Steve Keen's Urgent Warning: The Debt Bubbles About to Pop (and What Comes Next)

Economist Steve Keen critiques the failure of economic models to incorporate banking and credit, asserting that exploding debt bubbles will inevitably trigger the next financial crisis. He warns of an impending economic contraction in highly indebted nations like China, Australia, and Canada, advocating for radical government intervention, such as a "debt jubilee," to avert severe deflation.

Key Takeaways

• Private debt levels above 200% of GDP create unavoidable economic black holes that trap entire nations in deflationary spirals.
• China's credit expansion jumped 40% of GDP in 2009 alone, creating massive ghost cities and unsustainable property speculation bubbles.
• Australia, Canada, and South Korea now carry dangerous debt levels exceeding 200-240% of GDP, surpassing pre-2008 American crisis thresholds.
• Banks function as money factories, not warehouses, creating credit that directly adds to economic demand until debt limits are reached.
• Neoclassical economics fundamentally fails because its models cannot generate depressions, ignoring the role of banking and credit cycles entirely.
• Government balance sheet interventions through targeted debt reduction could prevent economic collapse, but require careful implementation to avoid runaway inflation.
• Business cycles inevitably accumulate debt over time, with each boom leaving higher baseline debt levels that eventually become unsustainable.
• The physiocrats of the 1600s understood energy and resource flows better than modern economists who ignore thermodynamic laws.

Timeline Overview

• 00:00–15:00 — Introduction to Steve Keen's background as crisis predictor; discussion of economic evolution from physiocrats through classical period, emphasizing energy flows and thermodynamics as foundation
• 15:00–30:00 — Transition to neoclassical economics with Newtonian mechanistic models; critique of rational preferences and equilibrium assumptions that ignore banks, debt, and money creation
• 30:00–45:00 — Keynesian revolution and synthesis discussion; Hicks' ISLM model limitations; Minsky's insight that economic models must be capable of generating depressions to be valid
• 45:00–60:00 — Banking system as money creators not intermediaries; credit expansion directly adds to demand; business cycle debt accumulation creating structural economic changes over time
• 60:00–75:00 — Balance sheet recession concept from Japan's lost decades; China's massive 2008 credit response creating ghost cities; debt-to-GDP thresholds around 150-260% triggering economic black holes
• 75:00–90:00 — Australia, Canada, South Korea debt levels analysis; inexorable nature of debt spiral once limits reached; modern debt jubilee solutions and balance sheet hack proposals with implementation challenges

The Foundation Crisis: Why Modern Economics Ignores Energy and Reality

Economics should have begun with the physiocrats of the late 1600s, who asked the fundamental question: where does stuff come from? Their answer recognized that agricultural productivity stemmed from free solar radiation, with seeds producing thousands of times more corn than initially planted. Manufacturing seemed "sterile" only because they didn't recognize that industrial processes harness solar energy stored millions of years ago in fossil fuels.

Adam Smith discarded this energy-centered framework, claiming wealth emerged from labor specialization instead. This critical error permeated economic thinking ever since, with economists forgetting that labor without energy becomes a corpse, while capital without energy becomes sculpture. The physiocrats remain the only school of economic thought consistent with thermodynamic laws.

The implications of this foundational error cannot be overstated. Modern economic models assume infinite substitutability between factors of production, treating the economy as a closed information system rather than recognizing its dependence on continuous energy inputs from the biosphere. This leads to absurd conclusions like the possibility of infinite economic growth on a finite planet, or the assumption that technological progress can overcome any resource constraint.

Contemporary environmental economics treats energy and natural resources as mere "externalities" - costs imposed on society that don't appear in market prices. This framework fundamentally misunderstands the role of energy as the primary driver of all economic activity. Every economic transaction involves the transformation of energy from one form to another, whether through human labor, machine operation, or material processing.

The disconnect between economic theory and physical reality explains why mainstream models consistently fail to predict resource crises, environmental degradation, or the economic impacts of energy price shocks. Climate change economics becomes nearly impossible to model accurately when the foundational framework ignores the thermodynamic basis of economic activity.

