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. pamery says:

    Steve the title of figure 5 has the incorrect date range. Thanks otherwise for a sobering summary of what awaits us, Bernanke or not. Greetings from London. Paul Amery

  2. Donlast says:

    If you want more reasons why Mr Bernanke should not be re-apointed go to Brad De Long’s website today. He has a Fed insider rationalising the Fed’s stance on bubbles and other issues. Incroyable!

  3. johngn888 says:

    Thanks for writing this up. One thing I don’t quite understand. You say that Bernanke could have been more effective at dealing with the crisis. He has tried to prevent debt-deflation. But is that in your view a long term solution? Will we eventually deflate/depress business even more at a later date? If not, why?

    thanks again Prof Keen.

  4. robjoh says:


    As Pamery states, wrong title on figure 5 or wrong figure 5.

    Otherwise a very good post, the only thing I miss is what we should do instead.

    Greatings from Sweden
    Robert Johansson

  5. Frank says:

    Everytime I come here I breathe a sigh of relief at the down to earth common sense and no-nonsense rationality of this site. Thank goodness for Steve Keen and(/or?) the Australian approach to things.

  6. David Colquitt49 says:

    Steve, I agree but surely the American people should address the real problem; in 1913 they lost control of the issuance of their currency to a cabal of world bankers. Wilson later admitted he had made a grave mistake while Lincoln would have rolled in his grave. Abolish the Fed.

  7. Steve Keen says:

    Thanks for that pamery, it’s now fixed on the blog and I’ll post an updated version of the PDF in a few minutes.

    Please distribute it as widely as possible everyone; there’s a real chance to derail Bernanke’s reappointment this week, and my extra argument as to why that would be a good thing could help sway a vote or two in the Senate if it gets into the right hands.

  8. Steve Keen says:

    Hi johngn888,

    The main issue there is giving the money to the banks rather than to the public as in Australia’s stimulus package. When I run the update next week I’ll include a simulation that shows giving funds to the public is much more effective in a credit crunch than giving it to the banks.

    I believe deflation is the likely medium term outcome, as with Japan. Ultimately the system has to be righted by a massive rebalancing of fiat to credit money, however that happens; my expectation is that it will be via deflation rather than inflation.

  9. Gamma says:

    I don’t see anything in the analysis which gives any reasons why deleveraging will result in true deflation (ie generalised price decreases) rather than asset-specific price deflation.

    After all, the leveraging period (specifically over the last 10-15 years), has not seen generalised price increases, but rather asset price increases. So isn’t it possible we will see the reverse during the deleveraging period?

    I think true deflation is an unlikely scenario.

  10. ak says:

    Below is what Bernanke wrote on 2009/07/21 in the context of worries about inflation. He clearly believes in the money multiplier theory. He thinks that it should work but the impact has been very limited.

    “Since the onset of the financial crisis nearly two years ago, the Federal Reserve has reduced the interest-rate target for overnight lending between banks (the federal-funds rate) nearly to zero. We have also greatly expanded the size of the Fed’s balance sheet through purchases of longer-term securities and through targeted lending programs aimed at restarting the flow of credit.
    These actions have softened the economic impact of the financial crisis. They have also improved the functioning of key credit markets, including the markets for interbank lending, commercial paper, consumer and small-business credit, and residential mortgages.”

    “When the Fed makes loans or acquires securities, the funds enter the banking system and ultimately appear in the reserve accounts held at the Fed by banks and other depository institutions. These reserve balances now total about $800 billion, much more than normal. And given the current economic conditions, banks have generally held their reserves as balances at the Fed.
    But as the economy recovers, banks should find more opportunities to lend out their reserves. That would produce faster growth in broad money (for example, M1 or M2) and easier credit conditions, which could ultimately result in inflationary pressures—unless we adopt countervailing policy measures. When the time comes to tighten monetary policy, we must either eliminate these large reserve balances or, if they remain, neutralize any potential undesired effects on the economy.”

