A solution to excessive asset price increases, and excessive credit use, which help create economic bubbles, high inflation, recessions, and financial crisis, follows this partial interview with Professor Steve Keen, Economist.
Subject: The Failure of Economics : Prof.Steve Keen
Check out this video on YouTube:http://www.youtube.com/watch?v=4sSfPkIUHPk&feature=youtube_gdata_playerThe following is a segment of the interview transcript between Mr. Paul Mason of BBC Radio and Prof. Steve Keen an economist.
MASON: Good evening and welcome to the Old Theatre of the London School of Economics. I am Paul Mason here with a packed audience. In this week’s addition of Analysis I will be speaking to Steve Keen about his claim that if we keep the parasitic banking sector alive the economy dies. Steve Keen is professor of economics and finance at the University of Western Sydney in Australia and has a cult following among critics of mainstream economics. He was one of a small number of economists who put their reputations on the line before the collapse of Lehman Brothers and predicted that there would be a major financial crisis. In his recently updated book Debunking Economics; The Naked Emperor Dethroned, he argues much of what is taught here at the LSE and other major intuitions is, to put it politely, flawed and not only flawed, but helped cause and accentuate the impact of the crash. Neo-classical economics, he says with its naïve money-less equilibrium theory of capitalism provided the unwitting cover for the greatest Ponzi schemes in human history.
MASON: Just briefly summarize for us the causes of the crisis.
KEEN: The fundamental cause of the crisis is the banking sector’s profits are limited when they can only finance investment. Or consumption like buying a house over time is a consumption item. They only make huge amounts of money when by fooling us into Ponzi schemes which they themselves don’t really like…
MASON: Ponzi schemes are like pyramid selling.
KEEN: Gambling on rising prices. You borrow money and they play flip that house and you think you can get wealthy by doing it. That’s ok for an individual. But for an entire society to believe you can get rich by playing flip that house and all you are doing is accumulating debt, driving up house prices getting more income for bankers, more income for real estate agents. Then ultimately the debt level reaches so high that society can’t substance it and we crash.
MASON: What draws us down that route though? We know that bankers individually behaviour can lead to that. What is the objective, and in the system, why it causes that?
KEEN: Well first of all this is the one thing I have been trying to explain to Paul Krugman, money is endogenous money is created by the financial system. Money is not controlled by the central bank. Money is something which is generated by the private banking sector and there are really no effective constraints on the rate at which they can increase that. There are constraints how fast they can do it, but they can’t be stopped from creating money. What it requires of course is a willing borrower on the other side. Of course when you get to the point where the willing borrowers disappear then that capacity to create can be constrained and we are seeing now, it’s falling down. But when they could persuade us that it is really smart to be in debt, then as that bubble goes that actually causes the rising asset prices which encourages more people in. It sets off the entire bubble. That is what gets us in.
MASON: This is a financial business cycle. So why should it cause depressions?
KEEN: Because when you can’t pay your debts you can’t eat. Everybody loves the guy that walks down Main Street with a credit card that is buying everything until he can’t afford to get the credit card out any more. And you built your own businesses based on this incredible demand brought by a person with a credit card and suddenly he can’t get another credit card and he is not there anymore and all the economic capacity you’ve built up to service that demand is suddenly excess and you go bankrupt.
The SolutionThe Culprits That Helped Create The Financial Crisis Is The 100% Interest Deduction , The Higher Tax Rate on Interest Income, And The Lower Capital Gains Tax Rate Being Continually Applied During Inflation Cycles, And Asset Bubbles, ie housing, real estate, energy and commodities bubbles.We must automatically neutralize the lower long term capital gains tax and the interest deduction before they create bubbles or high inflation!The following question and answer of the interview is what I would like you to pay close attention to because what follows is how bubbles are created and how we can help solve the problems of bubbles and high inflation.MASON: What draws us down that route though? We know that bankers individually behaviour can lead to that. What is the objective, and in the system, why it causes that?
