Friday 02 Jun 2023
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This article first appeared in Forum, The Edge Malaysia Weekly on February 10, 2020 - February 16, 2020

There is a major revolution in economics happening following the Global Financial Crisis (GFC) in 2007/08. A major conference was held in 2014 in London, where prominent economists, including Lord Adair Turner (former chairman of INET’s governing board and former chairman of the International Financial Stability Board’s major policy committee), who addressed the conference.

The speakers posited that during the GFC, conventional economic thinking at the time had difficulty explaining the crisis or providing any meaningful solutions. After all, prior to the crisis, economists had believed that the economic thinking at that time produced successful economic policies of growth and low inflation, referred to as the “great moderation”, fully ignoring the effects of debt and its consequences.

It is fortuitous that there is now a movement encompassing wide areas of economics around the creation of money, the effects of debt, the path to prosperity, role of government and so on. Leading economists in Rethinking Economics include Prof Steve Keen, Prof Mariana Mazzucato, Prof Ricardo Hausmann and Prof Stephanie Kelton, and their views are highly sought-after at conferences and forums. Even national leaders seek their help in formulating economic policies based on ideas espoused in Rethinking Economics. In light of the revolution in economics, progressive universities are initiating reviews of their economics courses and making changes to their existing syllabi. However, much of the change is taking place in smaller, non-traditional universities where there are no entrenched views on neoclassical theories.

As protagonists of Rethinking Economics, we encourage enlightened understanding and discourse on important economic concepts that are wrongly or simply not addressed by mainstream economists. In this article, we share the deeper understanding of the growth of debt and the role commercial banks play in creating money, and its implications. We believe it is crucial for policymakers to understand the effect of the level of debt, change in credit and their impact on aggregate demand as well as how the decrease/increase in debt impacts aggregate demand.


Understanding the effects of debt on aggregate demand

Steve Keen in his book, Can We Avoid Another Financial Crisis?, demonstrates that if credit growth is sustained, growth becomes robust, but at the expense of increasing debt-to-GDP ratio. The effects of debt and growth of debt on aggregate demand is an important takeaway from Keen’s research, that is, with the same level of gross domestic product but with a higher degree of growth of debt, there is a marked change in growth in demand.

Therefore, when debt levels are more than GDP, even larger levels of expansion of credit is required to ensure growth in demand. Carrying this train of thought to its logical conclusion, it is obvious that the negative effects of aggregate demand will be even greater when there is deleveraging. This is illustrated in the graphs of US and Japan pre- and post-crisis below (Exhibit 1) where debt deleveraging resulted in a contraction in demand.

From Exhibit 1, one can observe that there was an acceleration of growth with acceleration of credit in the US from 2001 (A) onwards and Japan from 1987 (B). Clearly, in the US, when there is a contraction in credit post-GFC (C), the economy contracts. Similarly, in Japan in the late 1990s (D1) and GFC (D2), that is when credit contracts, the economy contracts. It can also be observed sometime before 2015 (E), when there was credit expansion, growth emerged. Similarly, from 2010 onwards, the US’ increased expansion of credit was matched by economic expansion (F).

Understanding and managing the quantity of debt created is paramount in respect of managing demand in the economy. Yet, mainstream economists argue that bank credit plays no role in demand because the effects of savings and lending cancel each other out, completely ignoring the concept of endogenous money.

Economic models that do not consider the effects of credit and banks will continue to fail miserably when there is sharp expansion and contraction in credit. It was not surprising that despite huge quantitative easing post-GFC, demand initially shrank and mainstream economists were confounded by the problem as they did not appreciate that huge deleveraging was causing a fall in aggregate demand.

At times when bank credit growth is falling, the effects on aggregate demand will be felt in terms of weaker aggregate demand, in particular when private-sector debt levels are relatively high, as in the case of Malaysia where household debt is also at a historically high level.


Creation of money: Government versus banks

Excluding private-sector debt, the source of growth of the money supply and, consequently, growth in demand, excluding the external sector (exports and imports), is the government via deficit budgets. We strongly argue that federal government policymakers should not be constrained by thinking in a way similar to corporations or state governments. The proponents of Rethinking Economics espouse that the federal government, with fiat currency, should pursue deficit spending, which is a viable option if inflation remains in check and the balance of payments is positive.

The following section compares the effects of money creation by the government and commercial banks. Exhibit 2 (on Page 47) shows an economy where government only creates money within an economy.

