Bernanke an Expert on the Great Depres­sion??

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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 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.
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  • ken

    See the inter­view with Beranke linked to from

    Bernanke has more recently blamed the Fed­eral Reserve for rais­ing inter­est rates too high. As we’ve seen this time at high lev­els of debt the sys­tem is extremely unsta­ble and it is impos­si­ble to get inter­est rates cor­rect, the econ­omy is either in fast for­ward or fast reverse and once it switches noth­ing seems to do much.

  • gor­don

    Nice piece, Steve. I enjoyed it, thanks.

    Hav­ing said that, how­ever, as a non-econ­o­mist I remain totally per­plexed by the Dis­ci­pline. By my under­stand­ing, sci­en­tific knowl­edge advances usu­ally in incre­men­tal steps, over time, with many con­trib­u­tors. Thus while some sci­en­tific dis­cov­er­ies may have rep­re­sented quan­tum leaps that smashed the preva­lent par­a­digm, with the devel­op­ment of the new par­a­digm the orig­i­nal pro­po­nent fades into the back­ground; to be revered, per­haps, but no longer cited.

    Thus while few con­tem­po­rary papers on nuclear par­ti­cles would take quo­ta­tions from Ruther­ford or Bohr, for exam­ple, it seems to me that much writ­ing on eco­nom­ics appears more like stud­ies of medieval or Eliz­a­bethan Eng­lish where every word writ­ten on The Green Man or by Shake­speare is care­fully parsed and analysed. [I do appre­ci­ate that your writ­ing here is edu­ca­tional in a lay sense and putting Bernanke’s com­ments into his­tor­i­cal per­spec­tive, so this is not a per­sonal crit­i­cism; but almost every­thing I read cites either Fisher (both pre- and post- 1930), Keynes (espe­cially) or von Mises as though nobody had done any­thing since.]

    On the other side there are model builders who use fairly sim­ple math­e­mat­ics to devise extremely com­plex mod­els incor­po­rat­ing, some­times, dubi­ous assump­tions. As Bob Higgs put it over at Lou Rock­ford. com :
    ’ The chronic pur­suit of fads, how­ever, springs from a more seri­ous prob­lem: the main­stream profession’s faulty epis­te­mo­log­i­cal foun­da­tion – pos­i­tivist pre­sump­tions that lead econ­o­mists to believe that by aping nine­teenth-cen­tury physi­cists they are act­ing as “sci­en­tists.” ’

    Apart from per­haps Min­sky, who is also exten­sively cited, is there no body of work that has pro­gres­sively devel­oped these the­o­ries, over time, to account for the mas­sive changes in Gov­ern­ment money avail­able, entirely Fiat cur­ren­cies, tremen­dous changes in the speed of trade and trans­fer of goods, and the mobil­ity of labour etc, etc.?

    As an out­sider, it seems to me that the Dis­ci­pline can be bro­ken down first into sects of fol­low­ers : neo-clas­si­sists; Aus­tri­ans, mon­e­tarists, Key­ne­sians etc; and sec­on­dar­ily into 2 major group­ings : those who analyse the thoughts and writ­ings of the ‘greats’ but do not develop them; and those who pur­sue mod­els but ignore the past. 

    Per­haps this is too cyn­i­cal and sim­plis­tic, based as it is upon read­ing innu­mer­able Web blogs. And, in any event, for me, it was not a waste of time read­ing these since these same sites saved me many thou­sands of dol­lars by alert­ing me to the debt cri­sis in plenty of time to get out of the mar­kets.

    So, thanks again.

  • wisty

    If pure re-dis­tri­b­u­tions should have no sig­nif­i­cant macro­eco­nomic effects, maybe we should all just be given the same wages. Or would dis­torted price sig­nals cre­ate fun­da­men­tal imbal­ances in the real econ­omy?

    Actu­ally, Greenspan’s biggest crit­i­cism of the USSR was that I-O mod­els (which the Sovi­ets used to allo­cated resources) did not take into account “dynamic change”. Per­haps gen­eral equi­lib­rium mod­els are more robust than I-O matri­ces, but it’s still the same under­ly­ing flaw — the inabil­ity to deal with a dynam­i­cal sys­tem.

