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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  • nwood­man

    Hi Steve,

    I thought you might appre­ci­ate the fol­low­ing Q4 from Hois­ing­tons. It draws together many of the top­ics you have dis­cussed.


    In keep­ing an eye on Aus­tralian CC debt, this was inter­est­ing;,27753,24916087–31037,00.html

    Aus­tralians spent $17.614 bil­lion on their credit and charge cards in Novem­ber, com­pared with $19.413 bil­lion in Octo­ber, a decline of 9.3 per cent, fig­ures from the Reserve Bank of Aus­tralia (RBA) show”
    “The num­ber of pur­chases using credit cards also fell, down by 7.1 per cent in Novem­ber.
    The value of cash advances on credit and charge cards fell by nine per cent to $1.027 bil­lion in Novem­ber, from $1.128 bil­lion the pre­vi­ous month.

    The value of credit card repay­ments fell by 11.4 per cent in Novem­ber.

    Total credit and charge card bal­ances out­stand­ing was up 1.2 per cent in Novem­ber to $45.280 bil­lion, from $44.729 bil­lion the pre­vi­ous month.”
    “The value of credit card repay­ments fell by 11.4 per cent in Novem­ber.

    Total credit and charge card bal­ances out­stand­ing was up 1.2 per cent in Novem­ber to $45.280 bil­lion, from $44.729 bil­lion the pre­vi­ous month.”

    .….… so, while bal­ances grow, repay­ments col­lapse??

    This is exactly what was hap­pen­ing in 2008 before the US econ­omy fell off a cliff as con­sump­tion col­lapsed as con­sumers stopped spend­ing in earnest. Look­ing at the jobs data here in Aus­tralia, full time employ­ment has taken a major hit with much more to come in this cur­rent qtr.

    I would say Aus­tralia is about where the US was 2ndQtr08. Which means employ­ment, GDP and house prices are set­ting up for some pre­cip­i­tous declines. 

    Any­body who believes the spruick­ers and snake oil sales­men in Govt and the nightly “econ­o­mists” that are trot­ted out (except­ing of course the ven­er­a­ble Prof. Keen) to spin the bad news away is the dope in “rope-a-dope”.

    IMO, jobs data is being manip­u­lated, hous­ing prices are heav­ily manip­u­lated and I have absolutely NO DOUBT what­so­ever that we are in reces­sion which means GDP data also is being manip­u­lated — again tak­ing our queue from the US.

  • joshua

    Hi Steve,

    Just check out home­4aussies response and had a look at chris joye web­site. Do you agree with his analy­sis on “Will Aus­tralia face a ‘lost decade’?”. Also, I saw he had a go at you about what you said in the ABC inter­view. Would like if you could share your thoughts. Also, a response to my ques­tion is it a good thing or a bad thing? would be appre­ci­ated.


  • Steve Keen has asked me to inform his read­ers that he is cur­rently tak­ing a short break, and so is unable to respond to com­ments right away.

    He should be back on deck in a few days.

  • Steven Shaw

    vk, thanks for the link to the cor­rect RSS. It fixes things in my reader (Lif­erea on Ubuntu). Here’s that link again in case any­one missed it.

  • Steven Shaw


    Could you say more about your solu­tions to this cri­sis? You men­tion debt mora­to­ria and refla­tion. Wikipedia says “A debt mora­to­rium is a delay in the pay­ment of debts”. Are you sug­gest­ing that peo­ple be given a cou­ple of years grace with the mort­gage pay­ments to pre­vent bank­rupt­cies?

    As for refla­tion, are you talk­ing about putting a floor under house prices?

    I thought that refla­tion was what our gov­ern­ment and Bernanke were try­ing to do. Do you agree with their actions?

    I’m hop­ing for a bit of defla­tion myself — par­tic­u­larly with house prices (but in gro­ceries and elec­tronic goods would be wel­come too!). How­ever, as I’ve been read­ing lately a lit­tle about the Great Depres­sion, I really hope we avoid any­thing quite like that.

  • ueber­baer

    I really value the con­sid­er­ate tone and qual­ity of dis­cus­sion on this site and would like to thank all posters for “edu­cat­ing” me with their shared knowl­edge.

    I know this might not be 100% related but I am hop­ing to find an answer to my ques­tions here:

    1. I do assume we have a frac­tional bank­ing sys­tem here in AU. What are the reserve require­ments of the aus­tralian banks? Are there any? (searched on the RBA site, noth­ing found even using their search func­tion)

    2. Still under the assump­tion that we have indeed a frac­tional bank­ing sys­tem: If banks can cre­ate money “out of thin air” when writ­ing out loans, how comes that the inter­est rate set by the RBA (I think this rate is used for the inter­bank lend­ing between banks on reserve deposits at the RBA — overnight rate?) makes such a dif­fer­ence for the real econ­omy and the peo­ple with home loans? Or is this furore about it mainly pro­pa­ganda? If the bank writes a $100k mort­gage loan hav­ing, say, a 20% reserve require­ment, don’t they just pay inter­est on the 20% reserve while charg­ing inter­est for the full $100k?