  11. Steve Keen says:

    Hi David,

    I’m in favour of abolishing the Fed’s ability to be anything other than a clearing house between banks, but I don’t believe that the public can ever be in charge of currency issuance in a world with private banking. As I note in my reform proposals, I’d rather try to make taking on debt for leveraged speculation unattractive than try to reform the nature of banking.

  12. Goldilocksisableachblond says:


    I’d like to suggest an additional graph to add to your presentations to clarify the impact of debt on GDP growth. Here’s an example , using the well-known Shadowstats analysis of CPI calculation “lies”. ( Note : I’m only using this as an example of data presentation , not to suggest that the CPI data as corrected by Shadowstats is the “right” data.)

    Here’s a graph from Shadowstats , showing the year-by-year differential in GDP between the official stats and his own data , corrected for the phoney CPI calcs :

    There’s nothing wrong with this graph , but I don’t think it has nearly the impact of this one from itulip , which uses the same data , presented in a ‘classical’ GDP-growth-over-time format :

    Just eyeballing your Fig. 5 above , it looks like if you netted out added private debt from the official GDP , you’d end up with a peak GDP of $10-11 trillion , rather than $14 trillion. Even if you ( more conservatively ) netted out 60-70% of the added debt , the reduction would still be substantial and , of course , the further back in time you go , the more it adds up.

    The end result of this calculation might provide a reasonable stimate of what real GDP in the U.S. will look like in coming years , assuming total — public plus private — debt/GDP levels stabilize.

    Of course growth of public debt/GDP levels over the last few decades makes our current situation look even worse. I know you intend to include public debt in your models going forward , but it’s worth noting that the private debt levels probably understates the recent “debt-dependence” of U.S. economic growth.

  13. Goldilocksisableachblond says:

    I forgot to mention that I intend to forward your pdf to my Senators. I just emailed them on Friday to suggest voting “No” on Bernanke , but this will make a nice followup.

  14. Willy2 says:

    Mr. Keen,

    There was – at least – someone who saw already in 2005 what was coming. One Alan Greenspan !!!

    “”We’ve lost control over the budget””

    And you think Greenspan never ever discussed this with Bernanke ?

    And that’s the take of mr. Michael Hudson ( as well. See the frontpage of his website. But there was a clear reason to keep printing money like there’s no tomorrow: the socalled PETRODOLLAR, the war in Iraq and Afghanistan.
    Didn’t you read the book “”Superimperialism”” by mr. Michael Hudson ? It’s available on his website. (it requires some digging)

    There was a clear reason Greenspan lowered agressively rates from 6% to 1%. Lending broke down in the US in early 2001. This was a severe “”Credit Crunch””. And that was only two or three months after october 2000 when everyone who wanted to buy iraqi oil had to pay for that oil in Euro’s instead of USDs. (Coincidence ??? No way !!) That was simply the last straw on the breaking back of the camel. And Greenspan started to raise interestrates in 2004 when he saw that lending started to pick up again. I still have a graph of that.

    But I think there’s one MAJOR flaw in this entire USD Ponzi-scheme. The assumption that foreigners always will use their USDs to buy US Treasuries or Agency paper. Foreigners can also choose to sit on their pile of USD cash. That’s what happened in the late 1970s when Europe called America’s bluff. And it seems the chinese are about to do the same thing. (i.e. stop or reduce buying US Treasuries). See the latest TIC data !

    It seems that:
    1. Summers and Geithner are “”on the way out””
    2. Volcker and Donaldson are “”already in control””.

  15. Steve Keen says:

    Feasible Goldi, but I’ll have to see if I have time as I write the update for next week. I have a trip to Bangkok to meet with the UNEP and CSIRO to focus on in the meantime.

  16. Steve Keen says:

    Excellent–the more Senators who start to question whether Bernanke is actually an expert on the Great Depression, the better!

  17. Goldilocksisableachblond says:

    A good piece in the FT today , apropos to Steve’s post , comparing the U.S.housing busts of the GD vs. the GFC , and noting the failures of the Fed :

    “Housing, depressions and credit collapses”


    “The lesson is not just that the Fed failed to anticipate the collapse in the bubble: it also didn’t foresee its devastating consequences. This is reflected in the candid comment last year by Fed Vice Chairman Donald Kohn (Cato Journal): “I and other observers underestimated the potential for house prices to decline substantially, the degree to which such a decline would create difficulties for homeowners, and, most important, the vulnerability of the broader financial system to these events.”

