Australian economist Steve Keen’s latest debtwatch update analyses the US Fed Flow of Funds data and pinpoints an explanation for the recent recovery-like feeling in employment numbers. In essence, the private sector deleveraging is still going on, but at a slower pace, and it is this change of pace which has provided the boost:

The good news in the latest Flow of Funds data is therefore that a slowdown in the rate of deleveraging can impart a positive impetus to employment. However the bad news is that the economy is now hostage to changes in the rate of deleveraging, from levels of debt that far exceed anything it has ever experienced beforehand. Since much of this debt was taken on to finance speculation on asset prices rather than genuine investment, it is highly likely that deleveraging will accelerate in the future, as speculators tire—literally as well as metaphorically—of carrying large debt loads that finance stagnant or declining asset prices.

So, using completely different analytical methods, Steve Keen arrived at pretty much the same end result as Dr Gary Shilling whose analysis of the “four cylinders” that together power growth was presented here a couple of days ago: that the economy is in a very vulnerable state, and that we are one shock away from a second leg down in the US (and global) recession.

For those not familiar with Steve Keen’s work, he is one of very few economists worldwide to have accurately predicted and warned about the global financial crisis. The centerpiece of his work is the great emphasis he places on changes in debt levels as a big driver of changes in employment and output. In his own words,

This is obvious when one considers aggregate demand as I define it: the sum of GDP plus the change in debt (where this demand is spread across both goods & services and the asset markets).

Is there empirical evidence in support of this unconventional definition of aggregate demand? Steve supplies plenty on his blog, including this chart:

Click to read Steve Keen's entire post where this chart appears.

Although Steve explains that he feels aggregate demand including demand for assets is falling despite the small rise in employment, he goes on to embrace new concepts similar to his own proposed by other economists, where the “change in the change in the debt levels” or the “acceleration of debt” was correlated with, and a leading indicator of, employment. I think that a better explanation for the employment pickup seen in Steve’s numbers – and I am not sure where he got his unemployment numbers – was the huge (but unsustainable) increase in public debt levels offsetting the private deleveraging, plus the short-term hiring for the census.

That was the empirical half of my critique. The theoretical half is the following: all other things being equal, when private debt created is outweighed by private debt repaid, money is taken out of private sector circulation and therefore either the private sector velocity of circulation of money must rise, or private sector aggregate demand must fall (naturally, defining money to include tokens that were first created as bank credit). It does not make sense to me that a slowdown in deleveraging (positive second order derivative whilst first order derivative is still negative) would directly help aggregate demand. Rather, the positive second order derivative might be a good leading indicator of a potential imminent bottoming followed by a change of sign of the first derivative. Steve in fact pinpointed both features, that the falling aggregate demand went to the asset side of the economy, and that the second order derivative was empirically shown to be a leading indicator. Overall, my theoretical point is that with the first derivative in deep negative territory (see the chart above) I can’t see how the second derivative could directly help employment or output.

Turning back to real world data, other things are not equal of course, and in the numbers that Steve has been analyzing the government had stepped in with unsustainable firefighting efforts – huge deficits and large scale temporary hiring of census workers. So in my estimation, it is too early to analyse the data. Much more time is needed to distinguish what might ultimately amount to mere noise, out of the real trendlines that will play out in the coming months and years, whether in the form of a recovery or a second leg down.