Bernanke an Expert on the Great Depression??

flattr this!

Note: This post has been modified ni the light of comments that the initial version quoted Bernanke out of context.

A link to this blog from a US legal advisory website the Practising Law Institute's In Brief ( "DEFLATION IN THE REAL WORLD”) reminded me of  Bernanke’s book Essays on the Great Depres­sion, which I’ve been aware of for some time but have yet to read. I’ll make amends on that front early this year; for­tu­nately, an extract from Chap­ter One is avail­able as a pre­view on the Prince­ton site (I couldn’t locate the promised eBook any­where!; in what fol­lows, when I quote Bernanke it is from the orig­i­nal jour­nal paper pub­lished in 1995, rather than this chapter).

To put it mildly, Bernanke’s analy­sis is not promising.

The most glar­ing prob­lem on first glance is that, despite Bernanke’s claim in Chap­ter One “THE MACROECONOMICS OF THE GREAT DEPRESSION: A Com­par­a­tive Approach” that he will sur­vey “our cur­rent under­stand­ing of the Great Depres­sion”, there is only a brief, twisted ref­er­ence to Irv­ing Fisher’s Debt Defla­tion The­ory of Great Depres­sions, and no dis­cus­sion at all of Hyman Minsky’s con­tem­po­rary Finan­cial Insta­bil­ity Hypoth­e­sis (and a blog­ger informed me that his entire ref­er­ence to Min­sky in the book amounted to one dis­cus­sion and one foot­note, which I’ll get to later on).

While he does dis­cuss Fisher’s the­ory, he pro­vides only a par­ody of it–in which he nonethe­less notes that Fisher’s pol­icy advice was influential:

Fisher envi­sioned a dynamic process in which falling asset and com­mod­ity prices cre­ated pres­sure on nom­i­nal debtors, forc­ing them into dis­tress sales of assets, which in turn led to fur­ther price declines and finan­cial dif­fi­cul­ties. His diag­no­sis led him to urge Pres­i­dent Roo­sevelt to sub­or­di­nate exchange-rate con­sid­er­a­tions to the need for refla­tion, advice that (ulti­mately) FDR followed.

He then explains that neo­clas­si­cal econ­o­mists in gen­eral read­ily dis­missed Fisher’s the­ory, for rea­sons that are very instructive:

Fisher’s idea was less influ­en­tial in aca­d­e­mic cir­cles, though, because of the coun­ter­ar­gu­ment that debt-deflation rep­re­sented no more than a redis­tri­b­u­tion from one group (debtors) to another (cred­i­tors). Absent implau­si­bly large dif­fer­ences in mar­ginal spend­ing propen­si­ties among the groups, it was sug­gested, pure redis­tri­b­u­tions should have no sig­nif­i­cant macro­eco­nomic effects. ” (Bernanke 1995, p. 17)

Bernanke him­self does try to make sense of Fisher within a neo­clas­si­cal frame­work, which I’ll get to below; but the gen­eral neo­clas­si­cal reac­tion to Fisher that he describes is a per­fect exam­ple of the old (and very apt!) joke that an econ­o­mist is some­one who, hav­ing heard that some­thing works in prac­tice, then ripostes “Ah! But does it work in theory?”.

It is also–I’m sorry, there’s just no other word for it–mind-numbingly stu­pid. A debt-deflation trans­fers income from debtors to cred­i­tors? From, um, peo­ple who default on their mort­gages to the peo­ple who own the mortgage-backed secu­ri­ties, or the banks?

Well then, put your hands up, all those cred­i­tors who now feel sub­stan­tially bet­ter off cour­tesy of our con­tem­po­rary debt-deflation…

What??? No-one? But surely you can see that in the­ory

The only way that I can make sense of this non­sense is that neo­clas­si­cal econ­o­mists assume that an increase in debt means a trans­fer of income from debtors to cred­i­tors (equal to the ser­vic­ing cost of the debt), and that this has no effect on the econ­omy apart from redis­trib­ut­ing income from debtors to cred­i­tors. So ris­ing debt is not a problem.

