Debtwatch No. 42: The economic case against Bernanke

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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


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.


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

[1] This book was an untimely relaunch of his 1907 PhD thesis.
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368 Responses to Debtwatch No. 42: The economic case against Bernanke

  1. Erik Nelson says:

    Thank you very much for your reply.

    Saving (to pay down debt) diverts currency from spending. Thus, the flow of currency towards debt repayment represents foregone spending. In the early 1930s, debt repayment increased to nearly 25% of aggregate spending. So, in the absence of saving (to pay down debt), spending could have been up to 25% higher ?

    Conversely, “over-spending” (on new debt) increases spending. In the 1920s, debt generation increased to nearly 10% of aggregate spending. So, in the absence of “over-spending” (on credit), spending would have been up to 10% lower ?

    The swing in spending, from “over-spending” on new debt by +10%, to “under-spending” to reduce old debt by -25%, is comparable to the swing in accounted GDP. And, that swing in spending (-35%) is comparable to the swing in unemployment (+20%), by Okun’s Law which equates -2% of spending to +1% of unemployment.

    i offer that the debt-fueled “Roaring Twenties” artificially increased spending, and decreased unemployment, beyond natural levels; and that the Great Depression, which artificially decreased spending (for saving to pay down debt), and increased unemployment (paradox of thrift), was made to appear all the worse, by the swift swing from over-spending (on new debt) to under-spending (whilst saving against old debt).

    The net flow of money into savings (to pay down debt) was diverted away from spendings, and (numerically) accounts for the drop in GDP. Roger Farmer observes that spending depends more on (net) wealth than on income. Thus, asset price bubbles increase spending (on new debt), and price collapses decrease spending (for saving against old debt). Debt seems to have played a pivotal part in the Great Depression eighty years ago, and in the ‘Great Recession’ today.

    Tangentially, for the USA, the ratio of GDP to wages & salaries is 2:1. And GDP represents aggregate sales revenues. And if revenues decrease, businesses try to trim expenses to match. So if (US) GDP decreases 2%, wages decrease 1%. And wage expenses are reduced by disemploying workers. So perhaps Okun’s Law reflects the ratio of GDP to wages, and represents the aggregate effects of businesses matching expenses (wages) to revenues (GDP) ?

  2. Erik Nelson says:

    According to data from Richard T. Froyen’s Macroeconomics (6th ed.) (p.345), in the late 1920s, US banks began dipping into their Excess Reserves, thereby generating $2-3B in extra loans; whereas in the early 1930s, US banks began holding extra Excess Reserves, thereby foregoing $5-10 in potential loans. If so, then US credit-markets, like product markets, “whiplashed” from before to after the 1929 stock-market crash — US banks who had been drawing down ERs to make extra risky loans, suddenly switched to building up ERs and foregoing even safe loans. The total net effect may have amounted to $15B in foregone potential money. If so, then the demand for money by US banks was an important factor in the deflation after the 1929 stock-market crash.

  3. Erik Nelson says:

    From 1929-33, Excess Reserves (ER) in US banks rose from $1.8B to $3.0B, whilst nominal interest-rates (i) fell from 5.9% to 1.0%. Interest-rates are the price of credit, and prices reflect the ratio of demand-to-supply (i ~ D/S of credit). If ER reflect the supply of loanable funds, then the fact that interest-rates fell much more than ER rose, implies that the demand for credit fell. Quantitatively, defining a demand for credit (D = ER x i), then that D fell from $110M to $30M from 1929-33. So, even as US banks were accumulating ER, they were dropping their interest-rates, implying that they were trying to attract borrowers. Ipso facto, the collapse of the US money supply (M1) from 1929-33 was “demand driven” (nobody borrowing), not “supply driven” (banks had extra ER to lend). According to the plots provided by Prof. Keen, US private debt was being paid down from 1929-33.