KEEN: Well first of all this is the one thing I have been trying to explain to Paul Krugman, money is endogenous money is created by the financial system. Money is not controlled by the central bank. Money is something which is generated by the private banking sector and there are really no effective constraints on the rate at which they can increase that (money). There are constraints how fast they can do it, but they can’t be stopped from creating money. What it requires of course is a willing borrower on the other side. Of course when you get to the point where the willing borrowers disappear, then that capacity to create can be constrained and we are seeing now, it’s falling down. But when they could persuade us that it is really smart to be in debt, then as that bubble grows that actually causes the rising asset prices which encourages more people in. It sets off the entire bubble. That is what gets us in.
So the question is;
If money is debt, and excessive debt creates bubbles, and “money (debt) is something which is generated by the private banking sector, and there are really no effective constraints on the rate at which they can increase that (money)”, and this is what creates bubbles; How do we decrease the number of willing borrowers before a bubble is created which will create another financial crisis?
It was private sector debt that created the dot com, oil, and the housing bubble in the last 20 years. Tax policy has more to do with how much debt is created by the private sector than what has been discussed. The lower long term capital gains tax rate is used to convert earned income, and interest income into lower taxed capital gains income by investors, and homeowners.
There have been many reports lately that Presidential candidate Mitt Romney, many homeowners, and investors use this lower tax rate, on long term capital gains, in the tax code, to lower their tax bill as capital assets increase in price by selling the asset at the higher price derived from inflation. The appreciated asset prices and inflation they helped create with the excessive creation of credit money.
The extra demand that investors, and home owners create utilizing the interest deduction, and the lower long term capital gains tax rate, during the asset appreciation/inflation cycle, or a singular class of asset price increase (bubble), increases prices further by the excessive use of credit to finance the rising asset and home prices. Of course banks are eager to finance all the increases in debt, based on the higher asset, and real estate prices, because they are increasing their profit margin. They are also able to increase the interest rate based on demand for credit and risk assumption.
What is needed to have a sustainable balanced economy is encourage people to increase their investments and consumption during the recession cycle, and then when the inflation cycle begins to occur, people need to be encouraged to increase investments in production, and savings to increase supply by automatically changing the tax code as the economy changes economic cycles.
When Congress changed the tax code that allowed homeowners up to $500,000.00 long term capital gains to be taxed at 0% in 1999 and the banks were deregulated, it set up our economy for the financial crisis that occurred in 2008, because these policy changes created the possibility of extraordinary paper profits. Homeowners had a very profitable reason to sell their homes and buyers had a very profitable reason to buy a home with prices increasing so much each month.President Bush’s lowering of the long term capital gains tax rate increased the speculation and unproductive investments in our economy. The speculation and investment with credit increases the cost of many commodities, housing, energy, food and many other necessities of life. To eliminate this tax loop hole during the appreciation/inflation cycle and when credit bubbles start to form, we should use the tax code to slow down unproductive credit creation. We should not rely on the credit tightening policies used by central banks, which raises interest rates, and the cost of consumption and production, causing more credit use if wages are not increased as prices increase. When prices increase further, poverty is increased, increasing the cost of government social programs, and reducing the competitiveness of our exports in the world market place. If we don’t make changes to our guiding polices (taxes) we will continue to repeat history.We should use the Zero Appreciation/Inflation Taxation Policy to help reduce the severity of the recession and inflation cycles of our economy. The Zero Policy would create a more productive and efficient economy. Asset and commodity prices would be more stable, and long term interest rates would remain more constant. The value of debt (money) would be changed by the percentage of tax on interest earned, and the amount of credit created by the private sector would be reduced by the automatic reduction of the interest deduction, during the inflation cycle, and when asset and commodity price bubbles are being created. The percentage of the tax on interest earned would be reduced by the true annual asset appreciation/inflation rate. The interest deduction would be reduced by the same percentage rate. When the tax on interest earned is at the same rate as the long term capital gains tax rate, the lower long term capital gain tax rate would be neutralized. As the interest deduction is reduced the excessive use of credit leveraging, during the asset appreciation/inflation cycle, would be reduced. Thus preventing bubbles and financial crisis from being created. It is common knowledge that it was a housing credit bubble that created the financial crisis, that created the Great Recession