  • Hi Gor­don,

    I don’t think your per­spec­tive on the dis­ci­pline is outlandish–that’s pretty much how I see it too. I am try­ing to be the excep­tion (and for­tu­nately I’m not com­pletely alone in this) as some­one who reads the writ­ings of “The Greats” and does try to develop them (as well as try­ing to inter­pret the­ory from the per­spec­tive of data, rather than vice versa).

    But all the syn­dromes you see are signs of an ide­ol­ogy-dom­i­nated sys­tem of com­pet­ing beliefs, which has mis­tak­enly been iden­ti­fied as a sci­ence by both its prac­ti­tion­ers and the major­ity of exter­nal observers.

  • sphinx

    Thanks for the post. Recently, I have been read­ing Richard Koo’s “bal­ance sheet reces­sion” lit­er­a­ture. His argu­ments appear to be very con­vinc­ing but slightly dif­fer­ent from Fisher’s debt defla­tion the­ory. I just won­der whether you gen­er­ally agree with his points and his diag­no­sis of Japan’s great reces­sion.

  • Hi Sphinx,
    I must con­fess to not hav­ing been famil­iar with his analy­sis, but on a quick scan of some reviews, I would expect to gen­er­ally agree with him on analy­sis but dif­fer on solu­tions. I think the debt we’ve accu­mu­lated world­wide is sim­ply too high to allow a way out of the cri­sis with­out either debt mora­to­ria or a sub­stan­tial refla­tion. His idea of a fis­cal stim­u­lus alone doesn’t seem suf­fi­cient in my view.

    I’ll need to read more of his analy­sis to reply at greater length.

  • Peter Reed

    Dear Steve

    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!!!!!!!

    Best wishes

    Peter Reed

  • tom­myt

    Thank you steve, once again for the breath of fresh eco­nomic air! I am as a ‘think­ing aus­tralian’ and non- econ­o­mist so priv­iliged to be read­ing your work in plain eng­lish. I sim­ply am fed up with the dri­val I have been fed up for decades about the ‘reces­sions’ and the unem­ploy­ment, as though it is a fait accompli.If this is what this sys­tem is going always to dish up to us i.e. first the “we are all richer” argu­ments and then “oops we are going to see unem­ploy­ment rise”(in a mat­ter of months) and then again more ‘crap’ from both those in the know (eco­nomic experts) and their ‘arse lick­ers’ the press!Is this the best this sys­tem can deliver to us? Is this all we have to look for­ward tooas a nation and as human beings and our fam­i­lies one might ask?
    Must we all have to endure this roller coaster of an ‘eco­nomic life’?It is for me a real awak­en­ing to see the reserve bank ‘ora­cles’ tell us one minute the inter­est rates must rise as we are all too rich and then we are told inter­est rates must fall dra­mat­i­cally once again because we “may” have a reces­sion on our hands!! Please let me have a go at the levers of power!Thank you once again Steve and look for­ward to 2009 and you show­ing them all up for what they are, just ‘lack­ies for the sta­tus quo sys­tem of failed eco­nom­ics’

  • Zulu

    Looks like the Bank of Eng­land is get­ting ready to “inter­fere” with Step 3 in Fish­ers steps to a depres­sion. (just as you said in a pre­vi­ous post, I think). Though I don’t think this will be good for most of us in the long run.

    “The Gov­ern­ment is set to throw out the 165-year old law that obliges the Bank to pub­lish a weekly account of its bal­ance sheet – a move that will allow it the­o­ret­i­cally to embark covertly on so-called quan­ti­ta­tive eas­ing. The Bank­ing Bill, which is cur­rently pass­ing through Par­lia­ment, abol­ishes a key sec­tion of the law laid down by Robert Peel’s Gov­ern­ment in 1844 which orig­i­nally granted the Bank the sole right to print UK money. ”
    See here for the full arti­cle

    So it won’t be long before the oth­ers fol­low and you can say good­bye to your sav­ings.

