Debtwatch No. 42: The economic case against Bernanke
on January 24th, 2010 at 10:58 pm
The US Senate should not reappoint Ben Bernanke. As Obama’s reaction to the loss of Ted Kennedy’s seat showed, real change in policy only occurs after political scalps have been taken. An economic scalp of this scale might finally shake America from the unsustainable path that reckless and feckless Federal Reserve behavior set it on over 20 years ago.
Some may think this would be an unfair outcome for Bernanke. It is not. There are solid economic reasons why Bernanke should pay the ultimate political price.
Haste is necessary, since Senator Reid’s proposal to hold a cloture vote could result in a decision as early as this Wednesday, and with only 51 votes being needed for his reappointment rather than 60 as at present. This document will therefore consider only the most fundamental reason not to reappoint him, and leave additional reasons for a later update.
Misunderstanding the Great Depression
Bernanke is popularly portrayed as an expert on the Great Depression—the person whose intimate knowledge of what went wrong in the 1930s saved us from a similar fate in 2009.
In fact, his ignorance of the factors that really caused the Great Depression is a major reason why the Global Financial Crisis occurred in the first place.
The best contemporary explanation of the Great Depression was given by the US economist Irving Fisher in his 1933 paper “The Debt-Deflation Theory of Great Depressions”. Fisher had previously been a cheerleader for the Stock Market bubble of the 1930s, and he is unfortunately famous for the prediction, right in the middle of the 1929 Crash, that it was merely a blip that would soon pass:
“ 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.” (Irving Fisher, New York Times, October 15 1929)
When events proved this prediction to be spectacularly wrong, Fisher to his credit tried to find an explanaton. The analysis he developed completely inverted the economic model on which he had previously relied.
His pre-Great Depression model treated finance as just like any other market, with supply and demand setting an equilibrium price. In building his models, he made two assumptions to handle the fact that, unlike the market for, say, apples, transactions in finance markets involved receiving something now (a loan) in return for payments made in the future. Fisher assumed
“ (A) The market must be cleared—and cleared with respect to every interval of time.
(B) The debts must be paid.” (Fisher 1930, The Theory of Interest, p. 495)[1]
I don’t need to point out how absurd those assumptions are, and how wrong they proved to be when the Great Depression hit—Fisher himself was one of the many whose fortunes were wiped out by margin calls they were unable to meet. After this experience, he realized that his equilibrium assumption blinded him to the forces that led to the Great Depression. The real action in the economy occurs in disequilibrium:
We may tentatively assume that, ordinarily and within wide limits, all, or almost all, economic variables tend, in a general way, toward a stable equilibrium… But the exact equilibrium thus sought is seldom reached and never long maintained. New disturbances are, humanly speaking, sure to occur, so that, in actual fact, any variable is almost always above or below the ideal equilibrium…
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)
A disequilibrium-based analysis was therefore needed, and that is what Fisher provided. He had to identify the key variables whose disequilibrium levels led to a Depression, and here he argued that the two key factors were “over-indebtedness to start with and deflation following soon after”. He ruled out other factors—such as mere overconfidence—in a very poignant passage, given what ultimately happened to his own highly leveraged personal financial position:
I fancy that over-confidence seldom does any great harm except when, as, and if, it beguiles its victims into debt. (p. 341)
Fisher then argued that a starting position of over-indebtedness and low inflation in the 1920s led to a chain reaction that caused the Great Depression:
“(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.” (p. 342)
Fisher confidently and sensibly concluded that “Evidently debt and deflation go far toward explaining a great mass of phenomena in a very simple logical way”.
So what did Ben Bernanke, the alleged modern expert on the Great Depression, make of Fisher’s argument? In a nutshell, he barely even considered it.
Bernanke is a leading member of the “neoclassical” school of economic thought that dominates the academic economics profession, and that school continued Fisher’s pre-Great Depression tradition of analysing the economy as if it is always in equilibrium.
With his neoclassical orientation, Bernanke completely ignored Fisher’s insistence that an equilibrium-oriented analysis was completely useless for analysing the economy. His summary of Fisher’s theory (in his Essays on the Great Depression) is a barely recognisable parody of Fisher’s clear arguments above:
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. (Bernanke 2000, Essays on the Great Depression, p. 24)
This “summary” begins with falling prices, not with excessive debt, and though he uses the word “dynamic”, any idea of a disequilibrium process is lost. His very next paragraph explains why. The neoclassical school ignored Fisher’s disequilibrium foundations, and instead considered debt-deflation in an equilibrium framework in which Fisher’s analysis made no sense:
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. ” (p. 24)
If the world were in equilibrium, with debtors carrying the equilibrium level of debt, all markets clearing, and all debts being repaid, this neoclassical conclusion would be true. But in the real world, when debtors have taken on excessive debt, where the market doesn’t clear as it falls and where numerous debtors default, a debt-deflation isn’t merely “a redistribution from one group (debtors) to another (creditors)”, but a huge shock to aggregate demand.
