“It’s just a flesh wound…”

It seems we’ve moved from Stanley Kubrick to John Cleese. Rory Robertson’s reply to my “Rory Robertson Designs a Car” post reminds me of one of my many favourite scenes from Monty Python, the fight between King Arthur and the Black Knight:King Arthur: [after Arthur’s cut off both of the Black Knight’s arms] Look, you stupid Bastard. You’ve got no arms left.

Black Knight: Yes I have.

King Arthur: *Look*!

Black Knight: It’s just a flesh wound…

Most of Rory’s commentary in his newsletter has been reproduced by Christopher Joye in an amusing “ringside report” (Keen vs. Robertson: Round V) on the Business Spectator (incidentally, Chris’s post includes an excellent dig at the RBA’s performance in recent years; this is well worth a read in its own right).

Taking Chris’s extract as a guide, it seems that Rory’s entire consideration of my post boils down to this:

“**Needless to say, Dr Keen does not accept the assessment that a “schoolboy error” lies at the heart of his pessimistic forecast of a 40 per cent drop in Australian home prices. But instead of addressing the key point that debt servicing just got much easier for most home-buyers, Dr Keen responded by inventing a silly story about cars and fuel consumption – to make a point that completely missed the point…

“Does not accept the assessment”? Do we have a Dead Parrot talking here, as well as an armless Knight? The point of my post was that Rory’s argument that comparing Debt to GDP is a “schoolboy error” (”like comparing apples with oranges”) was itself a schoolboy error that betrayed the depressing lack of understanding that most neoclassical economists have of dynamics. In engineering and many other properly dynamic disciplines, stock to flow comparisons–like comparing Debt to GDP–abound. Far from being a “schoolboy error” to make them, it’s a “haven’t been properly educated at university” error to deride them.

They can be done in error, sure–when the resulting measure has nonsense dimensions, or is irrelevant to the issue at hand. Comparing Debt to GDP isn’t an instance of either error, since as I showed in that post, the resulting dimension is “Years”. The ratio matters because it tells you how long it would take to reduce debt to a given target, if a given percentage of income was devoted to repaying it.

The current answer is 1.59 Years, if all GDP was devoted to debt repayment (which can’t happen of course–5% of GDP p.a. is a more likely deleveraging rate) and if the target was a zero % debt ratio (which it wouldn’t be–the 1950-70 range of 25-50% is more likely), and if reducing debt didn’t affect GDP (which unfortunately ain’t the case–there will be many damaging positive feedbacks from reductions in debt to reductions in GDP).

And for Pete’s sake, a “stock to flow” comparison was the linchpin of Friedman’s Monetarism, as a blog member here pointed out:

cheapbastud said, on March 16th, 2009 at 1:22 am:

uhhhh, isn’t VELOCITY from the equation of exchange a stock/flow ratio (in this case it’s a flow/stock ratio)?


Maybe I’m making a horrible schoolboy error or maybe Mr. Robertson doesn’t know wtf he’s talking about.

Spot on. The “velocity of money” is the number you get from dividing nominal GDP ($/year) by the money stock ($). Its dimension is 1/years, so that the inverse of the ratio tells you how many times the money stock turns over in a year. The forlorn attempt to prove this was a constant was Friedman’s key research objective, since if V wasn’t a constant then much of the Quantity Theory of Money was invalidated.

Now I doubt that Rory is going to accuse Friedman of committing a “schoolboy error” here (though in truth Friedman is guilty of so many that there should be a Friedman Prize in Schoolboy Errors–and  virtually every year it could be awarded jointly with the Nobel Prize in Economics). So why accuse me?

In my long experience with attempting to debate economics with neoclassical economists, I have become accustomed to an often irrelevant and frequently false point being raised, after which discussion is terminated. The point of raising the point is not to engage in debate, but to shut it off. So too with this patently false argument that, because I use a “stock to flow” ratio, the remainder of my arguments can be ignored.

In itself, there’s nothing wrong with arguing this way–in a religious debate. If you have two perspectives, one of which sees a God as crucial to understanding the universe, and another which doesn’t, then they’re always going to argue past each other. But economics isn’t supposed to be a religion–it had, at least until this crisis hit, the pretension of being a science.