Sim­i­larly, a debt-deflation then means that cur­rent nom­i­nal incomes fall, rel­a­tive to accu­mu­lated debt that remains con­stant. This increases the real value of inter­est pay­ments on the debt, so that a debt-deflation also causes a trans­fer from debtors to creditors–though this time in real (inflation-adjusted) terms.

Do I have to spell out the prob­lem here? Only to neo­clas­si­cal econ­o­mists, I expect: dur­ing a debt-deflation, debtors don’t pay the inter­est on the debt–they go bank­rupt. So debtors lose their assets to the cred­i­tors, and the cred­i­tors get less–losing both their inter­est pay­ments and large slabs of their prin­ci­pal, and get­ting no or dras­ti­cally deval­ued assets in return. Nobody feels bet­ter off dur­ing a debt-deflation (apart from those who have accu­mu­lated lots of cash before­hand). Both debtors and cred­i­tors feel and are poorer, and the prob­lem of non-payment of inter­est and non-repayment of prin­ci­pal often makes cred­i­tors com­par­a­tively worse off than debtors (just ask any of Bernie Madoff’s ex-clients).

Back to Bernanke’s take on Fisher, rather than the generic neo­clas­si­cal idiocy on debt-deflation. Firstly, Bernanke’s “sum­mary” of Fisher’s argu­ment starts with asset price defla­tion: “Fisher envi­sioned a dynamic process in which falling asset and com­mod­ity prices cre­ated pres­sure on nom­i­nal debtors…”.

Sorry Ben, but (to use a bit of crude Aus­tralian ver­nac­u­lar), this is an “arse about tit” read­ing of Fisher.  Fisher’s dynamic process began with exces­sive debt, not with falling asset prices. You have con­fused cause and effect in Fisher’s the­ory: exces­sive debt and the delever­ag­ing process that engen­dered lead to falling asset and com­mod­ity prices as symp­toms (which then amplify the ini­tial prob­lem of exces­sive debt in a pos­i­tive feed­back process). To make this con­crete, Fisher referred to:

two dom­i­nant fac­tors, namely over-indebtedness to start with and defla­tion fol­low­ing soon after” (Fisher 1933, p. 341)

I hope that’s clear enough that, in Fisher’s argu­ment, overindebt­ed­ness is the first fac­tor and defla­tion the second–and in fact, Fisher argues that overindebt­ed­ness causes defla­tion, if the ini­tial rate of infla­tion is low enough (he also coun­te­nances the sit­u­a­tion in which infla­tion is higher and defla­tion doesn’t even­tu­ate, which he argues won’t lead to a Depres­sion). Before I dis­cuss Bernanke’s own attempt to express what his mis­in­ter­pre­ta­tion of Fisher in neo­clas­si­cal form, it’s worth set­ting Fisher’s own causal sequence out in full. In his Econo­met­rica paper, Fisher argued that the process that leads to a Depres­sion is the following:

(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)

(Check this pre­vi­ous blog entry for more on this topic)

In its own way, this is a very sim­ple process to both under­stand and to model. To under­stand it, all we have to do is look at the cur­rent eco­nomic sit­u­a­tion in the USA–all nine stages of Fisher’s process are already well under way there. I’ve also mod­elled the debt com­po­nent of this process in my papers on finan­cial insta­bil­ity (and the defla­tion aspect too in other research I’ve yet to pub­lish, but which will be in my forth­com­ing book for Edward Elgar, Finance and Eco­nomic Break­down [expected pub­li­ca­tion date is 2011]).

So why didn’t Bernanke–and other neo­clas­si­cal economists–understand Fisher’s expla­na­tion and develop it?

Because an essen­tial aspect of Fisher’s rea­son­ing was the need to aban­don the fic­tion that a mar­ket econ­omy is always in equilibrium.

