Credit, Demand and Unemployment

by Guest Author Steve Keen

Editor’s note: The author’s original title for this article was “A much more nebulous conception.”

Chris Joye’s reply to my last post on housing provides a neat segue into the broader topic of why I entered the public debate on economics in the first place.  It was because in December 2005, I became convinced that a major global economic crisis was about to hit. I felt that someone had to raise the alarm, and that—at least in Australia—I was probably that somebody.

Two years later, that crisis did hit. Called “the Global Financial Crisis” by Australians and “the Great Recession” by Americans, it is now universally regarded as the worst economic crisis since the Great Depression.

Everything was Fine

The vast majority of economists were taken completely by surprise by this crisis—including not just Chris Joye and the ubiquitous “market economists” that pepper the evening news, but the big fish of academic, professional and regulatory economics as well.

As late as June 2007, the Chief Economist of the OECD (Organization for Economic Cooperation and Development) observed that:

the current economic situation is in many ways better than what we have experienced in years… Our central forecast remains indeed quite benign: a soft landing in the United States, a strong and sustained recovery in Europe … In line with recent trends, sustained growth in OECD economies would be underpinned by strong job creation and falling unemployment. (Jean-Philippe Cotis, 2007, p. 7; emphases added)

In Australia, the Reserve Bank was equally confident that the future was rosy, both locally and globally:

Economic data in Australia over recent months have signalled a pick-up in the pace of growth in demand and activity… These conditions have been accompanied recently by higher-than-expected underlying inflation.

Growth of the Australian economy has for some time been assisted by favourable international conditions. Current expectations of official and private-sector observers are that the world economy will continue to grow at an above-average pace in both 2007 and 2008. (RBA, August 2007, p. 1; emphasis added)

The award for the worst timing has to go to Oliver Blanchard, founding editor of the American Economic Association‘s specialist journal, AER: Macro. On August 12, 2008, Blanchard published a glowing overview of conventional macroeconomics:

For a long while after the explosion of macroeconomics in the 1970s, the field looked like a battlefield. Over time however, largely because facts do not go away, a largely shared vision both of fluctuations and of methodology has emerged. Not everything is fine. Like all revolutions, this one has come with the destruction of some knowledge, and suffers from extremism and herding. None of this deadly however. The state of macro is good. (Olivier Blanchard, 2009p. 210; emphasis added, Olivier J. Blanchard, 2008)

How wrong they were. The economic and financial crisis that is now the defining social context of our times began months after the OECD declared the future “benign”, days after the RBA predicted above average growth, and one year before Blanchard’s hapless paean. Unemployment rose rather than fell—dramatically so in the USA.  Four years later, US unemployment remains stubbornly high, despite the biggest economic stimulus packages in history, while recent data even shows an uptick in unemployment in Australia, the OECD country that has weathered the crisis with the least damage to date.

Figure 1: Conventional economics forecasts of falling unemployment in 2007-08 were dramatically wrong

Why did conventional economists not see this crisis coming, while I and a handful of non-orthodox economists did (Dirk J Bezemer, 2009, Dirk J. Bezemer, 2011, 2010)? Because we focus upon the role of private debt, while they, for three main reasons, ignore it:

  • Firstly, they believe that the private sector is rational in everything it does, including the amount of debt it takes on. For this reason, Ben Bernanke, the neoclassical “expert” on the Great Depression, ignored Minsky’s Financial Instability Hypothesis:

    Hyman Minsky (1977) and Charles Kindleberger (1978) have in several places argued for the inherent instability of the financial system but in doing so have had to depart from the assumption of rational economic behavior. [A footnote adds] I do not deny the possible importance of irrationality in economic life; however it seems that the best research strategy is to push the rationality postulate as far as it will go. (Ben S. Bernanke, 2000, p. 43; emphases added.)

