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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