of 2008. We do not want to keep repeating history as we have done for the last one hundred years.The long term capital gains tax devalues money (debt) because the interest earned on debt and savings is taxed at a higher tax rate, than the paper profits realized by asset price increases that have increased without the investor increasing the supply, or value of the asset (inflation). The Zero Policy will neutralize the long term capital gains tax rate during the asset appreciation/inflation cycle, by reducing the tax on interest earned, and reducing the interest deduction, but the lower capital gains tax rate will still be available to encourage productive investment. In this way we can reduce the amount of debt (money) banks can create in the private sector, by reducing the number of people willing to borrow money during the asset appreciation/inflation or bubble cycle, without rising interest cost of productive businesses. The raising of interest rates by banks and the Fed is very damaging to the middle class and small businesses. Higher interest rates reduce demand and competition from the bottom of the economic ladder by increasing unemployment, and by causing small businesses to permanently close their doors, or being purchased by larger businesses. Maintaining the viability of small businesses would increase competition in a free market system.The Zero Policy reduces demand from the top of the economic ladder. By reducing the number of people with money desiring to protect their money from the devaluing effect of inflation, and benefit from the lower long term capital gains tax rate.While fighting inflation psychology, the Zero Policy will allow the normal production/consumption economy to continue operating, thereby continuing to provide jobs to the employed, and revenues to local, state and the federal government. The Zero Policy will dampen leveraged speculative investments, and calm people’s “animal spirits” which the policies of economist John Maynard Keynes help create. The Zero Policy reduces inflation psychology investments during the asset appreciation/inflation cycle, slowing down the velocity of money, which will allow production the time it needs to increase supply.
Charts that tell how much private debt was created.
To prevent another bubble being created we should enact the “Zero Appreciation/Inflation Taxation Policy” to make the recovery sustainable.
The Flaw In Our Economic Policies That Creates Bubbles And High Inflation
Under our current fractional banking system, economies get into trouble when people have too much confidence, resulting in too much credit creation. Or people don’t have enough confidence, and not enough credit creation is taking place. Since World War II a recession cycle has been preceded by an inflation cycle. The Great Recession was preceded by the popping of a housing price bubble created by the excessive use of credit in the private sector.
Currently the Federal Reserve uses monetary policies to change interest rates up or down trying to re-balance the economy. Using higher interest rates to control inflation psychology and bubble creation, is a flaw in our economic polices, because this is similar to using a sledge hammer to drive in a tack. Too much unnecessary damage is done to the economy when interest rates rise. Cost of production and consumption increases. Small businesses close their doors, people lose their homes, jobs, and go bankrupt. The government’s social programs increase in size. Taxes or deficits increase.
When interest rates are decreased we go back to the same credit leveraging use, we were using that created the excessive asset appreciation/inflation and the excessive money creation, that creates bubbles because the tax code has not changed.
How can we change tax policy, given that fiscal policy is under the control of politicians who have vested interest in creating booms?
Yes it is correct to say that fiscal and monetary policy makers have a vested interest in creating booms. This is why the Zero Appreciation/Inflation Taxation Policy is tied to how the economy is performing, not on the determinations of the Federal Reserve or Congress. We have a dynamic economy, but we have static guiding polices (tax code). In real estate, it is location, location location. In macro economics its timing, timing, timing. The Fed’s policies are out dated for our large and complex economy as we have seen in their inability to control the creation of bubbles and to heal our economy. The Fed cannot correctly guide the economy alone with the tools at it’s disposal.
Congress has the correct tools to change tax policy to help prevent the creation of bubbles, high inflation and deep recessions. Our economy is continually changing between economic cycles. We can’t rely on a 535 member politically divided committee to act quickly enough to prevent inflation psychology from growing cancerous. The Zero Policy would correctly guide people during the correct economic cycle, to increase the money supply when the economy is slowing down. It will decrease the creation of credit (money) and encourage money investments during the excessive asset appreciation/inflation cycle, or during a period of bubble creation.. The tax code would still have the lower long term capital gains tax rate. The higher tax rate on savings and money investment would also remain. It is only when the economy starts to become unbalanced and collateral prices begin to rise to fast, that the percentage of tax on savings and, money investments would begin to be reduced, base on the true inflation rate and asset price appreciation. When interest income is taxed at the same rate as the long term capital gains tax rate, the stimuli to capture lower taxed capital gains from inflation would be neutralized.
