorize that there is a limit to the cycle (collapse) or can it correct indefinitely? i guess both possibilities are probable, though maybe not of equal probability.. if the cycle is unavoidable i guess the focus needs to then be on controlling the amplitude of the cycle, letting the cycle happen, but without breaking free of gravitational pull..

    zeroday

    January 15, 2009 at 10:28 pm

  5. I think this is the answer to what you are asking: he thinks the cycle will get progressively worse.

    However, there is no reason for it to happen. Had the Fed not abandoned its responsibility to keep tabs on financial markets (in favor of the idea that the market is always right) then this could have been avoided. Probably after two or three more installments I’ll start addressing the real underlying question: what should policy be?

    rommeldak

    January 15, 2009 at 10:36 pm

  6. Sorry, Allen, I am new to this and only now realized that your comment was stuck in limbo! Many thanks for your readership and please let me know if you have questions.

    rommeldak

    January 23, 2009 at 10:36 pm


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