Steve Keen argues that returning to physiocratic insights about energy while incorporating classical insights about class conflict and modern understanding of financial systems would create far more robust economic theories. This would mean explicitly modeling energy flows, resource depletion rates, and the physical constraints that ultimately limit economic growth regardless of financial or technological innovations.

The Neoclassical Deception: How Equilibrium Models Deny Financial Reality

Neoclassical economics emerged in the late 19th century with the explicit purpose of neutralizing Marx's critique of capitalism. These economists replaced the classical focus on production costs with subjective utility theory, treating capitalism as a perfect trading system where consumers maximize utility while firms maximize profits, meeting in equilibrium.

This mechanistic approach required ignoring banks, debt, money creation, and disequilibrium conditions to make the mathematics work on paper. When mathematicians in the 1920s proved these equilibrium models were inherently unstable, economists simply assumed hyperintelligent agents capable of accurately predicting the future and jumping directly to equilibrium points.

The rational expectations assumption requires market participants to possess prophetic abilities, accurately forecasting complex economic outcomes. This absurd requirement became standard in models still used today, despite their mathematical foundations being disproven nearly a century ago.

The deeper problem lies in neoclassical economics' treatment of markets as mechanical systems subject to Newtonian physics principles. Just as Newton's laws describe predictable planetary motions, neoclassical economists envisioned supply and demand forces creating predictable market equilibria. This analogy breaks down completely when applied to human behavior and complex economic systems.

Behavioral economics has systematically demolished core neoclassical assumptions through experimental evidence. The ultimatum game reveals that humans routinely reject economically "rational" offers, preferring fairness over pure self-interest. Prospect theory demonstrates that people value losses differently than equivalent gains, violating utility maximization principles. Cognitive biases like anchoring, framing effects, and herd behavior contradict the assumption of rational, independent decision-making.

Yet these behavioral insights remain marginalized in mainstream economic modeling. Central banks and government agencies continue using Dynamic Stochastic General Equilibrium models based on rational expectations and market clearing assumptions. These models failed spectacularly to predict the 2008 financial crisis because they cannot generate endogenous instability or financial crises by design.

The mathematical requirements for equilibrium models become even more problematic when extended to multiple markets. Sonnenschein-Mantel-Debreu theorems prove that market demand curves derived from individual utility maximization can take virtually any shape, making aggregate market behavior unpredictable even if individuals behave rationally. This mathematical impossibility forced economists to assume representative agents - imaginary individuals whose preferences supposedly represent entire populations.

Modern economists remain trapped in geometric thinking patterns designed for drawing intersecting lines on paper, unable to embrace computational approaches that could model realistic economic behavior with feedback loops, path dependence, and emergent properties. They continue using 19th-century mathematical tools to analyze 21st-century economic complexity, producing elegant theories with little connection to observable economic phenomena.

Keynesian Insights Betrayed: How the Revolution Was Hijacked

John Maynard Keynes attempted to inject realism into economic theory by recognizing uncertainty, limited information, and instability in market behavior. His 1937 summary paper emphasized the unknowable nature of future economic conditions and the psychological foundations of investment decisions that create waves of exuberance and depression.

However, John Hicks created the ISLM model as an alleged interpretation of Keynesian economics, later admitting this model was developed before he even read Keynes. The "neoclassical synthesis" co-opted Keynes' name while subverting his core insights about fundamental uncertainty and instability, treating government intervention as merely another equilibrium adjustment mechanism.

Keynes' revolutionary insight centered on the concept of fundamental uncertainty - not risk that can be calculated probabilistically, but true uncertainty about future states that cannot be quantified or predicted. This uncertainty forces businesses to make investment decisions based on "animal spirits" rather than rational calculation, creating inherent instability in capitalist economies.

The liquidity preference theory represented another major departure from classical thinking. Unlike neoclassical models where interest rates balance saving and investment through supply and demand, Keynes argued that interest rates reflect people's preference for holding money versus bonds based on uncertainty about future bond prices. This makes monetary policy transmission unpredictable and dependent on psychological factors rather than mechanical relationships.