  • Secondly, they believed that the level of private debt—and therefore also its rate of change—had no major macroeconomic significance:

    Fisher’s idea was less influential in academic circles, though, because of the counterargument that debt-deflation represented no more than a redistribution from one group (debtors) to another (creditors).  Absent implausibly large differences in marginal spending propensities among the groups, it was suggested, pure redistributions should have no significant macro-economic effects… (Ben S. Bernanke, 2000, p. 24; emphases added)

  • Finally, the most remarkable reason of all is that debt, money and the financial system itself play no role in conventional neoclassical economic models. Many non-economists expect economists to be experts on money, but the belief that money is merely a “veil over barter”—and that therefore the economy can be modelled without taking into account money and how it is created—is fundamental to neoclassical economics.  Only economic dissidents from other schools of thought, like Post Keynesians and Austrians, take money seriously, and only a handful of them—including myself (Steve Keen, 2010;—formally model money creation in their macroeconomics.

Even the most “avant-garde” of neoclassical economists, like Paul Krugman, have only just begun to consider the role that debt might play in the economy:

Given both the prominence of debt in popular discussion of our current economic difficulties and the long tradition of invoking debt as a key factor in major economic contractions, one might have expected debt to be at the heart of most mainstream macroeconomic models—especially the analysis of monetary and fiscal policy. Perhaps somewhat surprisingly, however, it is quite common to abstract altogether from this feature of the economy. (Paul Krugman and Gauti B. Eggertsson, 2010, p. 2)

Even when he attempted to break from this mould, Krugman did so from the same point of view as Bernanke above—that the level of debt doesn’t matter, only its distribution, and that one can abstract completely from how money is created:

Ignoring the foreign component, or 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… In what follows, we begin by setting out a flexible-price endowment model in which “impatient” agents borrow from “patient” agents [where what is borrowed is not money, but “risk-free bonds denominated in the consumption good”], but are subject to a debt limit… (Paul Krugman and Gauti B. Eggertsson, 2010, pp. 3 & 5)

In contrast, I have dedicated my academic life to extending the Financial Instability Hypothesis first developed by Hyman Minsky, and for that reason I was always aware that private debt plays a much more important role in the economy than neoclassical economists comprehend.  Having been given the task of explaining (in an Expert Witness Report) how enforcing a predatory loan could have deleterious consequences for people who were not parties to the loan, I therefore turned immediately to the level and rate of growth of private debt.

What I saw in December 2005 shocked me.  Though five years earlier, when writing Debunking Economics, I had commented that I expected a debt-induced financial crisis at some stage in the future (Steve Keen, 2001, pp. 311-312), the sheer scale and rate of growth of debt was staggering.  The 40-year long trend for private debt to rise 4.2% faster than GDP simply couldn’t be sustained forever, and I felt that its breaking was imminent.  When it broke, I expected that the Australian economy would enter a slump that would be far worse than that of the early 1990s.  (I’ll discuss why I was wrong on this expectation later.)

Figure 2: Australian private debt rose 4.2% faster than GDP from 1965 till 2006

I quickly checked the US data to see whether this was merely an Australian phenomenon, or a global one. The private debt to GDP ratio was growing more slowly in the USA—though over a much longer timeframe (at an average 2.25% p.a. since 1945).  The US’s ratio was almost twice as high as Australia’s, and five times as high as it was at the end of WWII.

Figure 3: A five-fold increase in US private debt to GDP since 1945

When these trends of rising private debt ended, I felt we were certain to experience an economic downturn whose severity would be unprecedented in the Post-WWII period—and which could even rival the Great Depression.

The reason why I believed that a change in the rate of growth of debt could cause a crisis, while conventional economists (in which category I include everyone from Paul Krugman and Ben Bernanke to Chris Joye) saw no problem with a higher level of private debt, is because the economic tradition to which I belong acknowledges that the growth in private debt boosts aggregate demand. When a bank lends money, it creates spending power by creating a deposit at the same time. This additional money adds to spending power of the borrower, without reducing the spending power of savers.

Neoclassical economics, on the other hand, treats banks as simple intermediaries between savers and lenders. A loan therefore increases the spending power of the borrower, but reduces the spending power of the saver.