    3. A while ago I read some­where that our gov­ern­ment has “pumped” x-amount of money into the sys­tem… How exactly does this money get into the sys­tem?

    4. The Fed­eral Reserve in the USA is a pri­vate insti­tu­tion (as is the IMF, right?) — the bank for the banks. How does this com­pare to AU? Is our RBA truly gov­ern­ment owned? And as it is sup­pos­edly “inde­pen­dent” — how is it gov­erned and by whom?

    5. Why does the gov­ern­ment have to pay inter­ested for loans made by the banks to the gov­ern­ment when gov­ern­ment could per­fectly well “print” their own money at 0 inter­est?

    6. Usury (charg­ing inter­est) used to be pun­ish­able by death but some­how banks jus­ti­fied this by need­ing to be rewarded for the risk. Why do they then still need a colat­eral for loans? 

    Sorry, so many ques­tions but I think it’s the fun­da­men­tal stuff no one talks about to my (lim­ited) knowl­edge at least.

  • LetUsHave­Peace

    Dis­cus­sions about the finan­cial cri­sis are ham­pered by our inabil­ity to use the tra­di­tional def­i­n­i­tions of money and credit that can still be found in Arti­cle I Sec­tion 8 of the United States Con­sti­tu­tion. The rep­re­sen­ta­tives of the states who signed their names on 9/17/1787 were unan­i­mous in their assump­tion that Money was a finan­cial con­stant, a cur­rency for which the Stan­dard and Mea­sure would not be changed. In the 120 years from the adop­tion of the Coinage Act of 1792 to enact­ment of the Fed­eral Reserve Act in 1913, there was, in fact, only one change from the stan­dard that defined the U.S. dol­lar as 24.75 grains of fine gold. In 1837 Mar­tin Van Buren – the George Her­bert Walker Bush of his day – approved what was seen at the time as a scan­dalous reduc­tion of the gold con­tent of the dol­lar to 23.22 grains of fine gold — a 6.18% deval­u­a­tion. (The deval­u­a­tion also pro­voked by the first for­eign exchange cri­sis in Amer­i­can his­tory.) When Pres­i­dent Grant signed The Specie Resump­tion Act of 1875, it promised that green­backs would become de facto gold cer­tifi­cates exchange­able at the Van Buren stan­dard. Pres­i­dent McKinley’s sign­ing of the Gold Stan­dard Act of 1900 reset the def­i­n­i­tion of the Stan­dard and Mea­sure to 25.8 grains of 9/10ths fine gold, but the sub­stance remained the same: 23.22 grains of fine gold. Even after the adop­tion of The Fed­eral Reserve Act of 1913, Amer­i­cans still had Con­sti­tu­tional Money — i.e. paper that could be swapped on demand for specie. The mint con­tin­ued to pro­duce gold coins using the Van Buren stan­dard, and the Act made the new Fed­eral Reserve Notes explic­itly exchange­able for specie. What changed was that the Fed­eral Reserve Bank was required to hold gold reserves against its total deposits of only 35% and gold reserves against its notes in cir­cu­la­tion of only 40%. While Fed­eral Reserve Act explic­itly affirmed that noth­ing in the law could be read as con­trary to the Gold Stan­dard Act, “every­one knew” that the pur­pose of the Act had been to allow the Trea­sury to print paper that was to be treated as Money but was not a gold cer­tifi­cate. As is often the case, for­eign­ers were the first to dis­cover that Con­gress and the Pres­i­dent had reneged on their Con­sti­tu­tional promise. To pre­vent the Euro­pean bel­liger­ents in the First World War from sell­ing U.S. assets and pre­sent­ing their dol­lars to the Trea­sury for redemp­tion in gold, Trea­sury Sec­re­tary McAdoo closed the New York Stock Exchange. The Wil­son Admin­is­tra­tion proudly asserted that Amer­ica had remained on the gold stan­dard; but that was, like so many of Wilson’s grand state­ments, a com­plete fic­tion. The U.S. dol­lar was not, at that time, con­sid­ered a reserve cur­rency; that sta­tus was reserved for the British pound and French franc. The only dol­lar-denom­i­nated assets for­eign­ers held were the stocks and bonds (mostly bonds) traded on the NYSE; by clos­ing the exchange the Trea­sury had nul­li­fied the Gold Stan­dard Act. By the time the Stock Exchange reopened in Decem­ber, Euro­peans no longer wanted to swap dol­lars for gold. Their orders for food and sup­plies had made shifted the bal­ance of trade per­ma­nently in favor of the U.S. Before WW I ended both Britain and France had aban­doned the gold stan­dard and depended on loans from the U.S. gov­ern­ment to pay for their con­tin­u­ing imports from the United States. It took less than 2 decades for the United States to for­mally end its 141-year com­mit­ment to a Con­sti­tu­tional Money. Under the Emer­gency Bank­ing Relief Act of 1933 the Pres­i­dent and the Sec­re­tary of the Trea­sury were given the power to apply the Trad­ing with The Enemy Act of 1917 to U.S. cit­i­zens. All Amer­i­cans were com­manded to sur­ren­der all gold coin and gold cer­tifi­cates.