The notion that a mar­ket econ­omy is in equi­lib­rium at all times is of course absurd: if it were true, prices, incomes–even the state of the weather–would always have to be “just right” at all times, and there would be no eco­nomic news at all, because the news would always be that “every­thing is still per­fect”. Even neo­clas­si­cal econ­o­mists implic­itly acknowl­edge this by the way they analyse the impact of tar­iffs for exam­ple, by show­ing to their stu­dents how, by increas­ing prices, tar­iffs drive the sup­ply above the equi­lib­rium level and drive the demand below it.

The rea­son neo­clas­si­cal econ­o­mists cling to the con­cept of equi­lib­rium is that, for his­tor­i­cal rea­sons, it has become a dom­i­nant belief within that school that one can only model the econ­omy if it is assumed to be in equilibrium.

From the per­spec­tive of real sciences–and of course engineering–that is sim­ply absurd. The econ­omy is a dynamic sys­tem, and like all dynamic sys­tems in the real world, it will be nor­mally out of equi­lib­rium. That is not a bar­rier to math­e­mat­i­cally mod­el­ling such sys­tems however–one sim­ply has to use “dif­fer­en­tial equa­tions” to do so. There are also many very sophis­ti­cated tools that have been devel­oped to make this much eas­ier today–largely sys­tems engi­neer­ing and con­trol the­ory tech­nol­ogy (such as Simulink, Vis­sim, etc.)–than it was cen­turies ago when dif­fer­en­tial equa­tions were first developed.

Some neo­clas­si­cals are aware of this tech­nol­ogy, but in my expe­ri­ence, it’s a tiny minority–and the major­ity of bog stan­dard neo­clas­si­cal econ­o­mists aren’t even aware of dif­fer­en­tial equa­tions (they under­stand dif­fer­en­ti­a­tion, which is a more lim­ited but foun­da­tional math­e­mat­i­cal tech­nique). They believe that if a process is in equi­lib­rium over time, it can be mod­elled, but if it isn’t, it can’t. And even the “high priests” of eco­nom­ics, who should know bet­ter, stick with equi­lib­rium mod­el­ling at almost all times.

Equi­lib­rium has thus moved from being a tech­nique used when econ­o­mists knew no bet­ter and had no tech­nol­ogy to han­dle out of equi­lib­rium phenomena–back when Jevons, Wal­ras and Mar­shall were devel­op­ing what became neo­clas­si­cal eco­nom­ics in the 19th cen­tury, and thought that com­par­a­tive sta­t­ics would be a tran­si­tional method­ol­ogy prior to the devel­op­ment of truly dynamic analy­sis –into an “arti­cle of faith”. It is as if it is a denial of all that is good and fair about cap­i­tal­ism to argue that at any time, a mar­ket econ­omy could be in dis­e­qui­lib­rium with­out that being the fault of bungling gov­ern­ments or nasty trade unions and the like.

And so to this day, the pin­na­cle of neo­clas­si­cal eco­nomic rea­son­ing always involves “equi­lib­rium”. Lead­ing neo­clas­si­cals develop DSGE (“Dynamic Sto­chas­tic Gen­eral Equi­lib­rium”) mod­els of the econ­omy. I have no problem–far from it!–with mod­els that are “Dynamic”, “Sto­chas­tic”, and “Gen­eral”. Where I draw the line is “Equi­lib­rium”. If their mod­els were to be truly Dynamic, they should be “Dis­e­qui­lib­rium” models–or mod­els in which whether the sys­tem is in or out of equi­lib­rium at any point in time is no hin­drance to the mod­el­ling process.

Instead, with this fix­a­tion on equi­lib­rium, they attempt to analyse all eco­nomic processes in a hypo­thet­i­cal free mar­ket econ­omy as if it is always in equilibrium–and they do like­wise to the Great Depression.

Before the Great Depres­sion, Fisher made the same mis­take. His most notable con­tri­bu­tion (for want of a bet­ter word!) to eco­nomic the­ory was a model of finan­cial mar­kets as if they were always in equi­lib­rium.