If the neoclassical model of banking were correct, then the macroeconomic effects of debt would be muted, as Bernanke and Krugman argued. However, there is overwhelming empirical evidence that this model is wrong. This evidence was first comprehensively analysed by the American Post Keynesian economist Basil Moore (Basil J. Moore, 1979, 1988a, 1995, 1988b, 1997, 2001, 1983), but it was also recognized by the then Senior Vice-President of the New York Federal Reserve, Alan Holmes, in 1969. While explaining why the Monetarist-inspired attempt to control inflation by controlling the growth of the money supply had failed, Holmes quipped that “In the real world, banks extend credit, creating deposits in the process, and look for the reserves later“.

At more length, Holmes summed up the Monetarist objective of controlling inflation by controlling the growth of Base Money as suffering from “a naive assumption”:

that the banking system only expands loans after the [Federal Reserve] System (or market factors) have put reserves in the banking system. In the real world, banks extend credit, creating deposits in the process, and look for the reserves later. The question then becomes one of whether and how the Federal Reserve will accommodate the demand for reserves. In the very short run, the Federal Reserve has little or no choice about accommodating that demand; over time, its influence can obviously be felt”… [and] “the reserves required to be maintained by the banking system are predetermined by the level of deposits existing two weeks earlier.” (Holmes 1969, p. 73) (Alan R. Holmes, 1969, p. 73; emphasis added.)

Why did neoclassical economists ignore this perfectly sensible analysis, and the host of empirical evidence supporting it accumulated by Moore and others, including even neoclassical standard-bearers like Kydland and Prescott (Finn E. Kydland and Edward C. Prescott, 1990, p. 4)?  I would like to say that “faced with a choice between reality and their assumptions, neoclassical economists chose their assumptions”, but strictly speaking that wouldn’t be true.  The vast majority of neoclassical economists have no idea that this empirical evidence even exists.  But if they had heard of it, most of them would have dismissed it anyway because it undermines numerous core beliefs in neoclassical economics, including the belief known as Walras’ Law.  This is because, once it is acknowledged that the growth in credit can expand aggregate demand, then:

  • In place of a necessary equivalence between (notional) aggregate demand and aggregate supply (Robert W. Clower, 1969, Robert W. Clower and Axel Leijonhufvud, 1973), aggregate demand will exceed aggregate supply if debt is rising, and fall below it if debt is falling.
  • The nominal amount of money matters, and banking & debt dynamics have to be included in macroeconomic models, while neoclassical economics ignores them.
  • The neat separation of macroeconomics from finance can no longer be maintained, since the change in debt finances purchases of assets, as well as purchases of newly produced goods and services.
  • Worst of all, the belief that everything happens in equilibrium has to be abandoned. Rising debt is not necessarily bad—in fact it is an essential aspect of a growing economy—but it is necessarily a disequilibrium process, as Schumpeter argued long ago (Joseph Alois Schumpeter, 1934, pp. 95, 101).

Working from the perspective that the economy is driven by aggregate demand, and that aggregate demand is GDP plus the change in debt, I therefore expected the crisis to begin when the rate of growth of debt slowed down substantially. In August 2007, when the RBA published its optimistic forecast for 2007 and 2008, I published the following observation on the Australian economy:

Reducing the rate of growth of debt from its current level of 15% to the seven per cent rate of growth of nominal GDP would mean a reduction in spending next year, compared to the current trend, of over $100 billion. That is equivalent to an eight per cent reduction in aggregate demand compared to trend, and would have the same impact on the economy as a ten per cent fall in nominal GDP. This realisation is why I first observed in early 2006 that an eventual recession is inevitable—and why, in mock honour of Keating’s famous phrase, I gave it the moniker of “The Recession We Can’t Avoid”. (Steve Keen, 2007, p. 37)

That hypothetical process began in the USA in early 2008 (though Australia did in fact avoid that recession—a point I discuss later). Aggregate demand fell sharply in 2008 even though debt was still rising; then in mid-2009 the change in debt actually turned negative.

Figure 4: A slowdown in the rate of growth of debt caused the Great Recession

Since aggregate demand determines employment, the rate of unemployment exploded as the debt-financed portion of aggregate demand collapsed.

Figure 5: Change in debt-financed demand and unemployment, USA

Since debt finances asset purchases as well as purchases of goods and services, I also expected the turnaround in the growth of debt to cause asset markets to tank as well — which they did, in spectacular fashion.