    When 19th and early 20th cen­tury econ­o­mists dis­cussed Money and credit, they took for granted the fun­da­men­tal dis­tinc­tion between the two forms of wealth. With the excep­tion of the Key­ne­sian abo­li­tion­ists, they also took it for granted that Money and the paper forms of credit would com­pete with each other. They did not assume that cir­cu­lat­ing media would become just another part of the con­tin­uum of promises now described as “the finan­cial sys­tem”.

  • ken

    ueber­baer, reserve require­ments are set by APRA they are prob­a­bly about 8%.

    The term “cre­at­ing money” is a lit­tle mis­lead­ing, the banks still have to have the money on deposit. What hap­pens is that money lent cycles back through the econ­omy to become deposits, so these increase as lend­ing increases.

    Our RBA is a gov­ern­ment body but has a fair amount of inde­pen­dence because of the leg­is­la­tion. They have a board and a gov­er­nor. Of course the gov­ern­ment could at any time draft new leg­is­la­tion and they prob­a­bly have the power to sack and replace the board.

    Print­ing money puts more money into the sys­tem so is infla­tion­ary. Bor­row­ing is also but doesn’t seem as bad.

  • ueber­baer

    Ken, thanks for the reply.

    whow — 8% only! So if I am a bank and deposit $8k as a reserve at the RBA, can I then write a loan out for $92k? I still meet the 8% reserve require­ment. I really would call this “cre­at­ing money out of thin air”. 

    The dif­fer­ence in regards to infla­tion between “printed money” and bank money is that when it is paid back, it dis­ap­pears. Only one prob­lem: where’s the money for the inter­est com­ing from? As we all know the inter­est might be even higher than the prin­ci­pal, espe­cially for mort­gages.

    And I don’t even want to think about the sce­nario when that new money is then deposited at a bank where it again becomes “cap­i­tal” for that bank to write another loan and cre­ate even more bank money. I really hope I got this all wrong. Man, no won­der the banks are in trou­ble if their deb­itors start to default. No won­der a sin­gle bank col­lapse can cause a whole chain reac­tion and make this insane sys­tem wob­ble.

    I think the truth is that only 5% of the “money” in cir­cu­la­tion is in the form of the paper/plastic notes. The rest is dig­i­tal and in assets. So really most of the “money” cre­ated is bank money, cre­ated from debt. Cre­ated by banks out of thin air because our laws allow them to do it and to then lend out (at inter­est) some­thing they only have 8% of. 

    What a SCAM!

    Hey, frac­tional bank­ing almost meets the cri­te­ria of a ponzi scheme, this one with a twist because it actu­ally does cre­ate inter­est.

    Our fiat cur­rency is backed by noth­ing but a pledge of debt which is the only thing that gives it value. Human lifetime/labor and resources. 

    And I still don’t under­stand what the real impact of the “offi­cial inter­est rate” is for banks. What do they pay inter­est for? To whom? Inter­bank lend­ing? But that is only for the 8%. And as far as I know, credit card rates have not changed with the reduc­tions in the offi­cial inter­est rate. 

    And I still don’t under­stand why the gov­ern­ment bor­rows money from the banks and pays inter­est (taxes) to them when the it has the power to just print inter­est free money.

  • Neil

    nfaibis’ ref­er­ence to Mau­rice Allais is intrigu­ing espe­cially as he started out as a physi­cist and taught him­self eco­nom­ics.

    How­ever Prof Allais wrote some some 90 works which makes it dif­fi­cult to know where to start. Can nfaibis make some sug­ges­tions?

    I am doubt­ful that my out of prac­tice French is up to read­ing eco­nomic the­ory so ask whether these works avail­able in reli­able Eng­lish trans­la­tion?

  • Paul Harry

    Steve, I’m no expert but I think you may be mis­read­ing Bernanke’s com­ment “…the counter argu­ment that debt-defla­tion rep­re­sented no more than a redis­tri­b­u­tion from one group (debtors) to another (cred­i­tors)”. You have inter­preted this redis­tri­b­u­tion as being income but I think Bernanke may be refer­ing to debt. With­out see­ing the full con­text in which the com­ment is made, it is unclear what he is refer­ing to.