Fisher was in some senses a pre­de­ces­sor of Bernanke: though he was never on the Fed­eral Reserve, he was America’s most renowned aca­d­e­mic econ­o­mist dur­ing the early 20th cen­tury. He ruined his rep­u­ta­tion for aeons to come by also being a news­pa­per pun­dit and cheer­leader for the Roar­ing Twen­ties stock mar­ket boom (and he ruined his for­tune by putting his money where his mouth was and tak­ing out huge mar­gin loan posi­tions on the back of the con­sid­er­able wealth he earned from invent­ing the Rolodex).

Chas­tened and effec­tively bank­rupted, he turned his mind to work­ing out what on earth had gone wrong, and after about three years he came up with the best expla­na­tion of how Depres­sions occur (prior to Minsky’s bril­liant blend­ing of Marx, Keynes, Fisher and Schum­peter in hisFinan­cial Insta­bil­ity Hypoth­e­sis [here’s another link to this paper]). 

Prior to this life-altering expe­ri­ence how­ever, as a faith­ful neo­clas­si­cal econ­o­mist, Fisher por­trayed the mar­ket for loans as essen­tially no dif­fer­ent from any other mar­ket in neo­clas­si­cal thought: it con­sisted of inde­pen­dent sup­ply of and demand func­tions, and a price mech­a­nism that set the rate of inter­est by equat­ing these two functions–thus putting the mar­ket into a state of equilibrium.

How­ever even with this abstrac­tion, he had to admit that there were two dif­fer­ences between the “mar­ket for loan­able funds” and a stan­dard com­mod­ity mar­ket: firstly that the loan­able fund mar­ket involves com­mit­ments over time, whereas in stan­dard neo­clas­si­cal mythol­ogy, com­mod­ity mar­kets are barter mar­kets where pay­ment and deliv­ery take place instan­ta­neously; and sec­ondly, it is unde­ni­able that some­times peo­ple don’t live up to those com­mit­ments over time–they go bankrupt.

Fisher dealt with these dif­fer­ences in the time-honoured neo­clas­si­cal man­ner: he assumed them away. He imposed two con­di­tions on his models:

“(A) The mar­ket must be cleared—and cleared with respect to every inter­val of time. (B) The debts must be paid.” ( Irv­ing Fisher, 1930, The The­ory of Inter­est. New York: Kel­ley & Mill­man p. 495)

Fisher did dis­cuss some prob­lems with these assump­tions, but in keep­ing with the neo­clas­si­cal delu­sion that one couldn’t model processes out of equi­lib­rium, these prob­lems didn’t lead to a revi­sion of his model.

Of course, if Fisher had been a real­ist, he would have admit­ted to him­self that a model that pre­sumes the econ­omy is always in equi­lib­rium will be a mis­lead­ing guide to the behav­iour of the actual econ­omy. But instead, as seems to hap­pen to all devo­tees of neo­clas­si­cal eco­nom­ics, he began to see his model as the real world–and used it to explain the Stock Mar­ket bub­ble of the 1920s as not due to “irra­tional exu­ber­ance”, but due to the won­der­ful work­ings of a mar­ket econ­omy in equilibrium.

Since Wall Street was also assumed to be in equi­lib­rium, stock prices were jus­ti­fied. And he defended the bub­ble as rep­re­sent­ing a real improve­ment in the liv­ing stan­dards of Amer­i­cans, because: 

We are now apply­ing sci­ence and inven­tion to indus­try as we never applied it before. We are liv­ing in a new era, and it is of the utmost impor­tance for every busi­ness­man and every banker to under­stand this new era and its impli­ca­tions… All the resources of mod­ern sci­en­tific chem­istry, met­al­lurgy, elec­tric­ity, are being utilized–for what? To make big incomes for the peo­ple of the United States in the future, to add to the div­i­dends of cor­po­ra­tions which are han­dling these new inven­tions, and nec­es­sar­ily, there­fore, to raise the prices of stocks which rep­re­sent shares in these new inven­tions.” (Fisher, Octo­ber 23rd 1929, in a speech to a bankers’ association)