But here the causation was complex—because as well as rising debt causing asset prices to rise, rising asset prices also encourage would-be speculators to enter the stock and housing markets with borrowed money.  There was therefore what engineers call a “positive feedback loop” between the change in asset prices, and debt.

Figure 6: A positive feedback between rising (and falling) debt and rising (and falling) asset prices

This aspect of capitalism is completely abstracted from by neoclassical economics, since its macroeconomic analysis only considers the buying and selling of newly produced commodities. To consider it properly, we have to transcend the core concept of neoclassical thinking, Walras’s Law.

Walras’ Law

The cornerstone of the Neoclassical barter model of capitalism is “Walras’ Law“.  To cite the Wikipedia here, “Walras’ Law hinges on the mathematical notion that excess market demands (or, conversely, excess market supplies) must sum to zero. That is, Sum[XD] = Sum[XS] = 0″.

The essence of Walras’ Law is the proposition that, to be a buyer, one must first be a seller — so that the source of all demand is supply.  In an environment of free exchange where it is assumed that most market participants were “neither thieves nor philanthropists”, neoclassical economists asserted that “the net value of an individual’s planned trades is identically zero” (Robert W. Clower and Axel Leijonhufvud, 1973, p. 146).  A seller was assumed to only sell in order to buy, and to expect a fair return, so that the sum of each person’s supply would equal that person’s demand.  Calling the gap between a person’s demand and supply “excess demand”, neoclassical economists asserted that:

The money value of all individual EDs [excess demands] summed over all transactors and all commodities, is identically zero. (Robert W. Clower and Axel Leijonhufvud, 1973, p. 152)

The Schumpeter-Minsky Law

Seventy years ago, the great evolutionary economist Joseph Schumpeter argued that Walras’ Law was false in a credit economy, because credit gave entrepreneurs spending power that did not come from the sale of existing goods.

An entrepreneur, in Schumpeter’s model, was someone with an idea but no money to put it into practice.  How does such a person actually get the money, Schumpeter mused?

whence come the sums needed to purchase the means of production necessary for the new combinations if the individual concerned does not happen to have them?(Joseph Alois Schumpeter, 1934, p. 72)

After ruling out the conventional answer that it came solely from savings on partly quantitative and partly logical grounds, Schumpeter observed that:

there is another method of obtaining money … the creation of purchasing power by banks… It is always a question, not of transforming purchasing power which already exists in someone’s possession, but of the creation of new purchasing power out of nothing … which is added to the existing circulation. (Joseph Alois Schumpeter, 1934, p. 73)

The capacity for banks to create money endogenously—”out of nothing” — is crucial here.  Given this capacity—which Schumpeter took as obvious, and which later empirical work has shown to be the case — aggregate demand is greater than aggregate supply, with the difference being accounted for by the change in debt.

Schumpeter’s student Minsky added to this the observation that the growth of debt was necessary to support a growing economy:

If income is to grow, the financial markets, where the various plans to save and invest are reconciled, must generate an aggregate demand that, aside from brief intervals, is ever rising. For real aggregate demand to be increasing, . . . it is necessary that current spending plans, summed over all sectors, be greater than current received income and that some market technique exist by which aggregate spending in excess of aggregate anticipated income can be financed.  It follows that over a period during which economic growth takes place, at least some sectors finance a part of their spending by emitting debt or selling assets. (Hyman P. Minsky, 1982, p. 6; emphasis added)

Minsky also pointed out that the entrepreneur is not the only one who gets spending power this way:  so too does the Ponzi Financier, the speculator who attempts to profit by buying and selling assets on a rising market:

A Ponzi finance unit is a speculative financing unit for which the income component of the near term cash flows falls short of the near term interest payments on debt so that for some time in the future the outstanding debt will grow due to interest on existing debt. Both speculative and Ponzi units can fulfill their payment commitments on debts only by borrowing (or disposing of assets).  The amount that a speculative unit needs to borrow is smaller than the maturing debt whereas a Ponzi unit must increase its outstanding debts.  As a Ponzi unit’s total expected cash receipts must exceed its total payment commitments for financing to be available, viability of a representative Ponzi unit often depends upon the expectation that some assets will be sold at a high enough price some time in the future. (Hyman P. Minsky, 1982, p. 24; emphasis added)

