What Bernanke doesn’t under­stand about defla­tion

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Bernanke’s recent Jack­son Hole speech didn’t con­tain one ref­er­ence to the key force dri­ving the Amer­i­can econ­omy right now: pri­vate sec­tor delever­ag­ing (here’s the pre­vi­ous year’s speech for comparison’s sake). The rea­son the US econ­omy is not recov­er­ing from this cri­sis is because all sec­tors of Amer­i­can soci­ety took on too much debt dur­ing the false boom of the last two decades, and they are now busily get­ting them­selves out of debt any way they can.

Debt reduc­tion is now the real story of the Amer­i­can econ­omy, just as real story behind the appar­ent free lunch of the last two decades was ris­ing debt. The secret that has com­pletely eluded Bernanke is that aggre­gate demand is the sum of GDP plus the change in debt. So when debt is ris­ing demand exceeds what it could be on the basis of earned incomes alone, and when debt is falling the oppo­site hap­pens.

I’ve been bang­ing the drum on this for years now, but it’s a hard idea to com­mu­ni­cate because it’s so alien to the way most econ­o­mists (and many peo­ple) think. For a start, it involves a rede­f­i­n­i­tion of aggre­gate demand. Most econ­o­mists are con­di­tioned to think of com­mod­ity mar­kets and asset mar­kets as two sep­a­rate spheres, but my def­i­n­i­tion lumps them together: aggre­gate demand is the sum of expen­di­ture on goods and ser­vices, PLUS the net amount of money spent buy­ing assets (shares and prop­erty) on the sec­ondary mar­kets. This expen­di­ture is financed by the sum of what we earn from pro­duc­tive activ­i­ties (largely wages and prof­its) PLUS the change in our debt lev­els. So total demand in the econ­omy is the sum of GDP plus the change in debt.

I’ve recently devel­oped a sim­ple numer­i­cal exam­ple that makes this case eas­ier to under­stand: imag­ine an econ­omy with a nom­i­nal GDP of $1,000 bil­lion which is grow­ing at 10 per­cent a year, due to an infla­tion rate of 5 per­cent and a real growth rate of 5 per­cent, and in which pri­vate debt is $1,250 bil­lion and is grow­ing at 20% a year.

Aggre­gate pri­vate sec­tor demand in this economy—expenditure on all mar­kets, includ­ing asset markets—is there­fore $1,250 bil­lion: $1,000 bil­lion from expen­di­ture from income (GDP) and $250 bil­lion from the change in debt. At the end of the year, pri­vate debt will be $1,500 bil­lion. Expen­di­ture is thus 20 per­cent above the level that could be financed by income alone.

Now imag­ine that the fol­low­ing year, the rate of growth of GDP con­tin­ues at 10 per­cent, but the rate of growth of debt slows from 20 to 10 per­cent. GDP will have grown to $1,100 bil­lion, while the increase in pri­vate debt this year will be $150 billion—10 per­cent of the ini­tial $1,500 bil­lion total and there­fore $100 bil­lion less than the $250 bil­lion increase the year before.

Aggre­gate pri­vate sec­tor demand in this econ­omy will there­fore be $1,250 bil­lion, con­sist­ing of $1,100 bil­lion from GDP and $150 bil­lion from ris­ing debt—exactly the same as the year before. But since infla­tion has been run­ning at 5 per­cent, aggre­gate demand will be 5 per­cent lower than the year before in real terms. So sim­ply sta­bil­is­ing the debt to GDP ratio results in a fall in demand in real terms, and some markets—commodities and/or assets—must take a hit.

Putting this exam­ple in a table, we get the fol­low­ing illus­tra­tion:

Variable/Year Year 1 Year 2
Nom­i­nal GDP 1000 1100
Growth rate of Nom­i­nal GDP 10% 10%
Real growth rate 5% 5%
Infla­tion Rate 5% 5%
Pri­vate Debt 1250 1500
Growth rate of Pri­vate Debt 20% 10%
Change in Pri­vate Debt 250 150
Nom­i­nal Aggre­gate demand (GDP + Change in Debt) 1250 1250

Notice that nom­i­nal aggre­gate demand remains con­stant across the two years–but this means that real out­put has to fall, since half of the recorded growth in nom­i­nal GDP is infla­tion. So even sta­bil­is­ing the debt to GDP ratio causes a fall in real aggre­gate demand. Some markets–whether they’re for goods and ser­vices or assets like shares and property–have to take a hit.