    Thus, a clear & consistent picture emerges — from 1929-33, the US entered a “Balance Sheet Recession” (Richard Koo) during which nobody was borrowing, because everybody was paying down debt, so that banks were accumulating extra ER, without being able to on-lend the money back into circulation. If those extra ER had been borrowed, then from 1929-33, the US money supply could have grown by nearly $12B, an average rate of borrowing of $3B/year. The velocity (VM1) during that period was approximately 3, so that recirculating $3B/year by borrowing might have generated $9B/year of total spending, or nearly 14% of GDP. By Okun’s Law, that extra spending would have reduced unemployment by nearly 7%. Then, unemployment, which had fallen to 22% in 1934, would have fallen further to 15%, i.e. nearly back down to pre-Depression levels. For, according to “The Great Depression” by Paul Jeffers (p.21), the US unemployment rate during the term of Pres. Calvin Coolidge (1923-28) ranged from 5-13%, due to increasing productivity, owing to the increasing use of capital equipment. Use of tractors on farms, and machines in factories, led to over-production, falling prices for crops & commodities, and high unemployment.

    So, the pay-down of old debt, and the non-borrowing of new debt, from 1929-33, contracted the US money supply, and sequestered savings out of circulation, thereby reducing spending, and increasing unemployment. Such seemingly supports the importance of debt in the Great Depression (Steve Keen), interpretable as a Balance-Sheet Recession (Richard Koo).

  4. Erik Nelson says:

    If Prices & Wages can be “sticky”, then perhaps interest-rates can also be “sticky” ?

  5. Erik Nelson says:

    interest-rates are the “price” of credit, so reflecting the ratio of demand-to-supply of credit. During recessions, the rate of depositing (new deposits in banks), relative to the amount of currency, falls — unemployment rises, wages fall, people put less money into banks. Thus, recessions restrict the supply of loanable credit, usually driving up interest rates. But, during depressions (e.g. Great Depression, 1991), the demand for loanable credit evaporates, so that interest-rates actually fall. Inexpertly, depressions (severe recessions) seem associated with falling interest-rates, so that not only is unemployment high & output (and savings) low, but nobody is borrowing either. If so, then such highlights the important role of credit & new-debt in the (stream of spending of the) economy — the signal of “bad times” is negligible borrowing (and low interest-rates).

  6. Erik Nelson says:

    Both during the Great Depression, and in recent decades, the velocity of spending (V1 = Y/M1) tracks the velocity of net saving (VS = new deposits / currency) and the velocity of net (on-)lending (VL = new loans / currency; loans = deposits – reserves). The former tends to be 4-5x faster than the latter; the latter tends to be much more volatile, responding much more sensitively to downturns. Inexpertly, recirculation of money through banks is an important part of aggregate spending, underlying perhaps 20-25% of spending, such that decreasing (net) depositing & borrowing during downturns can reduce overall spending by between a fifth to a quarter:

  7. Erik Nelson says:

    During the GD,

    “Government statisticians decided that everyone working in these Federally sponsored “make-work” programs would have been unemployed otherwise. Consequently, they decided to count these millions of Americans as unemployed… After adjusting for people who were actually working but were counted as unemployed, he found a maximum unemployment rate of 17% [not 25%]” (Miller & Benjamin. Economics of Macro Issues, p.49-52)

    Thus, as early as 1933, New Deal programs were paying ~4 million people, reducing total unemployment by ~8%. The official statistics only report “private sector unemployment”, and thereby mask the effectiveness of the Fiscal stimulus. If official “private sector unemployment” was 17% in 1939; and if “public employment” was 10-20 million, or about 5-10% of the workforce, then “total unemployment” was actually only 7-12%.

    Today, statistics still seem misleading — millions of Americans are on public doles, but off official unemployment:

    “Since 1990, the number of people receiving disability payments from the Social Security Administration has more than tripled to over 8 million [because] the real value of monthly benefits a person can collect has risen more than 50% in the past thirty years… Indeed, those receiving disability payments make up the largest group of the 2 million or so who left the labor force during the latest [1990] recession”

    To compare current unemployment stats, to those during the GD, would require either subtracting “public employment” from the latter, or adding “public dole” to the former. Either way, the current economy looks allot less healthy, than the “doubly misleading” official statistics suggest.