Minsky thus integrates the dynamics of asset markets with Schumpeter’s vision of a credit-based economy, in which an important component of aggregate demand comes from the endogenous expansion of spending power by the banks. This yields an accounting identity which is true in a credit-based economy, whereas Walras’ Law is only true in the neoclassical fiction of a pure barter economy (David Graeber, 2011).  The “Schumpeter-Minsky Law” is thus that:

The sum of all incomes plus the change in debt equals the revenue the sale of goods and services plus net asset sales.

Putting this in a more stylized way:

Wages + Profits + Change in Debt = Price Level * Output + Net Asset Sales,


Net Asset Sales = Asset Price Level * Quantity of Assets * Fraction of Assets sold.

The change in debt is thus related to the current level of economic activity—on both commodity and asset markets—which explains the correlations shown earlier between the rate of change of debt, the level of output (and hence of unemployment), and the level of asset prices.

An obvious second-order implication of this—first explored statistically by (Michael Biggs et al., 2010; see – is that the acceleration of debt is related to the rate of change of output, unemployment, and asset prices. Enter “the nebulous conception” that Chris Joye derided, the “Credit Accelerator”:  It is a logical consequence of a credit-based view of how capitalism functions.


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Bezemer, Dirk J. 2009. “”No One Saw This Coming”: Understanding Financial Crisis through Accounting Models,” Groningen, The Netherlands: Faculty of Economics University of Groningen,

Bezemer, Dirk J. 2011. “The Credit Crisis and Recession as a Paradigm Test.” Journal of Economic Issues, 45, 1-18.

____. 2010. “Understanding Financial Crisis through Accounting Models.” Accounting, Organizations and Society, 35(7), 676-88.

Biggs, Michael; Thomas Mayer and Andreas Pick. 2010. “Credit and Economic Recovery: Demystifying Phoenix Miracles.” SSRN eLibrary.

Blanchard, Olivier. 2009. “The State of Macro.” Annual Review of Economics, 1(1), 209-28.

Blanchard, Olivier J. 2008. “The State of Macro.” SSRN eLibrary.

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Graeber, David. 2011. Debt: The First 5,000 Years. New York: Melville House.

Holmes, Alan R. 1969. “Operational Constraints on the Stabilization of Money Supply Growth,” F. E. Morris, Controlling Monetary Aggregates. Nantucket Island: The Federal Reserve Bank of Boston, 65-77.

Keen, Steve. 2001. Debunking Economics: The Naked Emperor of the Social Sciences. Annandale Sydney & London UK: Pluto Press Australia & Zed Books UK.

____. 2007. “Deeper in Debt: Australia’s Addiction to Borrowed Money,” Occasional Papers. Sydney: Centre for Policy Development,

____. 2010. “Solving the Paradox of Monetary Profits.” Economics: The Open-Access, Open Assessment E-Journal, 4(2010-31).

Krugman, Paul and Gauti B. Eggertsson. 2010. “Debt, Deleveraging, and the Liquidity Trap: A Fisher-Minsky-Koo Approach [2nd Draft 2/14/2011],” New York: Federal Reserve Bank of New York & Princeton University,

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About the Author

Steve Keen is Associate Professor of Economics & Finance at the University of Western Sydney, and author of the popular book Debunking Economics (Zed Books UK, 2001;

Steve predicted the financial crisis as long ago as December 2005, and warned that back in 1995 that a period of apparent stability could merely be “the calm before the storm”. His leading role as one of the tiny minority of economists to both foresee the crisis and warn of it was recognised by his peers when he received the Revere Award from the Real World Economics Review for being the economist who most cogently warned of the crisis, and whose work is most likely to prevent future crises.

He has over 50 academic publications on topics as diverse as financial instability, the money creation process, mathematical flaws in the conventional model of supply and demand, flaws in Marxian economics, the application of physics to economics, Islamic finance, and the role of chaos and complexity theory in economics. His work has been translated into Chinese, German and Russian.

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