Now let’s apply this to the US econ­omy for the last few years, in some­what more detail. There are some rough edges to the fol­low­ing table—the year to year changes put some fig­ures out of whack, and some change in debt is sim­ply com­pound­ing of unpaid inter­est that doesn’t add to aggre­gate demand—but in the spirit of “I’d rather be roughly right than pre­cisely wrong”, at your leisure please work your way through the table below.

Its key point can be grasped just by con­sid­er­ing the GDP and the change in debt for the two years 2008 and 2010: in 2007–2008, GDP was $14.3 tril­lion while the change in pri­vate sec­tor debt was $4 tril­lion, so aggre­gate pri­vate sec­tor demand was $18.3 tril­lion. In cal­en­dar year 2009-10, GDP was $14.5 tril­lion, but the change in debt was minus $1.9 tril­lion, so that aggre­gate pri­vate sec­tor demand was $12.6 tril­lion. The turn­around in two years in the change of debt has lit­er­ally sucked almost $6 tril­lion out of the US econ­omy.

Variable\Year 2006 2007 2008 2009 2010
GDP 12,915,600 13,611,500 14,337,900 14,347,300 14,453,800
Change in Nom­i­nal GDP 6.3% 5.4% 5.3% 0.1% 0.7%
Change in Real GDP 2.7% 2.4% 2.5% –1.9% 0.1%
Infla­tion Rate 4.0% 2.1% 4.3% 0.0% 2.6%
Pri­vate Debt 33,196,817 36,553,385 40,596,586 42,045,481 40,185,976
Debt Growth Rate 9.6% 10.1% 11.1% 3.6% –4.4%
Change in Debt 2,914,187 3,356,568 4,043,201 1,448,895 –1,859,505
GDP + Change in Pri­vate Debt 15,829,787 16,968,068 18,381,101 15,796,195 12,594,295
Change in Pri­vate Aggre­gate Demand 0.0% 7.2% 8.3% –14.1% –20.3%
Gov­ern­ment Debt 6,556,391.0 6,893,467.0 7,321,592.0 8,615,051.0 10,167,585.0
Change in Gov­ern­ment Debt 478,851.0 337,076.0 428,125.0 1,293,459.0 1,552,534.0
GDP + Change in Total Debt 16,308,638.0 17,305,144.0 18,809,226.0 17,089,654.0 14,146,829.0
Change in Total Aggre­gate Demand 0.0% 6.1% 8.7% –9.1% –17.2%

That suck­ing sound will con­tinue for many years, because the level of debt that was racked up under Bernanke’s watch, and that of his pre­de­ces­sor Alan Greenspan, was truly enor­mous. In the years from 1987, when Greenspan first res­cued the finan­cial sys­tem from its own fol­lies, till 2009 when the US hit Peak Debt, the US pri­vate sec­tor added $34 tril­lion in debt. Over the same period, the USA’s nom­i­nal GDP grew by a mere $9 tril­lion.

Ignor­ing this growth in debt—championing it even in the belief that the finan­cial sec­tor was being clever when in fact it was run­ning a dis­guised Ponzi Scheme—was the great­est fail­ing of the Fed­eral Reserve and its many coun­ter­parts around the world.

Though this might beg­gar belief, there is noth­ing sin­is­ter in Bernanke’s fail­ure to real­ize this: it’s a fail­ing that he shares in com­mon with the vast major­ity of econ­o­mists. His prob­lem is the the­ory he learnt in high school and uni­ver­sity that he thought was sim­ply “economics”—as if it was the only way one could think about how the econ­omy oper­ated. In real­ity, it was “Neo­clas­si­cal eco­nom­ics”, which is just one of the many schools of thought within eco­nom­ics. In the same way that Chris­tian­ity is not the only reli­gion in the world, there are other schools of thought in eco­nom­ics. And just as dif­fer­ent reli­gions have dif­fer­ent beliefs, so too do schools of thought within economics—only econ­o­mists tend to call their beliefs “assump­tions” because this sounds more sci­en­tific than “beliefs”.

Let’s call a spade a spade: two of the key beliefs of the Neo­clas­si­cal school of thought are now com­ing to haunt Bernanke—because they are false. These are that the econ­omy is (almost) always in equi­lib­rium, and that pri­vate debt doesn’t mat­ter.

One of Bernanke’s pre­de­ces­sors who also once believed these two things was Irv­ing Fisher, and just like Bernanke, he was orig­i­nally utterly flum­moxed when the US econ­omy col­lapsed from pros­per­ity to Depres­sion back in 1930. But ulti­mately he came around to a dif­fer­ent way of think­ing that he chris­tened “The Debt Defla­tion The­ory of Great Depres­sions” (Fisher 1933).