Crucially, even though Bernanke notes at the beginning of his book that “the premise of this essay is that declines in aggregate demand were the dominant factor in the onset of the Depression” (p. ix), his equilibrium perspective made it impossible for him to see the obvious cause of the decline: the change from rising debt boosting aggregate demand to falling debt reducing it.
In equilibrium, aggregate demand equals aggregate supply (GDP), and deflation simply transfers some demand from debtors to creditors (since the real rate of interest is higher when prices are falling). But in disequilibrium, aggregate demand is the sum of GDP plus the change in debt. Rising debt thus augments demand during a boom; but falling debt substracts from it during a slump
In the 1920s, private debt reached unprecedented levels, and this rising debt was a large part of the apparent prosperity of the Roaring Twenties: debt was the fuel that made the Stock Market soar. But when the Stock Market Crash hit, debt reduction took the place of debt expansion, and reduction in debt was the source of the fall in aggregate demand that caused the Great Depression.
Figure 1 shows the scale of debt during the 1920s and 1930s, versus the level of nominal GDP.
Figure 1: Debt and GDP 1920-1940
Figure 2 shows the annual change in private debt and GDP, and aggregate demand (which is the sum of the two). Note how much higher aggregate demand was than GDP during the late 1920s, and how aggregate demand fell well below GDP during the worst years of the Great Depression.
Figure 2: Change in Debt and Aggregate Demand 1920-1940
Figure 3 shows how much the change in debt contributed to aggregate demand—which I define as GDP plus the change in debt (the formula behind this graph is “The Change in Debt, divided by the Sum of GDP plus the Change in Debt”).
Figure 3: Debt contribution to Aggregate Demand 1920-1940
So during the 1920s boom, the change in debt was responsible for up to 10 percent of aggregate demand in the 1920s. But when deleveraging began, the change in debt reduced aggregate demand by up to 25 percent. That was the real cause of the Great Depression.
That is not a chart that you will find anywhere in Bernanke’s Essays on the Great Depression. The real cause of the Great Depression lay outside his view, because with his neoclassical eyes, he couldn’t even see the role that debt plays in the real world.
Bernanke’s failure
If this were just about the interpretation of history, then it would be no big deal. But because they ignored the obvious role of debt in causing the Great Depression, neoclassical economists have stood by while debt has risen to far higher levels than even during the Roaring Twenties.
Worse still, Bernanke and his predecessor Alan Greenspan operated as virtual cheerleaders for rising debt levels, justifying every new debt instrument that the finance sector invented, and every new target for lending that it identified, as improving the functioning of markets and democratizing access to credit.
The next three charts show what that dereliction of regulatory duty has led to. Firstly, the level of debt has once again risen to levels far above that of GDP (Figure 4).
Figure 4: Debt and GDP 1990-2010
Secondly the annual change in debt contributed far more to demand during the 1990s and early 2000s than it ever had during the Roaring Twenties. Demand was running well above GDP ever since the early 1990s (Figure 5). The annual increase in debt accounted for 20 percent or more of aggregate demand on various occasions in the last 15 years, twice as much as it had ever contributed during the Roaring Twenties.
Figure 5: Change in Debt and Aggregate Demand 1990-2010
Thirdly, now that the debt party is over, the attempt by the private sector to reduce its gearing has taken a huge slice out of aggregate demand. The reduction in aggregate demand to date hasn’t reached the levels we experienced in the Great Depression—a mere 10% reduction, versus the over 20 percent reduction during the dark days of 1931-33. But since debt today is so much larger (relative to GDP) than it was at the start of the Great Depression, the dangers are either that the fall in demand could be steeper, or that the decline could be much more drawn out than in the 1930s.
Figure 6: Debt contribution to Aggregate Demand 1990-2010
Conclusion
Bernanke, as the neoclassical economist most responsible for burying Fisher’s accurate explanation of why the Great Depression occurred, is therefore an eminently suitable target for the political sacrifice that America today desperately needs. His extreme actions once the crisis hit have helped reduce the immediate impact of the crisis, but without the ignorance he helped spread about the real cause of the Great Depression, there would not have been a crisis in the first place. As I will also document in an update in early February, some of his advice has made America’s recovery less effective than it could have been.