I hasten to add that I don’t see this as deliberate evasion by Rory, nor even necessarily conscious evasion–and ditto for the many neoclassical correspondents and referees I’ve dealt with over the years. They can, and do, cope with debates within the confines of their own belief systems; so if I was arguing that the NAIRU (don’t bother asking what it is if you don’t already know–it’s not worth the effort of discussion!) was 4% rather than 6%, or maybe even that prices were sticky downwards rather than perfectly flexible, I might get an argument.

But when you effectively challenge core beliefs–by arguing, for example, that equating marginal cost to marginal revenue doesn’t maximise profits (again, don’t bother, but if you must, check here)–you get a nonsense reply to shut the debate down.

In a true science, a substantive point is either contested or conceded. Rory did neither–though to cut him some slack here, he might not have realised why I wrote my piece either. I didn’t give him any forewarning, so he was free to make a mistaken interpretation of why I wrote something about him. Instead, whether he meant to or not, he ignored my main point, and changed the topic back to the house price issue .

From his point of view, I changed the topic, which in his post was house prices–his “stocks and flows” statement was just an aside. But in fact, if house prices had been all Rory had talked about in the newsletter to which I responded, I wouldn’t have bothered writing anything.

It was the “comparing stocks to flows is a schoolboy error” nonsense that inspired me to write something (and I was also responding to a reader’s request that I assist him in contesting that specific proposition). But Rory’s take is that I made my comment to distract attention from his argument about house prices:

“**Regardless, there remains a large hole in Dr Keen’s analysis (big enough to fit a bus?). Barely six months ago, he was highlighting the uptrend in the household sector’s interest-to-income ratio as the key force that would bring house prices crashing down.”

“Quoting Keen: In 1990, servicing mortgages cost three cents of the household dollar — now its 15 cents, even with lower interest rates. …This is because of the sheer size of the debt — that’s the pressure that’s going to be pushing house prices down and it’s actually the same kind of pressure that is in the US (see here; (The Age back in October also reported: “…Mr Keen said the lower end of the [housing] market was already collapsing”. Really?)”

“**Now that his debt-servicing ratio has crashed towards 10 per cent from 15 per cent, Dr Keen has nothing to say on the matter. Furthermore, with the ratio now trending lower, Dr Keen has stopped publishing the debt-service chart that once was at the centre of his analysis. (Between November 2006 and May 2008 the debt-service chart was regularly published in DebtWatch; for example, see Figure 21 in the February, April and May 2008 reports, and Figure 12 in the November 2006 report, see here).

“**Someone unkind might wonder if Dr Keen is steering clear of key facts that directly contradict the scary story he likes to tell. Pauline Hanson might be inclined to issue a “Please Explain”? In any case, contrary to Dr Keen’s ill-informed claim in the quote above, the situations in Australian and US housing and mortgage markets are very different, like chalk and cheese (see charts 4-15 in the attached PDF file).”

Well, actually, no Rory. Firstly, I mentioned two forces: the interest rate burden, and de-leveraging. True, the former has fallen somewhat; the latter is as potent as ever, and only just beginning to click in here, while it’s driving the collapse in the USA and Europe. I published two charts on that in the Dr StrangeLove post (they’re reproduced at the bottom of this post too), but I wasn’t ignoring the interest rate issue either.

The interest payment burden, while it has dropped substantially courtesy of the RBA’s belated and panicked cuts to rates, is still at higher levels than at any time outside the period 1989-1991–when rates were three times what they are now.

The reason I haven’t been publishing these charts in Debtwatch is not that they no longer make the case I want, but because the reports were growing too long and–given the software I was using to produce them–the layout was becoming too messy. I’m working with a few blog members to produce a web-accessible interface to all the data that will get around this problem ultimately, but it takes time to do this.

In the meantime, here are some of those charts. Firstly, interest rates and the interest rate payment burden as a percentage of GDP: rates and the burden have fallen, and sharply, but still only taken us back to levels that applied when average rates were 16% or higher between mid-1988 and early 1991. That’s hardly heaven.


How much further rates have to fall to return the interest rate burden to anything close to the average since 1960 is indicated by this next chart. We’re still way above the average burden for the last half century.