You would think Bernanke, as the alleged expert on the Great Depression—after all, that’s one of the main rea­sons he got the job as Chair­man of the Fed­eral Reserve—had read Fisher’s papers. And you’d be right. But the prob­lem is that he didn’t under­stand them—and here we come back to the belief prob­lem. The Great Depres­sion forced Fisher—who was also a Neo­clas­si­cal economist—to real­ize that the belief that the econ­omy was always in equi­lib­rium was false. When Bernanke read Fisher, he com­pletely failed to grasp this point. Just as a reli­gious scholar from, for exam­ple, the Hindu tra­di­tion might com­pletely miss the key points in the Chris­t­ian Bible, Bernanke didn’t even reg­is­ter how impor­tant aban­don­ing the belief in equi­lib­rium was to Fisher.

To know this, all you have to do is read Bernanke’s sum­mary of Fisher in his Essays on the Great Depres­sion:

The idea of debt-defla­tion goes back to Irv­ing Fisher (1933). 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.

Fisher’s idea was less influ­en­tial in aca­d­e­mic cir­cles, though, because of the coun­ter­ar­gu­ment that debt-defla­tion rep­re­sented no more than a redis­tri­b­u­tion from one group (debtors) to another (cred­i­tors). Absent implau­si­bly large dif­fer­ences in mar­ginal spend­ing propen­si­ties among the groups, it was sug­gested, pure redis­tri­b­u­tions should have no sig­nif­i­cant macro­eco­nomic effects. ” (Bernanke 2000, p. 24)

There’s no men­tion of dis­e­qui­lib­rium there, and though Bernanke went on to try to develop the con­cept of debt-defla­tion, he did so while main­tain­ing the belief in equi­lib­rium. Com­pare this to Fisher him­self on how impor­tant dis­e­qui­lib­rium really is in the real world:

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)

We might not be in such a pickle now if eco­nom­ics had started to become more of a sci­ence and less of a reli­gion by fol­low­ing Fisher’s lead, and aban­don­ing key beliefs when real­ity made a mock­ery of them. But instead neo­clas­si­cal eco­nom­ics com­pletely rebuilt its belief sys­tem after the Great Depres­sion, and here we are again, once more expe­ri­enc­ing the dis­con­nect between neo­clas­si­cal beliefs and eco­nomic real­ity.

For the record, here’s my “GDP plus change in debt” table for the 1930s, to give us some idea of what the next decade or so might hold if, once again, we repeat the mis­takes of our pre­de­ces­sors.

Variable\Year 1929 1930 1931 1932 1933 1934 1935
GDP 103,600 91,200 76,500 58,700 56,400 66,000 73,300
Change in Nom­i­nal GDP 6.0% –12.0% –16.1% –23.3% –3.9% 17.0% 11.1%
Infla­tion Rate –1.2% 0.0% –7.0% –10.1% –9.8% 2.3% 3.0%
Pri­vate Debt 161,800 161,100 148,400 137,100 127,900 125,300 124,500
Debt Growth Rate 3.7% –0.4% –7.9% –7.6% –6.7% –2.0% –0.6%
Change in Debt 5,700 –700 –12,700 –11,300 –9,200 –2,600 –800
GDP + Change in Pri­vate Debt 109,300 90,500 63,800 47,400 47,200 63,400 72,500
Change in Pri­vate Aggre­gate Demand 0.0% –17.2% –29.5% –25.7% –0.4% 34.3% 14.4%
Gov­ern­ment Debt 30,100 31,200 34,500 37,900 40,600 46,300 50,500
Change in Gov­ern­ment Debt –100 1,100 3,300 3,400 2,700 5,700 4,200
GDP + Change in Total Debt 109,200 91,600 67,100 50,800 49,900 69,100 76,700
Change in Total Aggre­gate Demand 0.0% –16.1% –26.7% –24.3% –1.8% 38.5% 11.0%

Bernanke, B. S. (2000). Essays on the Great Depres­sion. Prince­ton, Prince­ton Uni­ver­sity Press.

Fisher, I. (1933). “The Debt-Defla­tion The­ory of Great Depres­sions.” Econo­met­rica
1(4): 337–357.

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About Steve Keen

I am Professor of Economics and Head of Economics, History and Politics at Kingston University London, and a long time critic of conventional economic thought. As well as attacking mainstream thought in Debunking Economics, I am also developing an alternative dynamic approach to economic modelling. The key issue I am tackling here is the prospect for a debt-deflation on the back of the enormous private debts accumulated globally, and our very low rate of inflation.
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