Obama came to office promising change you can believe in. If the Senate votes against Bernanke’s reappointment, that change might finally start to arrive.
Addendum
This is an advance version of my monthly Debtwatch Report for February 2010. Click here for the PDF version. Please feel free to distribute this to anyone you think may be interested–especially people who may be in a position to influence the Senate’s vote.
Professor Steve Keen
www.debtdeflation.com/blogs
[1] This book was an untimely relaunch of his 1907 PhD thesis.
Re #335 Ramanan,
My model began as an attempt to put Basil’s ideas into a mathematical framework, using the Circuitist vision of a pure credit economy as a foundation. I have always found Basil’s work inspiring and I do recommend that everyone here read his “The Endogenous Money Supply”, “Unpacking the Black Box” and “Horizontalists and Verticalists”.
For my part I feel that most commentators here who are critical of Chartalism do appreciate this credit money perspective–certainly I have seen very little in their critiques (misguided or otherwise) of Chartalism that also breaches Basil’s insights about endogenous money.
The one issue where that might be perceived to be happening is in regard to restraints on government spending, where their objections could be seen as being grounded in a “gold money” perspective. From my reading, this is not the source of most objections–they rather seem concerned about feedback effects that they feel (rightly or wrongly) are not being considered within MMT.
Again I return to my suggestion above–let’s get a “reading group” on Chartalism going here, and refer to key references there when critiquing. Until that is done, I would appreciate both sides giving this topic a break.
For the Chartalist reading list, I nominate Randall Wray’s “Understanding Policy in a Floating Rate Regime”
This is a 2006 working paper (30 pages) for the Center for Full Employment and Price Stability. It explains Modern Monetary Theory without resorting to the accounting identities that many of us find confusing or meaningless, and gives examples from several countries to show how different ways of structuring your Treasury and Central Bank amount to the same thing. It makes the case for running deficits to cover an “Employer of Last Resort” program, and addresses the concerns about wage-price inflation and exchange rate driven cost-push inflation that many of us brought up.
Ultimately, it does not argue that pursuing full employment WILL NOT cause inflation. Someone else can recommend a work that does.
Rather, it seems to argue that tight money (with its side effect of mass unemployment) is a poor tool for controlling inflation, better addressed with banking regulations, tax reform, reducing wasteful government spending, reduced dependence on imported food and fuel, and other structural changes.
Framed this way, I find MMT very persuasive, find it consistent with Dr. Keen’s analysis, and think it is even compatible with an ideological aversion to big government, but Steve would probably rather we didn’t get into that on this forum.
This paper does not discuss banking crises (the horizontal dimension) or destabilizing international capital flows. Anyone know some chartalist works that do?
“Rather, it seems to argue that tight money (with its side effect of mass unemployment) is a poor tool for controlling inflation, better addressed with banking regulations, tax reform, reducing wasteful government spending, reduced dependence on imported food and fuel, and other structural changes”
you missed one of the most important aspects of their arguement, quantitative easing,
relating to the monopoly power of government in the prices it pays for labour and other goods and services as a means of controlling inflation.
as far as this whole debate over chartalism, well i dare say it has a few more followers than it did say 12 months ago on this blog stf(scott), and i include myself as one of its admirers, just like i admire steves ideas.
you might say with friends like this who needs enemies
.
the point is chartilism is forcing us to confront some of our predjudices and long held belief systems about how the financial system works. and when we join in battle with our predjudices, rumour and inuendo are part of the spoils regardless of whatever may have been read on the matter.
blogs arnet just about about what is said or what is read, its sometimes about the meaning behind what is said. its a broadcast to the world about how we percieve the world from our own instinctive and habituated point of view,
to quote bertrand russell
“If a man is offered a fact which goes against his instincts, he will scrutinize it closely, and unless the evidence is overwhelming, he will refuse to believe it. If, on the other hand, he is offered something which affords a reason for acting in accordance to his instincts, he will accept it even on the slightest evidence”
so the moral of the story is that we could be more circumspect in our praising or condemnation of caeser, but i say let the debate rage on, its all part of our individual and collective enlightenment
i dare say we will have learned a thing or two about who we are and what we are discussing in such a often troublsome process, even though there may be still much to resolve in our own minds.
some of us may not be convinced about mmt or for that matter steves prognossis on certain matters, but all of us are aware of the long shadow they cast.