The average interest rate used above is a weighted average of business, mortgage and personal rates (and it probably understates the burden on business slightly, since I had to guess the latest figure–the RBA only updates business rates on a quarterly basis, and I extrapolated from the September figure using the most recent gap between the 3 year fixed rate for small business and the variable rate for large business; this gap was the smallest it’s been in years, so the business rate is probably higher than I guesstimated here). Breaking this down, and comparing the business payment burden as a percentage of Gross Operating Surplus and the household rates as percentages of Household Disposable Income yields the following chart:


Thus while the burden on business is substantially below what it was in 1990 (when the RBA’s rate hike to attempt to tame the asset bubble back then had a crippling impact on business) the burden on households now is still more than 4% higher (as a proportion of disposable income) than it was in 1990.

The reason for this, of course, is the dramatic increase in mortgage debt over the last twenty years. Analysts who believe that house prices will always rise focus just on that datum itself. I’ve argued from a Hyman Minsky, “Financial Instability Hypothesis” point of view, that this trend of rising house prices only occurs because the debt borrowed to buy houses has risen faster still.  The next chart, which indexes both mortgage debt and household prices to 100 in 1996, illustrates that point:


Finally, there are of course two forces that determine the interest repayment burden–the rate of interest and the level of debt (three actually if one looks at the real burden, but I couldn’t find that chart in a hurry so I’ll  leave it for another day). If you plot the level of debt as a proportion of GDP on a horizontal axis, and the interest rate on the vertical, then you can show combinations of Debt to GDP ratios and interest rates that have an equivalent outcome in terms of the interest rate burden: thus a combination of a Debt to GDP ratio of 40% and a nominal interest rate of 20% has the same impact as a burden of 400% and an average rate of 2%.

Checking the actual time path of the interest rate burden on this chart, I surmised that a speculative boom seems to occur whenever the burden falls to about the 8% level, whereas the maximum burden we’d ever experienced was 16.7% in 1990, with a debt ratio of 83% and an average interest rate of 19.7%.

Also, interpolating from the mean gap between the cash rate and average interest rates of 3.3%, it appeared that the debt ratio at which the minimum debt burden would be that “good times” level of 8%, was 240%: if the debt to GDP ratio ever hit that level, then there was no way the “good times” could ever come back. That analysis is shown in the next chart. Though we’ve retreated from the “maximum pain” line of 16.7%, we’re still well above the “good times” level of 8%–it would in fact take a further 3% fall in interest rates to take us back there, if there was no change in the debt ratio.


So there isn’t much room for rate cuts to reflate the economy–a 3% fall in average rates would require the cash rate to fall to 0.25%, and all of the rate cut to be passed on. That headroom would fall even further if that “schoolboy error” Debt to GDP ratio rose any further.

Thus the interest rate cuts have reduced the pain of debt servicing, but they haven’t reduced them to anything near the comfortable levels of the pre-1980s. And the main problem of debt-deleveraging remains, and will be the main factor driving the economy down, as the contribution that change in debt makes to aggregate demand plunges. That effect is already patently obvious in the US data:


And the first signs of the same process are now turning up in the Australian data, with the most recent “unexpected” increase in the unemployment rate:


The impact of de-leveraging is the main force that I see driving us into Depression, and taking house prices down in the process. There may well be a fillip to the bottom end of the housing market out of the Government’s ludicrous boost to the First Home Buyer’s Grant, but the weight of deleveraging will, I expect, soon tell against that.

And Rory, let’s lighten up here please. My Dr StrangeLove post was meant to make in a comic fashion a point that obviously hadn’t gotten through via serious discussion: that stock to flow comparisons are, if done correctly, legitimate aspects of analysing a dynamic system. Concede that point, and I’ll tickle you with my next sword thrust, rather than slicing your legs off.

Over to you, Mr Joye, for the ringside commentary.

Originally published at Steve Keen’s Oz Debtwatch blog and reproduced here with the author’s permission.