Each column represents the revenue of poor households, rich households, firms and the government earned from each sector, with the exception of expenditure by that sector (in red). The rows show the expenditure of poor households, rich households, firms and the government spending on each other sector and the total expenditure spent by that sector in red. From the table, it can be seen that the government’s deficit equals the net savings of the private sector, which in this example is the poor household, rich household and the firms. The table shows that the combined private sector is saving when the government creates money by running a budget deficit. Policymakers ignore this important lesson at the expense of putting our economy in peril.

Exhibit 3 (on Page 47) shows what happens in an economy if money is only created by the banks.

For the same level of outgoing and incoming as in the earlier example, there is no net savings in the private sector as opposed to the earlier scenario of savings when the government is in deficit.

While it is possible for the private sector to sustain increasing debt levels, it is not sustainable indefinitely. Unlike the government, the private sector does not have its own central bank. It is worth noting that the only time the Malaysian government ran a surplus was pre-the Asian crisis when the private sector, mainly the corporate sector, raked in huge debt and the banking crisis ensued (refer to Exhibit 4 on Page 47).

Informed parties will attest that the banking crisis would have ensued regardless of the exchange rate crisis. It was merely accelerated and made worse by the exchange rate crisis and policy response to defend the ringgit and increase interest rates rather than to devalue the currency to a realistic exchange rate. The pattern of deleveraging of the private sector and government spending in Malaysia is similar to the resolution in the West, which also proved to be highly successful (see Exhibit 5). However, at the time Malaysia pursued those policies, the West severely criticised the initiatives of the Malaysian government, which were considered unorthodox.

There cannot be a simple answer to unconstrained government spending, which could be inflationary or crowd out the private sector. On the other hand, depending too much on private sector debt can be detrimental, with asset bubbles and unsustainable debt levels. However, in Malaysia on balance, the pendulum has swung towards increasing government expenditure, especially to shore up aggregate demand immediately to remedy lacklustre demand in the local economy. More so because banks are increasingly taking a cautious stance towards lending, given that there are more prudent regulations on loan classification, limitation of financing to certain sectors and in anticipation of a weakening economy due to international and domestic factors.


Long-term economic development

If we are realistic and accept that aggregate demand is weak, then the role of government in increasing deficit spending is urgently required, as advocated by Keynes. However, the proponents of Rethinking Economics espouse that the application of deficit spending is not limited to just this perspective. The article on Rethinking Economics (Fortune Favours the Bold) in respect of the role of government which was published in The Edge on Nov 18, 2019, puts forward the argument that if the (mission-critical) initiatives were important enough and are critical to long-term economic development, then the government must and will find money to fund these initiatives.

Even the most ardent opponents of expansion of credit cannot deny that debt for productive purposes is not detrimental to the economy. Therefore, private-sector debt expansion by entrepreneurs for fixed and working capital, and by governments for mission critical initiatives and public good, that is, beyond managing demand, should not be seen as an evil to be restricted and tightly constrained.

Proponents of Rethinking Economics strongly advocate deficit spending for mission-critical initiatives and for the public good. These mission-critical initiatives, in our view, are unlikely to play a significant role in influencing aggregate demand in the long term in a capitalist economy because the largest creation of money remains with commercial banks and the main engine of growth remains the private sector. Therefore, government expenditure, similar to many other government activities, complements the private sector to optimise the economy.



There is an urgent need to review what are the levers for improved aggregate demand and credit. While policymakers may be somewhat frustrated with commercial banks and their prudent approach in the current market, their actions are very much in response to market forces. Commercial banks will take their cue from the government if they are convinced by the government being deemed business-friendly and would thus be confident to grow their loan books at a faster pace, which in turn increases aggregate demand.

Therefore, if the government is confident in managing leakages and is transparent in the procurement process for projects that increase aggregate demand, then it should not be constrained to increase aggregate demand vide deficit spending, or being beholden to debt-to-GDP ratios indicating danger of a crisis that have been discredited. Moreover, with prevailing low interest rates and expected further lowering of rates, the government has the capacity to increase debt. The correct policy response is only possible if there is serious discourse on these issues and there is fuller understanding of issues on the ground affecting aggregate demand.

Datuk Mohd Anwar Yahya is a partner and an executive director at Sage 3, a boutique corporate finance advisory, and currently serves on the boards of directors of several Malaysian public and private corporations. He has over 25 years of experience in public policy, corporate finance and strategy at a Big Four accounting firm.

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