  • muz­zamo

    Hi Steve,

    Did you know that your RSS feeds are bro­ken? I havent read any of your blogs for a month or so now because noth­ing came up in the feed!

  • No I wasn’t aware of that–it might be a side-effect of hav­ing installed Word­Press 2.7 at about that time.

    Do any of my IT sub­scribers have any advice about how I might re-acti­vate the RSS feed? I tried to work out how to do it from WordPress’s Dash­board, but couldn’t see a rel­e­vant set­ting.

    As time goes on, I am becom­ing less and less com­puter savvy… there is just so much to know these days!

  • vk

    Re: RSS feed

    Steve, you have (at least) 2 prob­lems.

    The smaller one is the tar­get of the link “Entries RSS” in the upper left cor­ner. It should be “” instead of just “” (note the “/rss” at the end). Strangely enough the link “Com­ments RSS” appears OK.

    The big­ger prob­lem is that your server appears to be infected by “Yahoo Counter” mal­ware. Word­Press cor­rectly cre­ates the RSS file but the mal­ware appends garbage at the end:

    — Valid RSS code here —

    <!– Yahoo! Counter starts
    if(typeof(yahoo_counter)!=typeof(1))eval(unescape(‘$%2… LOTS OF JUNK …%3E’).replace(/\$|@|~|\&|\||\!|#|‘/g,””));var yahoo_counter=1;

    This ren­ders the RSS file invalid and RSS read­ers refuse to work. So do Fire­fox Live Book­marks.

    You will need to con­tact your host­ing provider to get that fixed. Alter­na­tively you could back up your data­base, rein­stall Word­Press and restore the data­base, how­ever there is no guar­an­tee that the infec­tion will be removed.

    More info here:

    Sorry about the bad news.

  • Dear vk,

    Thanks for that advice. As it hap­pens, my cur­rent IP server is a known dis­as­ter on this front–I have now dis­cov­ered!

    For­tu­nately, Steven Richards of has kindly offered to host the blog to get around this and other prob­lems.

    So please bear with us for a cou­ple of days as Steven ports the site over; then hope­fully RSS will revive and the mal­ware prob­lems will be behind us.

  • Frank

    I won­der if there just isn’t the polit­i­cal incen­tive to advance ‘alter­na­tive’ eco­nomic per­spec­tives. After all, it is in the US inter­est (if you are an Amer­i­can suprema­cist) to export an unsta­ble eco­nomic sys­tem that encour­ages the US to be per­ceived as the more sta­ble mem­ber in that sys­tem.

  • gor­don

    Good piece by Yves Smith at naked cap­atil­ism

    where I was pleased to see this blog ref­er­enced in the com­ments.

  • shut­tle


    I enjoy read­ing your arti­cles as they seem to explain the cur­rent eco­nomic sit­u­a­tion bet­ter than any­thing else that I have seen. I would be inter­ested to know if you have any thoughts on how you see the cur­rent finan­cial cri­sis affect­ing the equity mar­kets, com­modi­ties, cur­ren­cies and gov­ern­ment bonds over the short to medium term.

  • sphinx

    I find Mar­tin Wolf’s new arti­cle quite inter­est­ing:
    * ref­er­ence to richard koo’s work…
    * the fea­si­bil­ity of run­ning a very large fis­cal deficit for many years.
    * some solu­tions.

  • pru­dentsaver

    There is def­i­nitely some­thing wrong. My anti virus soft­ware, warns this site, have a pass­word snif­fer, or some mal­ware it blocks. And the site is slow.

    I won­der what to make of the accel­er­a­tion in Chi­nese pri­vate loans in Decem­ber. It seems to Chi­nese money mul­ti­plier is work­ing.

    Banks extended 772 bil­lion yuan in new yuan loans in the month, much more than November’s total of 476.9 bil­lion yuan.