Investment decisions drive economic fluctuations in Keynesian theory, not consumption patterns as neoclassical models suggest. When business confidence collapses, investment falls dramatically regardless of interest rate reductions, creating what Keynes called a "liquidity trap" where monetary policy becomes ineffective. Only fiscal policy can restore aggregate demand by directly injecting spending into the economy.

The multiplier effect demonstrates how initial government spending creates cascading increases in economic activity as recipients spend their additional income, generating further rounds of economic activity. This dynamic process contradicts neoclassical assumptions about government spending "crowding out" private investment through higher interest rates.

Keynes also understood that financial markets operate more like beauty contests than efficiency mechanisms. Investors try to predict what other investors think will be popular, creating speculative bubbles disconnected from underlying economic fundamentals. This perspective anticipated modern behavioral finance insights about market psychology and herd behavior.

The tragedy of Keynesian economics lies in how quickly his insights were domesticated and neutered by the academic establishment. Paul Samuelson's "neoclassical synthesis" treated Keynesian policies as temporary fixes for market imperfections rather than recognizing the fundamental instability that Keynes identified as inherent to capitalism.

By the 1970s, stagflation provided an excuse to abandon even bastardized Keynesianism in favor of supply-side economics and monetarism. The rise of rational expectations theory explicitly rejected Keynesian insights about uncertainty and animal spirits, returning to the mechanical equilibrium models that Keynes had attempted to overthrow. This intellectual regression set the stage for the financial instability and recurring crises that Keynes had warned against.

Banking Exposed: The Money Creation Machine Behind Economic Cycles

Banks function as money factories, not the intermediation warehouses that neoclassical theory portrays. When approving loans, banks simultaneously create both the asset (borrower's debt) and the liability (money deposited in the borrower's account) through accounting entries, directly adding to economic demand without requiring existing deposits.

This contradicts mainstream "loanable funds" theory that treats banks like matchmaking services connecting savers with borrowers. The reality is far more consequential: banks create money ex nihilo (out of nothing) through the lending process, making them central players in determining aggregate demand rather than passive intermediaries.

The mechanics of money creation reveal why credit expansion drives economic booms while credit contraction causes busts. When a bank approves a $100,000 business loan, it creates $100,000 in new money that didn't previously exist. The borrower uses this money to purchase equipment, hire workers, or invest in expansion, directly adding to economic activity. Simultaneously, the economy's money supply increases by $100,000, providing additional liquidity for other transactions.

Conversely, when borrowers repay loans, money disappears from circulation. The $100,000 repayment reduces both the bank's assets (the loan) and liabilities (deposits), effectively destroying the money that was created during the original lending process. This asymmetric relationship between credit creation and destruction creates inherent instability in monetary systems.

Reserve requirements and capital adequacy ratios theoretically constrain bank lending, but these limits are far less restrictive than commonly believed. Banks can expand credit substantially before hitting regulatory constraints, and central bank policies often accommodate increased lending through additional reserves or reduced requirements during economic expansions.

The endogenous money theory developed by post-Keynesian economists like Basil Moore demonstrates that money supply responds to money demand rather than being exogenously controlled by central banks. When creditworthy borrowers demand loans for profitable investments, banks typically accommodate this demand, expanding the money supply accordingly. Central banks then provide the necessary reserves to support this lending ex post facto.

This process explains why monetary aggregates like M1 and M2 correlate poorly with economic activity in empirical studies. The relevant variable is not the stock of money but the flow of new credit creation, which directly translates into additional aggregate demand. Steve Keen's empirical work shows strong correlations between credit acceleration and economic growth across multiple countries and time periods.

Hyman Minsky's financial instability hypothesis builds on this understanding of endogenous money creation. During economic expansions, successful borrowers encourage both banks and borrowers to take increased risks, leading to progressively more speculative lending practices. "Hedge finance" (where borrowers can service both principal and interest) gives way to "speculative finance" (where borrowers can only service interest) and eventually "Ponzi finance" (where borrowers must borrow additional money to service existing debt).