Have you heard that one before: a “new era”? If I had a dol­lar for every time I saw that twad­dle used to jus­tify com­pa­nies with neg­a­tive earn­ings hav­ing sky­high val­u­a­tions dur­ing the Inter­net Bubble…

Fisher even dis­missed the 6% fall in the stock mar­ket that had occurred in the day before his speech as due to “a cer­tain lunatic fringe in the stock mar­ket, and there always will be when­ever there is any suc­cess­ful bear move­ment going on… they will put the stocks up above what they should be and, when fright­ened, … will imme­di­ately want to sell out.” 

The future, he told the assem­bled bankers, was rosy indeed:

Great pros­per­ity at present and greater pros­per­ity in view in the future … rather than spec­u­la­tion … explain the high stock mar­kets, and when it is finally rid of the lunatic fringe, the stock mar­ket will never go back to 50 per cent of its present level… We shall not see very much fur­ther, if any, reces­sion in the stock mar­ket, but rather … a resump­tion of the bull mar­ket, not as rapidly as it has been in the past, but still a bull rather than a bear move­ment.” (Fisher 1929)

Prior to this speech, he had made his fate­fully wrong pre­dic­tion on the future course of the Dow Jones in the New York Times. For the record, his state­ment was:

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.”

Well, so much for all that. The stock mar­ket crash con­tin­ued for three years, unem­ploy­ment blew out from lit­er­ally zero (as recorded by the National Bureau of Eco­nomic Research) to 25 per­cent, America’s GDP col­lapsed, prices fell… the Great Depres­sion occurred.

At first, Fisher was com­pletely flum­moxed: he had no idea why it was hap­pen­ing, and blamed “spec­u­la­tors” for the fall (though not of course for the rise!) of the mar­ket, lack of con­fi­dence for its con­tin­u­ance, and so on… But expe­ri­ence ulti­mately proved a good if painful teacher, when he devel­oped “the Debt-Deflation The­ory of Great Depressions”.

An essen­tial aspect of this new the­ory was the aban­don­ment of the con­cept of equilibrium.

In his paper, he began by say­ing that:

We may ten­ta­tively assume that, ordi­nar­ily and within wide lim­its, all, or almost all, eco­nomic vari­ables tend, in a gen­eral way, to ward a sta­ble equi­lib­rium. In our class­room expo­si­tions of sup­ply and demand curves, we very prop­erly assume that if the price, say, of sugar is above the point at which sup­ply and demand are equal, it tends to fall; and if below, to rise.

How­ever, 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.

There­fore in the­ory as well as in real­ity, dis­e­qui­lib­rium must be the rule:

The­o­ret­i­cally there may be—in fact, at most times there must be— over– or under-production, over– or under-consumption, over– or under spend­ing, over– or under-saving, over– or under-investment, and over or under every­thing else. It is as absurd to assume that, for any long period of time, the vari­ables in the eco­nomic orga­ni­za­tion, or any part of them, will “stay put,” in per­fect equi­lib­rium, as to assume that the Atlantic Ocean can ever be with­out a wave.” (Fisher 1933, p. 339; empha­sis added)

He then con­sid­ered a range of “usual sus­pects” for crises–the ones often put for­ward by so-called Marx­ists such as “over-production”, “under-consumption”, and the like, and that favourite for neo­clas­si­cals even today, of blam­ing “under-confidence” for the slump. Then he deliv­ered his intel­lec­tual (and per­sonal) coup de grâce:

I ven­ture the opin­ion, sub­ject to cor­rec­tion on sub­mis­sion of future evi­dence, that, in the great booms and depres­sions, each of the above-named fac­tors has played a sub­or­di­nate role as com­pared with two dom­i­nant fac­tors, namely over-indebtedness to start with and defla­tion fol­low­ing soon after; also that where any of the other fac­tors do become con­spic­u­ous, they are often merely effects or symp­toms of these two. In short, the big bad actors are debt dis­tur­bances and price– level disturbances.