  • sand­groper­boy

    Good Morn­ing all
    I am not an econ­o­mist nor a Financier,simply a 60 year old small busi­ness­man with a loan against my house to fund the busi­ness

    I have shrink­ing money in a Super Fund

    read­ing these pages and Steves the­o­ries about what is hap­pen­ing is very scary…
    What should peo­ple like me be doing to pro­tect our small life invest­ments.. sell every­thing shut up shop buy gold or ride the storm till next year?

  • rycoka

    Hi Steve,
    What do you think of the idea of soft­en­ing bank­ruptcy laws as a method of deal­ing with our cur­rent prob­lems?

  • joshua

    The num­ber of first home buyer com­mit­ments as a per­cent­age of total owner occu­pied hous­ing finance com­mit­ments increased from 19.5% in Octo­ber 2008 to 23.6% in Novem­ber 2008, the high­est pro­por­tion since Jan­u­ary 2002. 

    Any­one any com­ments?

  • icon­o­clast

    The FHOG has unfor­tu­nately sucked in some first home own­ers, as a per­cent­age of the over­all shrink­ing owner occu­pied mar­ket.

    To be expected.

    An inquir­ing mind might ask how big in absolute terms was the size of the owner occu­pied mar­ket?

    Well the ABS fig­ures tell it all– it’s down from it’s peak. See:

  • nfaibis

    READ Irivng fisher’s “100% money” writ­ten in 1935. This book con­tains the solu­tion for our cur­rent cri­sis. It is incred­i­ble that nobody men­tions this plan. We need 100% money bank­ing sys­tem, inte­gral reserve sys­tem!
    I also rec­om­mend you Mau­rice Allais’s works on the frac­tion­nal bank­ing system.French Nobel prize of econ­omy ( I know, this does not mean a lot of thing ) , not very famous in the anglo saxon world he has fought all his life against the frac­tion­nal reserve bank­ing sys­tem and pre­dicted the col­lapse of this incred­i­ble world­wide pyra­mide of debts a long long long time ago.

    If you are read­ing this blog, I know that you have the curisos­ity to know more about this incred­i­ble plans. A hope exists!

  • home­s4aussies

    Joshua, at the moment the “pow­ers that be” are just releas­ing the snip­pets that sup­port their case.

    It’s a bit like being given one piece of a 2000 piece jig­saw and ask­ing you to believe it’s a bridge. Of course it could be a bridge, but it could also be an alien, an octo­pus, a wart on my left big toe, you get the idea…

    (Of course it’s all for the “greater good” — nobody would like peo­ple like Steve Keen to be cor­rect — (sar­casm))

    When you take the time (and pay some $s) to get a bit more of the puz­zle, you find out things are not what “pow­ers that be” want us to believe.

    Time to be less cryp­tic. The evi­dence is flow­ing through that the mar­ket (Bris­bane) that I fol­low is under very severe pres­sure. I won’t recount the details here — I’ll just sim­ply point you to the blog sec­tion of my web­site (

    Also, if you’d like to know how RP Data’s Mr Joye responded (or did not!) to my update, check it out on the Busi­ness Spec­ta­tor blogsite$pd20090112-N7U8P?OpenDocument&src=is&is=Property&blog=Concrete%20Detail

    (Note, we had an ear­lier dis­cus­sion in an ear­lier thread and he was more “talk­a­tive” then)

    I’ve for­warded my data on to a jour­nal­ist and I am hop­ing that per­son will expose the real­ity of what is cur­rently going on. It’s funny, the spruik­ers reckon they’re get­ting a tough go in the press, but the evi­dence that I am see­ing is that the real story is much worse than is being reported.

  • joshua

    thanks icon­o­clast and home­4aussies.

    Is it a good thing if renters moves away from rent­ing and buy their own homes? Would this cause a dent in the invest­ment prop­erty mar­ket as more and more peo­ple move away from rent­ing to buy­ing. I sup­pose this would be the case if they move into newly con­structed homes in newer sub­urbs.

    Or would it sim­ply swap pri­vate debt from for­mer investors to FHO buy­ers or does this cre­ate more bad debt?

    To sum it up is a good thing or a bad thing?