  18. stf says:

    Great blogpost, Steve!

  19. GSM says:


    Thanks once again for a clear, simple and logical explanation of events that got us to this GFC.

    Can I humbly point to another danger which I hope and trust you will be keeping your eyes on?;

    “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.”

    In their egotistical desires to become re-elected, Govts will attempt to oppose all efforts to delever. They have no choice really. To allow deleveraging to occur, Govts are in essence admitting that it was the debt (and its attendant loose policies which they actively encouraged) that has brought about the GFC and so much public hardship. So, Govts will be sorely tempted to dramatically and continuously increase their own levels of debt fuelled spending as an offset to the withdrawal of the private sector. It could be that the real Crisis is ahead of us with Sovereign debt defaults being the big hammer to drop.

  20. Karmaisking says:


    Couldn’t agree more. With this insane system we’re in, like a shark, debt levels need to constantly increase or the system dies (due to Fisher’s debt deflation thesis, or Mises’ “crack up boom” – both talk about exactly the same consequence of unsustainable debt).

    Iceland, Dubai, Ireland, Greece, Portugal, heck, even the UK all have massive govt debt loads now. When govt bonds yields spike or there’s a currency crisis, these countries will be on fire.

    I support a free market in money (ie a return to a precious metals based monetary system) and nationalisation, then a break up of all TBTF banks, then the elimination of the lender of last resort function from central banks to remove the moral hazard issue that infests the system at present.

    I guarantee these are the only viable long term solutions (regardless of the short term pain of adjusting to a deflationary monetary system). The longer the current insane system drags on like a zombie the more govt and public debt, the more malinvestments, the more unemployment when even govt employees have to be laid off and public services are wiped out (like in Iceland today).

    Financing “consumption” through debt is a recipe for disaster and govts are now financing health care, and basic services (not capital investment!) with debt. This is yet another disaster in the making. I don’t they’ll be able to blame “the free market” this time around.

  21. Karmaisking says:

    “I doubt”

  22. noah cross says:

    Bill Mitchell examines Bernanke’s record on his post yesterday –

    The Great Moderation myth

  23. GSM says:


    From the prior thread;
    “How do you create all these jobs ‘and have them productive’, if you have at least a generation whose principal skills are
    “shuffling paper’?”

    My sense is that productivity will be of secondary concern. The headline Joblessness will be all that matters to Obama’s administration come end 2010 and beyond. We can expect to see massive public renewal and construction programs combined, I suspect, with a much higher level of protectionism.All of it funded by monetization of new debt. If we have concerns about the status of Sovereign debt now, it will be nothing compared to what it will be in a couple of years.

  24. TheAntipodean says:

    Longtime listener, firsttime caller.
    Another erudite contribution thank you.
    It was your much simpler comments on the progressive tightening of Westpac’s LVR reported in the mainstream media today that will finally give you the credit you deserve. I think that the Great Unwashed are finally waking up to the fact that debts must be repaid, and that the orgy of cheap debt is over.
    May you continue to receive the kudos you deserve.

  25. Goldilocksisableachblond says:


    One minor quibble I have with your post:

    Bernanke said :

    “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. ”

    To which you countered with:

    “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.”

    I don’t think Bernanke’s statement is necessarily true even in the idealized world he describes , because in an economy with extreme levels of wealth and income inequality ,such as the one that’s evolved in the U.S. over the last three decades , there are PLAUSIBLY large differences in marginal spending propensities. The after-tax marginal propensity to consume for someone like Bill Gates might be very near zero , while the same measure for many in the bottom 90% of the income/wealth distribution could approach 100%.

    Simple , market-clearing distributions from debtors to creditors would likely have significant impacts on aggregate demand , even if there were no defaults , just because of their contribution to inequality. On the other end of the spectrum , the same process contributes to the phenomenon of “hot money” chasing global asset bubbles , as many of these folks choose gambling over consumption.

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