While quite ready to change my opin­ion, I have, at present, a strong con­vic­tion that these two eco­nomic mal­adies, the debt dis­ease and the price-level dis­ease (or dol­lar dis­ease), are, in the great booms and depres­sions, more impor­tant causes than all oth­ers put together…

Thus over-investment and over-speculation are often impor­tant; but they would have far less seri­ous results were they not con­ducted with bor­rowed money. That is, over-indebtedness may lend impor­tance to over-investment or to over-speculation.

The same is true as to over-confidence. I fancy that over-confidence sel­dom does any great harm except when, as, and if, it beguiles its vic­tims into debt. (Fisher 1933, pp. 340–341. Emphases added.)

From this point on, he elab­o­rated his the­ory of the Great Depres­sion which had as its essen­tial start­ing points the propo­si­tions that debt was above its equi­lib­rium level and that the rate of infla­tion was low. Start­ing from this posi­tion of dis­e­qui­lib­rium, he described the 9 step chain reac­tion shown above.

Of course, if the econ­omy had been in equi­lib­rium to begin with, the chain reac­tion could never have started. By pre­vi­ously fool­ing him­self into  believ­ing that the econ­omy was always in equi­lib­rium, he, the most famous Amer­i­can econ­o­mist of his day, com­pletely failed to see the Great Depres­sion coming.

How about Bernanke today? Well, as Mark Twain once said, his­tory doesn’t repeat, but it sure does rhyme. Just four years ago, as a Gov­er­nor of the Fed­eral Reserve, Bernanke was an enthu­si­as­tic con­trib­u­tor to the “debate” within neo­clas­si­cal eco­nom­ics that the global econ­omy was expe­rien­ing “The Great Mod­er­a­tion”, in which the trade cycle was a thing of the past–and he con­grat­u­lated the Fed­eral Reserve and aca­d­e­mic econ­o­mists in gen­eral for this suc­cess, which he attrib­uted to bet­ter mon­e­tary policy:

In the remain­der of my remarks, I will pro­vide some sup­port for the “improved-monetary-policy” expla­na­tion for the Great Moderation.”

Good call Ben. We have now moved from “The Great Mod­er­a­tion!” to “The Great Depres­sion?” as the debat­ing topic du jour.

On that front, his analy­sis of what caused the Great Depres­sion cer­tainly doesn’t imbue con­fi­dence. This chap­ter (first pub­lished in 1995 in the neo­clas­si­cal Jour­nal of Money Credit and Bank­ing [ Feb­ru­ary 1995, v. 27, iss. 1, pp. 1–28]–the same year my Min­skian model of Great Depres­sions was pub­lished in the non-neoclassical Jour­nal of Post Key­ne­sian Eco­nom­ics [Vol. 17, No. 4, pp. 607–635]) con­sid­ers sev­eral pos­si­ble causes:

  • A neo­clas­si­cal, laboured re-working of Fisher’s debt-deflation hypoth­e­sis, to inter­pret it as a prob­lem of “agency”–“Intuitively, if a bor­rower can con­tribute rel­a­tively lit­tle to his or her own project and hence must rely pri­mar­ily on exter­nal finance, then the borrower’s incen­tives to take actions that are not in the lender’s inter­est may be rel­a­tively high; the result  is both dead­weight losses (for exam­ple, inef­fi­ciently high risk-taking or low effort) and the neces­sity of costly infor­ma­tion pro­vi­sion and mon­i­tor­ing)” (p. 17);
  • Aggre­gate demand shocks from the return to the Gold Stan­dard and its effect on world money sup­plies; and
  • Aggre­gate sup­ply shocks from the fail­ure of nom­i­nal wages to fall–“The link between nom­i­nal wage adjust­ment and aggre­gate sup­ply is straight­for­ward: If nom­i­nal wages adjust imper­fectly, then falling price lev­els raise real wages; employ­ers respond by cut­ting their work­forces” (p. 21).