The interest deduction would also be reduced by the same percentage amount during the excessive price asset appreciation/inflation cycle to discourage credit creation. This change in taxation policy would maintain a closer balance of values between the money that is lent, and the paper profits on capital assets during the asset price appreciation/inflation cycle. The lower capital gains tax rate would still be available for productive investment and production. By slowing down the velocity of money in this manner, it would give production the time it needs to balance supply with normal demand, thus maintaining employment without creating a recession to control inflation psychology.
A majority of the population would also not be doing the same thing at the same time which creates the herd effect. Appreciation of capital assets, without improvement, would not be taken for granted. When asset price appreciation/inflation is subdued the tax on interest would automatically slowly increase to previous rates, and the interest deduction would slowly return to a 100% tax deduction.
I want to point out that there is a transfer of value from the money (debt) holders to the holders of capital assets as capital asset prices rise. By enacting the Zero Policy, at the end of the year the values would be somewhat re-balanced. One person would pay a little more tax, and the other would pay a little less tax if asset prices were increasing. In this way we don’t allow the balance of values to get so far out of balance that the economy has to be put through a recession to increase the value of money (debt), as the economy is presently doing. You can now buy more real estate with less debt (money). The value or purchasing power of money has increased in the last 5 years. During asset price appreciation/inflation cycles, and bubbles, money loses purchasing power, it takes more debt to buy real estate, to focus on one commodity.
Where does the democratic right to decide how you will be taxed fit into this.
In a representative free society the people have the right to confer and advise their representatives in government. The government serves the people. Our forefathers went to war with England to gain the right to make our own determination on how we the people would be taxed.
The people have the right of free speech, petition and assembly. I believe people are ready for a change. They are tired of the cycles of boom and bust in our economy. Our representatives and the people will need to be educated on the benefits of the Zero Appreciation/Inflation Taxation Policy.
Academia needs to be involved. If necessary the people need to use their rights to encourage our representatives to make the needed changes to the tax code. The timing could not be better. Tax reform discussions are scheduled to start in 2013 in the USA. The financial sector and special interest have had their way for the last 30 years. The people need to stand up and speak out so they will be seen and heard. Our revolution history is proof that we can do it again.
What are your thoughts on the Zero Policy? Will it make our economy more productive and efficient? Will less paper profits be created and more real wealth be created. The real wealth that is needed to increase the standard of living in countries. Will it help dampen the cycles of high inflation and deep recessions. Would you support the change to the tax code. I believe the Zero Policy should be adopted in all modern economies around the world. Many countries have an income tax with the same guiding polices of the USA. This is one of the reasons capital asset, and homes have increased so fast in price around the world.
To have a sustainable recovery we must increase people’s confidence in their ability to succeed at taking on the responsibility of a mortgage. We must also improve people’s disposable income to increase aggregate demand. I have posted on my web site the terms of a new mortgage that people can succeed at, unlike the mortgage terms that created the financial crisis in many nations. The mortgage also increases people’s disposable income and the terms of the mortgage offer a way we can de-leverage the primary home market, in a safe and controlled manner, which will be beneficial to all parties concerned. Thereby resolving the underwater mortgage situation.
Please read “Economic Recovery – The Fed Can’t Do It Alone” and other articles I have posted on my web sites at http://www.foreclosurecrisissolved.wordpress.com/ and http://www.recoverygovforthepeople.wordpress.com/
Leonard C. Tekaat is an economic scholar, author, and retired small businessman with over forty years of experience in home finance and real estate investment. He is a former candidate for the California Congress. He is the Chairman of a special Committee For Economic Reform and A Better Economic Future.