2 Responses to "“It’s just a flesh wound…”"

  1. MissAmerica   March 18, 2009 at 12:53 pm

    Ha…Miss America here. I love the anology of the Black Kniight. I used it some tima ago on NR’s blog.Nice article. I have an article (evaporflation) that too fichts the classic dogmatic view of economics.All the Best, Rich H…and for your amusement:Rich H here again…For those serious investors on this sight… Hindsight has provided me with a better picture of what has transpired the past few days on the market.It is my belief that the markets have rallied on the news that Tuesday’s DVD release of “Beowulf” was in fact the “unrated director’s cut” version! This is extremely good news for all of the McMansion owners here with nice new flat screens!!! The standard release of this DVD would’ve left the world guessing what Robert Zemeckis was thinking.People. My only “investing advice” is Buyer Beware! You’re buying into a rigged market, which will return profit consistency that is similar to Vegas roulette tables.I’m sometimes dumbfounded by people’s inability to really grasp this concept. (this is nothing new. Rigging has always existed to some degree… but recent times have amplified it as a necessity.) Before you dispute how serious the rigging is, explain mid august 2007 investing to me. (when you realize how “contained” the situation is, you’ll finally see the control that exists, and how it works in grand scheme.)The current irrationality that exist can best be described by the follows from Monty Python’s Holy Grail… If you’ve seen the movie, yyou’ll know the scene:LOGIC:You fight with the strength of many men, Sir Wall St… I am Logic, King of the Investors… I seek the finest and the bravest assets in the land to join me in my portfolio… You have proved yourself worthy. Will you join me??? You make me sad. So be it. Come, Public.BLACK KNIGHT OF WALL ST:None shall profit.LOGIC:What?BLACK KNIGHT OF WALL ST:None shall profit.LOGIC:I have no quarrel with you, good Sir Wall St, but I must do something with my money.BLACK KNIGHT OF WALL ST:Then you shall die broke.LOGIC:I command you, as King of the investors, to stand aside!BLACK KNIGHT OF WALL ST:I move for no logic.LOGIC:So be it!LOGIC and BLACK KNIGHT OF WALL ST:Aaah!, hiyaah!, etc.[LOGIC chops the BLACK KNIGHT OF WALL ST’s Mortgage Back Securities]LOGIC:Now stand aside, worthy adversary.BLACK KNIGHT OF WALL ST:’Tis but a scratch.LOGIC:A scratch? Your ABS’s are off!BLACK KNIGHT OF WALL ST:No, it isn’t.LOGIC:Well, what’s that, then?BLACK KNIGHT OF WALL ST:I’ve had worse.LOGIC:You liar!BLACK KNIGHT OF WALL ST:Come on, you pansy![LOGIC chops the BLACK KNIGHT OF WALL ST’s access to credit]LOGIC:Victory is mine! [kneeling] We thank Thee Lord, that in Thy mer–BLACK KNIGHT OF WALL ST:Hah! [kick] Come on, then.LOGIC:What?BLACK KNIGHT OF WALL ST:Have at you! [kick]LOGIC:Eh. You are indeed brave, Sir Wall St, but the fight is mine.BLACK KNIGHT OF WALL ST:Oh, had enough, eh?LOGIC:Look, you stupid bastard. You’ve got no income left.BLACK KNIGHT OF WALL ST:Yes, I have.LOGIC:Look!BLACK KNIGHT OF WALL ST:Just a rate cut. [kick]LOGIC:Look, stop that.BLACK KNIGHT OF WALL ST:Chicken! [kick] Chickennn!LOGIC:Look, I’ll have your Monolines. [kick] Right! [whop][LOGIC chops the BLACK KNIGHT OF WALL ST’s monoline insurers]BLACK KNIGHT OF WALL ST:Right. I’ll do you for that!LOGIC:You’ll what?BLACK KNIGHT OF WALL ST:Come here!LOGIC:What are you going to do, bleed on me?BLACK KNIGHT OF WALL ST:I’m invincible!LOGIC:You’re a looney.BLACK KNIGHT OF WALL ST:The Black Knight of Wall St always triumphs! Have at you! Come on, then. [whop][LOGIC chops the BLACK KNIGHT OF WALL ST’s Muni Bonds]BLACK KNIGHT OF WALL ST:Oh? All right, we’ll call it a draw.LOGIC:Come, Patsy.BLACK KNIGHT OF WALL ST:Oh. Oh, I see. Running away, eh? You yellow bastards! Come back here and take what’s coming to you. I’ll bite your legs off!Rich “always look on the bright side of life.. dada, dada, dada!” H@Rich HROTFL! Great piece!Written by Alessandro on 2008-02-27 11:21:10

    • London Banker   April 18, 2009 at 7:59 am

      As ever, Rich, you were way ahead of your time!