None of these “causes” includes exces­sive pri­vate debt–the phe­nom­e­non that I hope now even Ben Bernanke can see was the cause of the Great Depression–and the rea­son why he and neo­clas­si­cal econ­o­mists like him are no longer dis­cussing “The Great Moderation”.

Whle they were doing that, a minor­ity of economists–myself included–were avidly devel­op­ing both Fisher and Minsky’s the­o­ries of Great Depres­sions. We are known gen­er­ally as “Post Key­ne­sian” econ­o­mists, and there Min­sky is an intel­lec­tual hero.  And how did Ben han­dle Min­sky? I have yet to read all of the Essays, but a blog­ger who has made the fol­low­ing comment:

In the entire vol­ume (Bernanke, ‘Essays on Great Depres­sion’, 2000, Prince­ton) there is a sin­gle refence to Min­sky in Part Two, page 43 — “Hyman Min­sky (1977) and Car­les Kindle­berger (1978) have … argued for the inher­ent insta­bil­ity of the finan­cial sys­tem but in doing so have had to depart from the assump­tion of ratio­nal eco­nomic behav­iour.” A foot­note adds — “I do not deny the pos­si­ble impor­tance of irra­tional­ity in eco­nomic life; how­ever it seems that the best research strat­egy is to push the ratio­nal­ity pos­tu­late as far as it will go.”

No need for any comment!!!!!!!

Indeed! Hav­ing not prop­erly com­pre­hended the best con­tem­po­rary expla­na­tion of the Great Depres­sion, and dis­missed the best mod­ern expla­na­tion because it didn’t make an assump­tion that neo­clas­si­cal econ­o­mists insist upon,  Bernanke is now trapped repeat­ing his­tory (inci­den­tally, this com­ment by Bernanke also gives the lie to the “assump­tions don’t mat­ter, it’s only the results that count” non­sense that Fried­man dished up as neo­clas­si­cal eco­nomic methodology–neoclassical econ­o­mists in fact care des­per­ately about their assump­tions and are will­ing to dis­miss rival the­o­ries sim­ply because they don’t make the same assump­tions, regard­less of how accu­rate they are). It is painfully obvi­ous that the real cause of this cur­rent finan­cial cri­sis was the exces­sive build-up of debt dur­ing pre­ced­ing spec­u­la­tive manias dat­ing back to the mid-1980s. The real dan­ger now is that, on top of this debt moun­tain, we are start­ing to expe­ri­ence the slip­pery slope of falling prices.

In other words, the cause of our cur­rent finan­cial cri­sis is debt com­bined with deflation–precisely the forces that Irv­ing Fisher described as the causes of the Great Depres­sion back in 1933.

About Steve Keen

I am a professional economist 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 debts accumulated in Australia, and our very low rate of inflation.
Bookmark the permalink.

54 Responses to Bernanke an Expert on the Great Depression??

  1. Erik Nelson says:

    Under FDR, orga­nized labor recruited mil­lions of work­ers. By 1938, the AFL & CIO com­bined had more than 7 mil­lion mem­bers, nearly 15% of the US work­force. In 1938, the “pro-labor” Fair Labor Stan­dards Act (FLS Act) imposed a min­i­mum wage (25 cents / hour) which affected approx­i­mately 20% of the US work­force. Other leg­is­la­tion seems to have increased taxes, to decrease the bud­get deficit. Mean­while, Mex­ico had nation­al­ized rail­roads & oil fields, appro­pri­at­ing their prof­its from the US & UK. US unem­ploy­ment increased 5%, and GDP decreased 10% (in accor­dance with Okun’s Law). Ipso facto, in 1938, the US econ­omy was hit with a series of shocks, increas­ing busi­ness expenses (labor & taxes), whilst decreas­ing rev­enues (oil prof­its from Mex­ico), plau­si­bly explain­ing the 1938 reces­sion. US busi­ness dis-employed a quar­ter of those whose wages were arti­fi­cially increased by the FLS Act, increas­ing unem­ploy­ment by mil­lions of work­ers, and decreas­ing GDP by bil­lions of dollars.

