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 a professional economist 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 debts accumulated in Australia, and our very low rate of inflation.
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206 Responses to What Bernanke doesn’t understand about deflation

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  3. LightsOut says:

    Hi Steve.

    Thanks for the clar­i­fi­ca­tion.
    Thought you might be inter­ested in this BIS paper as a pos­si­ble way of cal­i­brat­ing your cir­cuit model.


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