Has Debt-Deflation Begun?

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Today’s CPI data from the US Bureau of Labor Sta­tis­tics reveals that con­sumer prices fell by 1 per­cent in the month of Sep­tem­ber. This is the steep­est month­ly fall in the index since Jan­u­ary 1938, and comes after two pre­vi­ous month­ly falls (of 0.4 and 0.14 per­cent). It is there­fore pos­si­ble that a debt-defla­tion­ary process is under­way.

Monthly Change in US CPI since 1924

Month­ly Change in US CPI since 1924

There is no doubt that we are in a debt-induced eco­nom­ic cri­sis; Amer­i­ca may now have entered a defla­tion­ary cri­sis as well. The com­bi­na­tion of the two is the motive force that sets in train a Depres­sion, as Irv­ing Fish­er explained in 1933, in his aca­d­e­m­ic paper “The Debt-Defla­tion The­o­ry of Great Depres­sions” (Econo­met­ri­ca, 1933, Vol­ume 1, pp. 337–357).

Accord­ing to Fish­er, the steps that lead from a debt cri­sis, to falling prices, and a Depres­sion are:

(1) Debt liq­ui­da­tion leads to dis­tress sell­ing and to

(2) Con­trac­tion of deposit cur­ren­cy, as bank loans are paid off, and to a slow­ing down of veloc­i­ty of cir­cu­la­tion. This con­trac­tion of deposits and of their veloc­i­ty, pre­cip­i­tat­ed by dis­tress sell­ing, caus­es

(3) A fall in the lev­el of prices, in oth­er words, a swelling of the dol­lar. Assum­ing, as above stat­ed, that this fall of prices is not inter­fered with by refla­tion or oth­er­wise, there must be

(4) A still greater fall in the net worths of busi­ness, pre­cip­i­tat­ing bank­rupt­cies and

(5) A like fall in prof­its, which in a “cap­i­tal­is­tic,” that is, a pri­vate-prof­it soci­ety, leads the con­cerns which are run­ning at a loss to make

(6) A reduc­tion in out­put, in trade and in employ­ment of labor. These loss­es, bank­rupt­cies, and unem­ploy­ment, lead to

(7) Pes­simism and loss of con­fi­dence, which in turn lead to

(8) Hoard­ing and slow­ing down still more the veloc­i­ty of cir­cu­la­tion. The above eight changes cause

(9) Com­pli­cat­ed dis­tur­bances in the rates of inter­est, in par­tic­u­lar, a fall in the nom­i­nal, or mon­ey, rates and a rise in the real, or com­mod­i­ty, rates of inter­est.” (Econo­met­ri­ca, 1933, Vol­ume 1, p. 342)

This process is stark­ly appar­ent in the US data. After 1930, every­one in the USA was try­ing to reduce debt–but the debt to GDP ratio rose nonethe­less.

US Debt to GDP Ratio 1925-1935

US Debt to GDP Ratio 1925–1935

The ratio rose because prices fell by up to 10 per­cent per annum, and real GDP also col­lapsed by as much as 13 per­cent in one year (the GDP data is year­ly and there­fore under­states the steep­ness of the fall in out­put). Attempts by indi­vid­u­als to pay down their debts were swamped by prices and incomes that fell faster still. The phe­nom­e­non that, as he put it, “the more debtors pay, the more they owe”, deserves to be named “Fish­er’s Para­dox” in his hon­our.

Falling Prices and Falling Output

Falling Prices and Falling Out­put

That train of events is now quite pos­si­bly unfold­ing in the USA right now–and from a lev­el of debt that is twice as high (rel­a­tive to its GDP) as it was in 1929.

Americas modern debt bubble dwarfs the one that caused the Great Depression

Amer­i­ca’s mod­ern debt bub­ble dwarfs the one that caused the Great Depres­sion

Fish­er’s expla­na­tion of how the Great Depres­sion came about was one of the great, neglect­ed con­tri­bu­tions to eco­nom­ic the­o­ry. There are two rea­sons why it was neglected–one trag­ic, the oth­er scan­dalous.

The tragedy was that, pri­or to the Great Depres­sion, Fish­er was the pre-emi­nent aca­d­e­m­ic cheer­leader for the boom of the Roar­ing Twen­ties, and he had also invest­ed his for­tune in mar­gin-loan-financed stock pur­chas­es. His rep­u­ta­tion was destroyed when, in the mid­dle of the mar­ket crash, he made the fol­low­ing pro­nounce­ment (which was duly report­ed in the New York Times):

Stock prices have reached what looks like a per­ma­nent­ly high plateau.

I do not feel that there will soon, if ever, be a fifty or six­ty point break below present lev­els, such as Mr. Bab­son has pre­dict­ed. I expect to see the stock mar­ket a good deal high­er than it is today with­in a few months.”

His for­tune was destroyed by the mar­gin calls that came with the col­lapse. Hav­ing made a tidy sum by invent­ing the Rolodex and sell­ing it to the Rand Cor­po­ra­tion, his paper worth (in 2000 dol­lar terms) was well over $100 mil­lion. He lost the lot and was only saved from bank­rupt­cy by his wife’s sis­ter’s wealth, and her for­give­ness of his debts to her on her deathbed.