This evolutionary process is endogenous to the credit creation mechanism itself. Banks, motivated by profit opportunities and competitive pressures, gradually relax lending standards and extend credit to increasingly marginal borrowers. The initial success of these loans validates the strategy, encouraging further expansion until the system becomes dangerously leveraged.

The 2008 financial crisis exemplified this dynamic perfectly. Mortgage lending evolved from conservative 20% down payment requirements to NINJA loans (No Income, No Job, No Assets verification) with zero down payments. Banks securitized these mortgages and sold them to investors, believing they had transferred the risk while retaining the profits from loan origination fees.

Understanding banking as money creation rather than intermediation transforms macroeconomic analysis fundamentally. Fiscal and monetary policy effectiveness depends critically on the banking system's willingness and ability to expand credit. During financial crises, when banks restrict lending regardless of central bank policy, only direct government spending can restore aggregate demand and economic stability.

The Debt Trap Mechanics: How Countries Fall Into Economic Black Holes

Private debt accumulates during each business cycle, creating a ratcheting effect where each boom begins with higher baseline debt levels. Countries hit critical thresholds around 150-260% of GDP, beyond which market mechanisms cannot restore growth without external intervention.

When credit growth approaches zero after reaching these limits, economies lose crucial aggregate demand. The United States experienced this in 2008 when private credit fell from +15% to -5% of GDP. Australia, Canada, South Korea, and China currently operate with debt levels between 200-240% of GDP while depending on annual credit expansion of 10-30% of GDP to maintain employment.

China's Spectacular Bubble and Global Implications

China's response to the 2008 crisis created history's largest credit expansion, jumping 40% of GDP in 2009 as the government ordered banks to lend to anyone "with a pulse" to maintain social stability. This funded both infrastructure projects and speculative developments that created ghost cities with millions of uninhabitable apartment shells.

Chinese citizens purchased these incomplete properties as savings vehicles because bank deposits offered poor returns, creating a Ponzi scheme where rising prices justified continuous speculation. China's private debt has grown from 100% of GDP in 2008 to over 200% today, placing it in the danger zone where further credit expansion becomes mathematically impossible.

The scale and speed of China's credit expansion dwarfs previous historical examples. Japan's bubble economy of the 1980s took nearly a decade to build similar leverage ratios, while China achieved comparable debt levels in less than five years. This compressed timeframe suggests that the eventual unwinding could be correspondingly rapid and severe.

The political economy of Chinese credit creation reveals unique vulnerabilities absent in market economies. State-owned enterprises (SOEs) receive preferential lending regardless of profitability, creating massive inefficiencies and bad debt accumulation. Local government financing vehicles (LGFVs) borrowed trillions of yuan for infrastructure projects with questionable economic returns, using land sales as collateral in an unsustainable feedback loop.

China's household savings rate, historically above 20% of income, enabled the rapid accumulation of property wealth during the boom years. However, demographic trends suggest this savings rate will decline as the population ages and the one-child policy's effects reduce family support systems. Lower savings rates will constrain domestic funding for continued credit expansion just as debt servicing needs increase.

The geographic concentration of China's property speculation creates additional systemic risks. First-tier cities like Beijing and Shanghai experienced price appreciation comparable to historical bubbles, with price-to-income ratios exceeding 40 in some districts. Second and third-tier cities built massive oversupply in anticipation of continued urbanization, but migration patterns have not materialized as expected.

Corporate debt represents an even larger problem than household debt in China's case. Non-financial corporate debt reached 160% of GDP by 2020, concentrated in industries like steel, coal, and construction with severe overcapacity problems. Many SOEs operate at losses while continuing to access credit through government guarantees, creating zombie companies that drain resources from productive sectors.

The shadow banking system's rapid growth complicates efforts to measure and control China's total debt burden. Wealth management products, trust companies, and off-balance-sheet financing vehicles expanded rapidly to circumvent regulatory constraints, creating interconnected webs of liability that obscure the true extent of leverage throughout the system.