every debate we have about mmt on this blog im sure leads many of us to go and read further on these matters, and hense awareness grows, whether we believe it or understand it is an alltogether different proporsition
awareness is the first step, we are there
understanding, well that still has many battles to be won
the cynical view of blogging suggests its like the UN,
its a forum for dissunity, one upmanship and venting ones spleen,
. luckily we have had the good sense to conduct such affairs on this blog in a generally cordial manner.
my knowledge of affairs economique has grown considerabley since ive joined this blog, to the extent, that ive become a sort of expert to my friends and work mates, poor unsuspecting fools that they are.
if the criterion for posting on this blog was getting ones facts straight or knowing what you were talking about most of the time , it would be a more exclusive gathering than the havnt slept with paris hilton club,
which at the moment consists of me and the pope i think
but in all seriousness, i think the last thing we should be doing is stifling discussion however ill informed, and thus destroy the dialectic process on matters economic on this blog,
we should let the forces of one upmanship with his trusted ally curiosity, wend their merry way through this blog, and in the long run , not the short run, witness the general increase in the level of economic enlightenment
mahaish,
I agree the debate so far has been enlightening. However, it has not helped to answer my lingering doubt about chartalism: does the idea that “government spending will [only] approach an inflation barrier as the economy approaches full employment of resources” make any sense in a dynamic, disequilibrium economy? I couldn’t follow the debate over electrical engineering between Brightspark and Iconoclast, but I’m guessing that’s what it was about. Sadly, my answer may have to wait until Steve can “put an agreed Chartalist position into an accepted dynamic model of the economy and see how it functions.” I look forward to seeing it. But in the meantime, I can attempt to resolve another area of dispute. If there’s errors in this interpretation, it’s because my formal training was in botany, not economics. Sorry.
Steve Keen has made it clear that the GFC is rooted in an imbalance between debt and income, and that the US, UK, and Australia can no longer borrow their way out of recession. The horizontal avenue for money creation has reached its limit. He and Michael Hudson have limited their recommendations to discussing the distributional aspects of debt reduction, bailouts, and taxes, arguing that Wall Street not Main Street should take the hit. This is extremely important for both justice and economic recovery. But what about the vertical avenue emphasized by chartalism? Can governments print their way out of recession?
The indisputable accounting of MMT says that governments “print money” by spending in excess of their tax revenues. By accounting necessity, if the domestic private sector has too much debt and the foreign sector is unwilling to run a larger surplus, the only way to improve the private sector’s net nominal balance sheet is for the government to run a large enough deficit.
The rest of us are unimpressed by this epiphany. Yes, an expansionary monetary policy can increase employment. Yes, you can pay off debts by printing money. But how will this affect the real purchasing power of my income or savings? Even if the overall price level is unaffected, how will a drop in the exchange rate influence the relative price of oil, food, and other necessities?
Chartalism has a surprisingly good answer. Let’s consider the United States, with its giant and worrisome imbalance between debt and income and between imports and exports.
US private debt, especially mortgage debt, is too high relative to wage income. The Finance, Insurance, and Real Estate sector has sucked the life out of the real economy. I’ll even go so far as to quote James Howard Kunstler and say that the so-called service economy was merely “the final blowout of the cheap oil era: the hypertrophic build-out of suburban sprawl and the furnishing and final accessorizing of it. In other words, our living arrangement essentially became the remaining basis of our economy, in the absence of any other purposeful creation of value or wealth, such as manufacturing things.”
The price of real estate must fall relative to wages. AIG should go bankrupt and there should be fewer jobs for real estate agents, stockbrokers, tract home builders and other professionals who can no longer ride the speculative boom. The US will need to rebuild its manufacturing sector. Fine, but why should the overall price level fall, keeping down wages and sales in industries that did not gamble on home prices? Do neoclassical economists need to be punished with unemployment, or might it be better for the government to hire them at minimum wage to build roads? Then they’d learn some skills that would benefit society.
Quantitative easing could limit the damage of the financial collapse and speed recovery. The trick is spending it in the right place, boosting the manufacturing economy rather than propping up the FIRE sector. Japan did some of both. Zero interest rates benefited foreign speculators in the yen carry trade more than domestic borrowers, but fiscal stimulus boosted aggregate demand by making some construction jobs building (presumably) useful infrastructure.