  8. Erik Nelson says:

    Inexpertly, those who “ran” on the banks were those who had lost confidence in those banks. And, banks had, in fact, made many bad loans, to and for speculation, on the stock market. And, only a few percent of the US population had (being wealthy & sophisticated enough) partaken in stock-market speculation. So, perhaps banks had taken deposits of “many poorer blue collar workers”, and used their money, for loans to “fewer richer white collar speculators” (or speculated directly themselves). When the stock-market crashed, and word got out, the masses “ran” to the banks, to “get their money back”. Bank runs imply a loss of confidence, in banks, whose balance sheets were tied to the stock-market. People were walking away with currency, preferring to hold it themselves than risk it to “speculating bankers”; and, thereby, emptying the banks of the same, and motivating FDR’s executive order to return gold to banks.

    i perceive the following aspects of the GD:

    speculative bubble (stock)
    loss of confidence in banks (stock assets)
    consumer debt (houses, cars, appliances)
    corporate debt (wages ??)
    speculator debt (banks ??)

    If so, then the debt-fueled “roaring” 1920s left persons, businesses, and speculators (banks) deep in debt; everybody had been borrowing to spend beyond their means. Then, with the stock-market crash, and loss of confidence in banks, the credit market was “attacked” with bank-runs. To cash out depositors, banks began calling in all their own loans. The bank runs “pulled the plug”, inducing banks to switch, from lending, to demanding payment. In turn, non-bank private lenders demanded repayment, too. So, everybody began paying down debts (total private debt declined $50B from 1929-33), ultimately to banks (total deposits declined by $15 during that period, implying that bank loans, mirroring the same on bank balance sheets, declined by a similar amount). Thus, the public loss of confidence in banks, and the public “attack” on banks with bank-runs, induced a cascade of demanded-loan-repayments — the public demanded money from banks, who demanded money from investors, who demanded money from others. Thereby, the US economy switched from debt-fueled spending beyond means (“super-spending mode”), to debt-repayment (“super-saving mode”).

    Then, to top it all off, what money was accumulating back into banks (excess reserves) was not being borrowed (since everybody was paying down debts, not taking out new ones). Given the money-multiplier (x10), those accumulating excess reserves could have generated billions of dollars in new loans… but didn’t. Interest-rates fell, implying banks were trying, and failing, to push loans. In 1929, 10% of US GDP spending was done on credit; in the early 1930s, debt repayments amounted to 25% of US GDP. Thus, the switch from “over-spending” by +10%, to “under-spending” (for saving) by -25%, accounts for almost all of the drop in GDP.

    so, i perceive that:

    speculative bubble led to loss of confidence in banks
    public “attack run” on banks induced cascade of demanded debt repayments
    economy switched from “over-spending” +10% on new debt, to “under-spending” -25% to pay down old debt
    aggregate spending (GDP) fell by 40%
    loss of confidence in banks kept new cash out of banks, and left their cash reserves un-borrowed
    nobody was borrowing, everybody was saving, few people were spending, GDP fell
    few people were depositing into banks, nobody was borrowing from banks, money stopped circulating, leading to deflation


  9. Erik Nelson says:

    executive order 6102[/URL] stopped Great Depression ?

    i perceive, that public “attack runs” on banks induced a domino-cascade of called loans, which switched the US economy, from debt-fueled expansion, to debt-repaying contraction. The following figures show, that after 1933, US banks stopped failing; and US private debt-levels (which had been falling -$10B / year) stabilized. Then, US aggregate spending (GDP) promptly began improving. Thus, as soon as FDR ended the bank-runs, banks (and private lenders) stopped running on their debtors. Private debt stabilized, with a trickle of new loans presumably offsetting gradual repayment of old loans. Public debt, from the New Deal, increased, making up for the lethargic private sector, and improving the US economy:

  10. Erik Nelson says:

    executive order 6102 stopped Great Depression ?
    i perceive, that public “attack runs” on banks induced a domino-cascade of called loans, which switched the US economy, from debt-fueled expansion, to debt-repaying contraction. The following figures show, that after 1933, US banks stopped failing; and US private debt-levels (which had been falling -$10B / year) stabilized. Then, US aggregate spending (GDP) promptly began improving. Thus, as soon as FDR ended the bank-runs, banks (and private lenders) stopped running on their debtors. Private debt stabilized, with a trickle of new loans presumably offsetting gradual repayment of old loans. Public debt, from the New Deal, increased, making up for the lethargic private sector, and improving the US economy:

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  12. Erik Nelson says:

    From 1929-1933, total private debt declined by about 25% (from about $160B to $120B), stabilizing afterwards. Meanwhile, price-levels declined by about 25%, stabilizing afterwards. The two data series (declining nominal private debt, deflating price level) seem strongly correlated. Inexpertly, that corroborates, that deflation motivated debt repayment, in support of the debt-deflation explanation.

  13. Erik Nelson says:

    From 1929-1933, bank deposits decreased by nearly $16B, split equally between checking & savings deposits. ($1.3B of which were wiped out in bank failures.) Thus, amidst the flurry of deleveraging, of debtors repaying creditors (e.g. businesses paying back bond-holders), money wended its way back to banks, to pay off bank loans (e.g. mortgages), and “vanished” (bank assets (loans) co-cancelling bank liabilities (deposits)), contracting the money supply.

    Now, in the 1920s, the speed of spending (velocity, MV1) had been about 3-4. Every dollar in circulation [$] generated 3-4 dollars of spending per year [$/year], as it changed hands, over & over, across the economy, over the course of the year. Thus, gradually eliminating MONEY [$16B, over 4 years] out of the stream of spending, would have eliminated 3-4x as much SPENDING [$50-60B per 4 years] by 3-4x as much. Indeed, from 1929-1933, nominal GDP fell by nearly $50B.

    Economist Mike Konczal has argued that mortgage debt explains the current US recession. Microeconomically, communities having the highest debt ratios have the slowest spending, and sluggish employment growth. Mortgage debt peaked in 2008, and has been paid down for 4 years. The plot of mortgage debt over time resembles the plot of private debt, in the original blog post above. Mortgage debt is special, because it comes from banks, so repaying it contracts the money supply. Money siphoned out of spending, to pay off mortgages, “vanishes”, and eliminates an amount of spending, per dollar, equal to the current velocity of money (8-10 in the US at present). Thus, paying down nearly $1T, over 4 years, would be predicted to reduce nominal spending, by up to $2T per year ($8T over 4 years). Those kinds of figures can account for the fall in US GDP.

    Perhaps debt reduction is crucial, generally; and deposit reduction (paying back banks, contracting the money supply) is crucial, specifically ?

  14. Erik Nelson says:

    i’m trying to say, “perhaps everybody was always right”? Irving Fisher’s critics argued:

    “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 … pure redistributions should have no significant macroeconomic effects.”

    So, a business buys back its bonds, paying off bond-holders, who then go golfing, and eat out at expensive restaurants. When NON-BANK debt is repaid, money merely changes hands. The kind of spending may change (business investment to personal consumption), but not the degree.

    But when BANK debt is repaid, the money “vanishes”. Bank accountants simultaneously co-cancel the loan, and the money (bank deposit) used to pay off the loan. The money supply contracts. And “disappeared” money has ZERO propensity to be spent. Once the money is eliminated, it can no longer change hands, and stimulate a series of spendings in the economy.

    So, BANK debt is different from NON-BANK debt. Irving Fisher’s critics were correct, about the latter. But debt DEFLATION, from paying back banks, and so contracting the money supply, does not transfer money, but eliminates money. Eliminated money cannot be spent; its “propensity to be spent” is zero. That represents a “surprisingly large” difference in spending propensity, between debtors (e.g. mortgaged home-owners, borrowing money) and creditors (banks, trimming down their balance sheets, eliminating money).

    So, everybody was always (partially) correct. Debt reduction is crucial to understanding depressions. And (perhaps) especially BANK DEBT REDUCTION.

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