China's external position adds another dimension of vulnerability. The country's current account surplus has declined significantly from its peak levels, reducing the buffer available to finance domestic deleveraging. Capital flight pressures have intensified as wealthy Chinese seek to diversify their holdings internationally, putting downward pressure on the yuan and constraining monetary policy options.

The Belt and Road Initiative represents an attempt to export excess capacity and leverage China's construction industry internationally. However, many recipient countries have struggled with debt sustainability, creating potential diplomatic and financial complications as projects fail to generate expected returns. Sri Lanka's forced lease of Hambantota Port illustrates the geopolitical risks associated with China's debt-driven development model.

Environmental costs compound the economic risks of China's credit-fueled growth model. Rapid industrialization and urbanization have created severe pollution problems that require massive remediation investments. The transition to renewable energy, while necessary for long-term sustainability, requires additional capital expenditure that competes with debt service obligations.

When China's credit expansion inevitably slows or reverses, the global implications will be profound. China's imports of commodities, intermediate goods, and capital equipment drive growth in numerous countries across Asia, Africa, and Latin America. A significant reduction in Chinese demand could trigger recessions in commodity-dependent economies while reducing global trade volumes substantially.

The timing of China's debt crisis remains uncertain but appears increasingly difficult to delay indefinitely. Property sales volumes have declined in major cities, corporate bond defaults have increased, and local governments face mounting fiscal pressures. The Chinese government's emphasis on "common prosperity" and reduced inequality may conflict with the continued leverage accumulation needed to maintain high growth rates.

The Balance Sheet Solution: Modern Debt Jubilee Implementation

Steve Keen proposes using government money creation to simultaneously reduce private debt and provide cash to non-debtors, avoiding traditional jubilee unfairness. The mechanism distributes money equally to all citizens, with debtors using their portion for debt reduction while non-debtors receive cash to purchase corporate shares for debt paydown.

This recognizes that governments and banks both create money, but government creation doesn't burden recipients with debt obligations. Implementation faces challenges including legal complexities, inflation risks, and market gaming, requiring gradual, monitored rollout rather than immediate debt elimination.

The theoretical foundation for debt jubilee policies rests on the recognition that excessive private debt creates deflationary forces that market mechanisms cannot overcome. Unlike normal recessions where falling prices eventually restore equilibrium, balance sheet recessions feature debt-deflation spirals where declining asset prices increase debt burdens relative to income, forcing further deleveraging that deepens the economic contraction.

Irving Fisher's debt-deflation theory, largely ignored by mainstream economists, provides the intellectual framework for understanding why debt reduction becomes necessary. Fisher observed that overleveraged economies experience cascading effects where falling prices increase real debt burdens, forcing borrowers to sell assets, which depresses prices further, creating a vicious cycle that continues until debt levels are reduced through default, inflation, or direct cancellation.

Modern debt jubilee proposals must address several practical challenges absent from historical precedents. Contemporary financial systems feature complex securitization structures where mortgage-backed securities, collateralized debt obligations, and other instruments scatter ownership across multiple parties. Legal frameworks for debt reduction would need to navigate these complexities while ensuring fair treatment of all stakeholders.

The inflation question represents perhaps the most significant policy challenge. Injecting money directly into the economy while simultaneously reducing debt loads could potentially trigger rapid price increases if not carefully calibrated. However, Keen argues that the deflationary forces created by debt reduction would largely offset the inflationary impact of money creation, particularly if the policy targets debt reduction rather than consumption stimulation.

Sectoral targeting would be essential for effective implementation. Household debt reduction would provide the most direct benefit to aggregate demand since families have higher marginal propensities to consume than corporations or wealthy individuals. However, corporate debt reduction might be necessary to restore business investment and employment, particularly in highly leveraged industries.

The democratic ownership aspect of Keen's proposal deserves particular attention. By requiring non-debtors to use their jubilee funds to purchase corporate equity, the policy would redistribute ownership of productive assets while reducing corporate leverage. This could address growing inequality concerns while providing a political constituency for debt reduction policies beyond direct beneficiaries.