People with a conservative or libertarian bent hate the “socialist implications” of chartalism. “Government is big enough already. You want bigger deficits!?” MMT is silent about how government should spend, or how much it should tax. If you want to slash taxes and spending in order to reduce government’s role to enforcing laws and the borders, MMT will not argue. MMT only specifies the size of the deficits needed to overcome the deflationary effects of private debts and savings. If you think that the government can produce nothing useful by hiring the unemployed, or that ELR is a somehow a slippery slope to a command economy, then the deficit could be dispersed as a tax credit for industry, or as a per capita citizen’s dividend. But if you’re at all concerned about unemployment, it’s worth taking a second look at the Employer of Last Resort proposal—-by pegging the currency to the minimum wage, it provides full employment with labor market flexibility, a check on inflation, and an automatic stabilizer of the business cycle.
What about the trade deficit and national debt? China is weaning itself off the US export market and diversifying its reserves. It will probably buy fewer treasury bonds. That’s what chartalism says it should do—-print its own money to develop its domestic economy, rather than holding worthless dollar reserves to defend its exchange rate. Will the US be the next Argentina? No. Hyperinflation is only a concern for countries that borrow in a foreign currency (see Steve Zarlenga’s The Lost Science of Money). The US borrows in its own currency, from foreign central banks with political reasons to avoid a sudden crash of the US$. The more likely scenario is what Eric Janszen calls Argentina Lite, the slow fall of the dollar as foreign creditors manage down their reserves, leading to a rise in import prices (including oil) and moderately high inflation (or recession) like the oil shocks of the 1970s.
Conventional wisdom suggests smaller fiscal austerity to raise interest rates to reassure bondholders and support the exchange rate. A dozen currency crises in the developing world show us that this strategy does not always work; bondholders are skittish. Furthermore, high interest rates put a strain on the domestic economy and do not address the underlying imbalance. At some point, the US needs to rebuild its local economies and reduce its dependence on foreign oil. Tight money can buy time to make the transition, but the people who advocate balanced budgets are the same people denying global warming, peak oil, and the problems with globalization. The better policy is to run deficits to invest in alternative energy and support those who are hurt by high energy prices.
I think chartalists and circuitists are developing separate parts of a largely complementary analysis of the monetary system. If Steve Keen’s model of the horizontal dimension doesn’t look stock-flow consistent to Bill Mitchell, it’s because it leaves out the government and foreign sectors (whose net surplus would have to balance out the private sector net deficit) and because it speaks of “money” as a financial flow rather than a stock. For example, the broadest measure of the US$ “money supply”, M3, is a cash flow position, not a balance sheet variable. But Mitchell and Keen are describing the same proverbial elephant.
Which reminds me…
A group of economists are examining the business cycle in the dark. “It’s like a snake” says the circuitist, feeling its trunk. “It’s like a tree trunk” says the chartalist, feeling its leg. “It’s like a rope” says the behavioral economist, feeling its tail. “I have no clue what it is,” says the Austrian school economist, “but stop poking it, you’ll make it angry!” The others agree and back away, except for the neoclassical economist, busy removing its chains. “Don’t worry,” he insists. “It’s perfectly tame.” The elephant gores the neoclassical economist and runs off, depressed. “Told you so,” say the others. “It’s just a flesh wound,” says the dismembered neoclassical economist.
QuantitativeEasing
Great imagery. Economists are all blind men feeling different parts of beast, thinking that they are the only ones who know what it is!
Lyonwiss and QuantitativeEasing
My argument is not that people are looking at different parts of a beast and reaching different conclusions but that they are looking at one or two photographs taken at different times and coming up with different explanations as to how the changes took place.
Around 1680, 330 years ago Sir Isaac Newton realised that to gain an understand of the physical world he would need to create a mathematical equation which would describe not just the position of an apple before and after it fell from a tree but also the for entire time for which it was falling. He would also need to consider other effects the velocity of the apple and the acceleration of the apple.
With this he made the major contribution to the science of physics and went on to develop (in parallel with Liebnitz) the branch of mathematics know as calculus. Thus kicking off the enlightenment.
My point is that his work though 300 years old is relevant to economics in a big way. However the first economist to apply this and later mathematical, engineering, and scientific work, to economics is Steve Keen 300 years late (obviously not Steve’s fault). Neoclassical economists have not even tried the first step, defining economic parameters as a function of time, that is what I mean by dynamics. Neoclassical economics is a refuge for the greedy and intellectually lazy.
Cheers Brightspark
PLEASE WATCH THIS YOUTUBE VIDEO EXPLAINING HOW MAINSTREAM ECONOMICS FAILS TO JUSTIFY QUANTITATIVE EASING.
http://www.youtube.com/watch?v=VL7V9BnJXO8