In a reverse of the old para­ble about “the boy who cried wolf”, Fish­er’s accu­rate diag­no­sis of the caus­es of the Great Depres­sion was taint­ed by his pre­vi­ous fail­ure to see it com­ing, and by his mis­lead­ing assur­ances to the pub­lic that there was noth­ing to wor­ry about.

The scan­dal is that, after he dra­mat­i­cal­ly revised his approach to eco­nom­ics and came up with a cogent expla­na­tion of the process that could cause a Depres­sion, his work was ignored by the eco­nom­ics pro­fes­sion because it was incom­pat­i­ble with the con­cept of equi­lib­ri­um. I will cov­er this issue in much more detail in my next Debt­watch Report in Decem­ber, but here is a quick pre­cis.

The dom­i­nant eco­nom­ic the­o­ry of the 1920s assumed that the econ­o­my was always in over­all equi­lib­ri­um, and would tend back to equi­lib­ri­um from any dis­tur­bance. Fish­er sub­scribed to this belief, and devel­oped the appli­ca­tion of this the­o­ry to finance.

In the ear­ly 1930s, chas­tened and effec­tive­ly bank­rupt­ed, Fish­er came to appre­ci­ate that a mis­guid­ed belief in equi­lib­ri­um was the rea­son he had failed to antic­i­pate the Great Depres­sion. He rea­soned that, even if the econ­o­my did in fact tend towards equi­lib­ri­um, in the real world “New dis­tur­bances are, human­ly speak­ing, sure to occur, so that, in actu­al fact, any vari­able is almost always above or below the ide­al equi­lib­ri­um”.

The world there­fore had to be analysed using dis­e­qui­lib­ri­um thinking–and using this insight, he devel­oped the debt-defla­tion analy­sis, in which he rea­soned that the “two dom­i­nant fac­tors” that cause a Depres­sion are “over-indebt­ed­ness to start with and defla­tion fol­low­ing soon after”.

Fol­low­ing Fish­er’s lead would thus have required the eco­nom­ics pro­fes­sion to aban­don the prac­tice it had developed–of analysing the econ­o­my as if it were always in equilibrium–and take on a new, chal­leng­ing approach of mod­el­ling dis­e­qui­lib­ri­um process­es.

Faced with this choice, the eco­nom­ics pro­fes­sion did what it has always to date done–it obfus­cat­ed and bifur­cat­ed. The dom­i­nant  major­i­ty of the pro­fes­sion ignored Fish­er’s argu­ments, and stuck with the famil­iar tools of equi­li­bi­um analy­sis; only a minor­i­ty (most notably Hyman Min­sky) heed­ed Fish­er’s warn­ing.

Today, econ­o­mists trained in the major­i­ty tradition—who almost cer­tain­ly did­n’t study Fish­er in their uni­ver­si­ty cours­es, and who cer­tain­ly did­n’t fol­low his guid­ance in their eco­nom­ic analysis—continue to analyse the econ­o­my using mod­els that pre­sume it tends towards equi­lib­ri­um.

Worse still, these mod­els ignore com­plete­ly the issue that Fish­er empha­sised was the most impor­tant one—the lev­el of pri­vate debt. And econ­o­mists who believe in them occu­py all the offi­cial posi­tions in Trea­suries and Cen­tral Banks around the world. Politi­cians fol­low­ing their advice can be for­giv­en for not real­is­ing that they are being mis­led, because even those econ­o­mists them­selves don’t realise it (though they are begin­ning to appre­ci­ate this les­son the hard way–see Aus­trali­a’s RBA Gov­er­nor Glenn Steven­s’s com­ment yes­ter­day that the cur­rent finan­cial cri­sis has taught Cen­tral Bankers that they “could have a more con­ser­v­a­tive atti­tude to debt build-up”.

The eco­nom­ic cri­sis we are now expe­ri­enc­ing is in no small mea­sure a prod­uct of that aca­d­e­m­ic deci­sion to ignore debt, and to mod­el the econ­o­my as if it is always in equi­lib­ri­um. Had eco­nom­ics instead fol­lowed Fish­er’s lead, our eco­nom­ic man­agers would have been attuned to the dan­gers of exces­sive debt, and aware of the ten­den­cy for the econ­o­my to under­go bouts of debt-financed exu­ber­ance that dri­ve it far from equilibrium–and poten­tial­ly to the brink of a debt-defla­tion.

With the appar­ent devel­op­ment of a defla­tion­ary trend in Amer­i­ca, we may now have tak­en the first step over that precipice.

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About Steve Keen

I am Professor of Economics and Head of Economics, History and Politics at Kingston University London, and a long time critic of conventional economic thought. As well as attacking mainstream thought in Debunking Economics, I am also developing an alternative dynamic approach to economic modelling. The key issue I am tackling here is the prospect for a debt-deflation on the back of the enormous private debts accumulated globally, and our very low rate of inflation.