  2. Erik Nelson says:

    The 1938 FLS Act imposed a min­i­mum wage (25 cents / hour) on over 20% of the US work­force (~10 mil­lion work­ers). At 2000 hours per worker year, that amounts to a total wage bill of $5B. If the aver­age prior wage had been half of the new min­i­mum, then the prior total wage bill would have been half of that fig­ure, or $2.5B.

    Now, nom­i­nal GDP in 1937 was ~$100B. And, aggre­gate cor­po­rate prof­its typ­i­cally total 7% of GDP. Thus, cor­po­rate prof­its in 1937 were plau­si­bly about $7B. So, the FLS Act nearly “sunk the US pri­vate sec­tor” with bil­lions in new labor costs — con­cen­trated, to boot, amongst mar­gin­ally prof­itable firms who had been employ­ing cheap unskilled labor to earn what lit­tle they did. No won­der, then, that sev­eral mil­lion work­ers were fired, as US busi­nesses shed over $1B of least-profitable, least-productive labor, in order to “stay afloat”.

  3. Erik Nelson says:

    In the 1938 reces­sion, US indus­try reduced employ­ment by nearly 30%, and reduced hours of work per employee by nearly 20% (Bernanke, Essays on Great Depres­sion, p.196). Per­haps US busi­nesses, bur­dened by the new min­i­mum wage imposed on the labor of 10 mil­lion work­ers by the FLS Act, fired sev­eral mil­lion work­ers, and reduced the hours of every­body else, in order to defray per­haps half (-30% employ­ees + –20% hours per employee) of the imposed costs ? The 1938 reces­sion coin­cides with the new min­i­mum wage imposed in 1938, by the FLS Act; the US econ­omy had strug­gled through the esca­lat­ing series of strikes legal­ized by the Wag­ner Act in 1935, even amidst the GD brought about by the bear mar­ket, after the stock mar­ket col­lapse of Octo­ber 1929.

  4. Erik Nelson says:

    Accord­ing to Steve Wiegand’s “Lessons from the Great Depres­sion” (p.34,46):

    “By the end of the decade [1920s], more than 60% of appli­ances & fur­ni­ture was bought on install­ment plans. Con­sumer debt rose from $2.6B in 1920 to $7.1B in 1929. Install­ment buy­ing at such high lev­els kept up prod­uct demand — and thus pro­duc­tion — at higher rates than the amount of real money in the econ­omy could sus­tain indef­i­nitely. The result was a sit­u­a­tion that could — and did — lead to severe defla­tion… By 1929, the US was pro­duc­ing 17% more than it could buy. The result of all this over-production was a sud­den halt to man­u­fac­tur­ing in many areas when the econ­omy slowed. That halt led to lay­offs and higher unem­ploy­ment, which nat­u­rally led to even less buying.”

    Naively, over-production & inven­tory accu­mu­la­tion sug­gests that prices exceeded equi­lib­rium market-clearing lev­els, so that sup­plied quan­ti­ties exceeded demanded quan­ti­ties, as sug­gested in the fol­low­ing figure:

    Now, the 1920s were known as a decade of increas­ing consumer-credit-based “over-spending”. Per­haps consumer-credit allowed sup­pli­ers to charge higher total prices than the mar­ket demand would bear, by entic­ing addi­tional cus­tomers with the lower “teaser” ini­tial pay­ments ? If so, then quan­ti­ties trans­acted WITH con­sumer credit would reflect the lower “teaser” prices; whereas quan­ti­ties trans­acted WITHOUT credit would reflect the higher total price. So sud­den quench­ing of con­sumer credit would sud­denly con­tract quan­ti­ties trans­acted, leav­ing inven­to­ries to accu­mu­late (and reduc­ing need for fur­ther pro­duc­tion, once the depres­sion began) ?

Leave a Reply