International coordination challenges complicate jubilee implementation in open economies. Countries implementing debt reduction unilaterally might face capital flight as investors seek higher returns elsewhere. Exchange rate effects could either amplify or offset the domestic impact depending on trade patterns and capital mobility. Coordinated action among major economies would likely prove more effective but exponentially more difficult to negotiate.

The sequencing of debt reduction requires careful consideration of systemic risks. Reducing mortgage debt before corporate debt might trigger corporate bankruptcies as consumer demand shifts from debt service to consumption. Conversely, corporate debt reduction before household deleveraging might benefit shareholders more than workers. Simultaneous reduction across sectors would be ideal but administratively complex.

Central bank cooperation would be essential for successful implementation. The monetary authority would need to accommodate the fiscal expansion required for debt jubilee while managing inflation expectations and exchange rate stability. This might require fundamental changes to central bank mandates and operational frameworks that currently prioritize price stability over financial stability.

Political feasibility represents the ultimate constraint on debt jubilee policies. Financial sector opposition would be intense given the direct impact on banking profitability and asset values. Wealthy savers might resist policies that reduce the relative value of their holdings through inflation or currency depreciation. Building sufficient political support would require clear demonstration that the alternative - continued debt deflation and economic stagnation - imposes even greater costs on society.

Historical precedents provide some guidance for modern implementation. Germany's post-World War II currency reform effectively eliminated private debt while providing a foundation for rapid economic growth. However, the extreme circumstances of wartime destruction and occupation created political conditions unlikely to be replicated in peacetime democratic societies.

The timing of intervention proves crucial for effectiveness. Implementing debt reduction policies before financial crisis strikes would be far more efficient than emergency responses after collapse occurs. However, the political will for proactive intervention typically emerges only after crisis conditions create widespread economic pain, by which point the costs and complexities of intervention have increased substantially.

Conclusion

Steve Keen's analysis exposes fundamental flaws in mainstream economic thinking that ignore energy flows, banking realities, and debt dynamics. With China, Australia, Canada, and South Korea carrying dangerous debt levels above 200% of GDP, the next financial crisis appears inevitable unless governments implement proactive debt reduction strategies. The choice facing policymakers is stark: engineer managed solutions now through balance sheet interventions, or face chaotic collapse when mathematical debt limits are reached and credit expansion becomes impossible.

Practical Questions & Answers

Q: What early warning signs should investors watch for the next crisis? A: Monitor when credit growth in high-debt countries approaches zero, property speculation peaks, and central banks exhaust monetary policy tools. China's property market and Australian household debt levels deserve particular attention as leading indicators.

Q: Why don't government bailouts and quantitative easing solve debt problems?

A: These policies address liquidity issues but not the fundamental demand problem. Only direct government spending that doesn't create equivalent private debt can offset the deflationary spiral caused by excessive private sector leverage.

Q: How realistic is implementing a modern debt jubilee politically?

A: Extremely difficult given vested financial interests and ideological resistance to admitting mainstream economic models are wrong. Keen deliberately wrote a short book hoping politicians might actually read it, but expects crises to force solutions rather than proactive policy changes.

Q: What differentiates this debt situation from previous economic cycles?

A: Scale and mathematical limits. Unlike normal recessions where markets self-correct, balance sheet recessions occur when debt levels become so high that private sector deleveraging creates permanent deflationary forces requiring government intervention to break the cycle.

Q: Which sectors would benefit most from debt jubilee policies?

A: Highly leveraged households and corporations would see direct debt relief, while savers would receive cash or equity stakes. The broader economy benefits from restored demand and investment, though financial sector profits would decline significantly.

Q: How long before these debt limits trigger the next crisis?

A: Impossible to predict precisely, but mathematical constraints suggest countries at 200-240% debt levels cannot sustain current credit expansion rates indefinitely. External shocks could accelerate the timeline, but internal debt dynamics make crisis inevitable regardless.