  • This com­ment appeared on Naked Cap­i­tal­ism:
    “Anony­mous said…
    I rec­om­mend actu­ally read­ing Bernanke’s paper, because Keen is clearly mis­rep­re­sent­ing him with an out-of-con­text quote.

    The struc­ture of Bernanke’s argu­ment is: (1) intro­duce Fisher’s debt defla­tion idea, (2) men­tion the neo­clas­si­cal eco­nom­ics cri­tique of that idea, (3) and dis­cuss how debt defla­tion is con­sis­tent with neo­clas­si­cal eco­nom­ics under an asym­met­ric infor­ma­tion frame­work. Unfor­tu­nately Keen stops after #2, enabling him to set up a straw man.”

    Steve Keen — any response?

  • mccartjt

    Dr Keen,

    Thank you ever so much for this blog. If the big issue for the cur­rent eco­nomic tur­moil is total debt ver­sus gdp, then with Japan’s asset bub­bles hav­ing been spiked close on 20 years ago, shouldn’t their econ­omy be in a much bet­ter posi­tion in the short to medium (even long ?) term than the rest of the world?

    John M

  • Hi every­one,

    Firstly to Reason’s com­ment: yes I accept that com­ment on Naked Cap­i­tal­ism, and I actu­ally mod­i­fied the post to make a fuller state­ment of Bernanke, and to make it clear that my over­all reac­tion in that post was to neo­clas­si­cal eco­nom­ics in gen­eral, rather than Bernanke him­self.

    Unfor­tu­nately my mod­i­fi­ca­tions were one of the things lost in the tran­si­tion to the new Cyanide ISP. For some time my link still pointed to the old IXWeb­host­ing ISP, after it had been ported. Such is com­puter life!

    I’ll make those mods to this post later today.

    How­ever I still regard Bernanke’s dis­cus­sion of Fisher as a par­ody, and the com­plete absence of a ref­er­ence to Min­sky there as unforgivable–let alone the cal­i­bre of his actual com­ment on Min­sky later in the post.

    Paul Harry, while that inter­pre­ta­tion is fea­si­ble, neo­clas­si­cal eco­nom­ics in gen­eral doesn’t incor­po­rate pri­vate debt in its think­ing. The two pos­si­ble can­di­dates for what he meant by a “trans­fer” (he doesn’t say) are income or wealth. Given its con­text, income is the most prob­a­ble mean­ing.

    Mccartjt (where do you guys get some of these user names??? -:) ), Japan should be in a bet­ter shape, but its attempt to reflate out of the cri­sis by debt-financed gov­ern­ment spend­ing has meant that Japan’s aggre­gate debt sit­u­a­tion is now worse than in 1990, even though pri­vate debt has fallen somewhat–but not by much.

    I’m still try­ing to assim­i­late reli­able cross-coun­try com­pa­ra­ble data on Japan, so I’ll put num­bers to that at some later date.

    And re the dis­cus­sions on frac­tional bank­ing, I’m afraid the prob­lem is much worse than that. We have a frac­tional bank­ing sys­tem in name only–the real­ity is that the sys­tem endoge­nously deter­mines the amount of credit itself, and drags the gov­ern­ment along with it with a time lag.

    The expla­na­tion for all that is com­ing in the Feb­ru­ary Debt­watch.

    Other blog­gers, sorry but I have to get on to some press­ing writ­ing tasks now (includ­ing that Debt­watch) so I’ll have to leave some queries for a later date.

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  • Steven Shaw

    The Mises Insti­tute recently pub­lish­ing an inter­est­ing arti­cle on defla­tion.

    Falling Prices Are the _An­ti­dote_ to Defla­tion

    The arti­cle makes a lot of sense to me but unfor­tu­nately doesn’t answer all my ques­tions about the sub­ject.

  • city­is­lander

    > I also rec­om­mend you Mau­rice Allais’s works on the frac­tion­nal bank­ing sys­tem

    There’s an ongo­ing debate about Mau­rice Allais at Jean-Peyrelevade’s blog where I pointed to Steve Keen’s deb­de­fla­tion blog to help dis­pell some myths about the money mul­ti­plier.

    The finan­cial cri­sis has prompted a surge in inter­est for Allais but for the most part he remains an enigma(his books are out of print and few econ­o­mists have stud­ied his work). 

    Per­haps Steve Keen has been there and will grat­ify us of a sec­tion on Allais in his new book, as he did for other under-esti­mated authors in the pre­vi­ous one?

  • Wel­come aboard city­is­lander,

    I have per­sued Allais’s work and it’s still too much in the neo­clas­si­cal mould for my lik­ing (though I prob­a­bly define that more widely than most peo­ple do). But I will cover him in more detail for the revised ver­sion of Debunk­ing Eco­nom­ics (which won’t see light of day before 2015).

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