Sense from Krugman on private debt

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I was highly critical of Paul Krugman’s recent academic paper on the financial crisis, because it argued, on neoclassical a priori grounds, that:

Ignoring the foreign component, or looking at the world as a whole, the overall level of debt makes no difference to aggregate net worth — one person’s liability is another person’s asset. (p. 3)

Given that criticism, I feel obliged to point out that in his recent comment on Rick Perry’s nomination for the Presidency, “The Texas Unmiracle”, Krugman makes a very sensible observation about the importance of “the overall level of debt” that contradicts the assumption he made in that paper. Observing that Texas’s allegedly better performance on employment growth is due mainly to “cheap labor”, Krugman comments that:

at a national level lower wages would almost certainly lead to fewer jobs — because they would leave working Americans even less able to cope with the overhang of debt left behind by the housing bubble, an overhang that is at the heart of our economic problem.

Bravo! The aggregate level of private debt does matter, and simplistic attempts to make businesses feel better by lowering their wage costs may actually reduce their revenue even more as already debt-depressed households see their disposable income above debt servicing and repayments shrink dramatically.

Here Krugman repeats the wisdom of Keynes on the same point during the Great Depression. Generally I regard Irving Fisher as superior to Keynes on the causes of the Great Depression, because he focused on the role of debt and deleveraging whereas Keynes, by and large, ignored it. However on one occasion—when considering the argument that neoclassical economists were making that the Depression could be ended by a cut in wages, Keynes made the following comment:

“Since a special reduction of money-wages is always advantageous to an individual entrepreneur … a general reduction … may break through a vicious circle of unduly pessimistic estimates of the marginal efficiency of capital…

On the other hand, the depressing influence on entrepreneurs of their greater burden of debt may partially offset any cheerful reactions from the reductions of wages. Indeed if the fall of wages and prices goes far, the embarrassment of those entrepreneurs who are heavily indebted may soon reach the point of insolvency–with severe adverse effects on investment.” (Keynes 1936, p. 264)

This points out the fallacy in neoclassical thinking that blames unemployment on wages being too high: since neoclassical theory ignores the role of debt, it imagines that dropping the price of labor will increase demand for it, by improving the profitability of firms. However as both Keynes and Krugman note, since private debt both exists and matters, cutting wages while leaving the level of debt unaltered can actually end up reducing demand by more than the fall in wages—leaving employer worse off than before.

Keynes also argued that a cut in money wages would also cause a fall in the price level, which would also increase the debt burden—though his statement of this was very convoluted, as was often the case when what he wrote challenged conventional theory:

“The method of increasing the quantity of money in terms of wage-units by decreasing the wage-unit increases proportionately the burden of debt; whereas the method of producing the same result by increasing the quantity of money whilst leaving the wage-unit unchanged has the opposite effect. Having regard to the excessive burden of many types of debt, it can only be an inexperienced person who would prefer the former.” (1936: pp. 268-69)

(“An inexperienced person” was Keynes’s satirical code for “a neoclassical economist”)

In English, Keynes is saying that cutting money wages will reduce the price level, which will increase the real debt burden. This is precisely what happened during the early years of the Great Depression. Here Fisher is the one to read rather than Keynes: his 9-step process of debt deflation began with:

(1) Debt liquidation leads to distress selling… (Fisher 1933, p. 342)

Which caused:

(3) A fall in the level of prices

Leading to the paradox that:

“the more debtors pay, the more they owe. (Fisher 1933, p. 344)

This is precisely what happened in the early, seriously deflationary stage of the Great Depression: businesses cut prices in an attempt to stimulate demand for their products, and paid their debt down with the proceeds, only to find that their real debt burden rose because the fall in revenue more than outweighed the reduction in debt.

I normally present just the ratio of debt to GDP when talking about how excessive debt causes economic crises:

Figure 1: US Private Debt to GDP

But the really important story of the Great Depression is, as Fisher notes, is that the debt ratio rose even though the absolute level of debt was falling:

Figure 2: Rising Private Debt Ratio with Falling Debt

The same paradox applies when considering what might happen if wages are cut: by cutting wages without reducing the level of nominal debt, the debt burden will rise in real terms. It also leads to a paradoxical idea: the best way to reduce the debt burden might not be “printing money”—which Keynes in effect recommended in that second quote, and which Bernanke has in fact been trying—but raising money wages.

This wouldn’t increase real wages—because employers would pass on the cost increase—but it would very directly cause inflation, and thus reduce the real burden of debt.

Of course, there’s zero chance of that policy being tried, for at least two reasons. Decentralized wage setting means that there is no mechanism to do it in the first place, while both neoclassical economists and conventional pundits vehemently oppose wage rises anyway.

Here they’re being a bit like amateur drivers who find themselves in a spin because they’ve driven too fast around a bend. Their response is to turn into the bend even more—which results in the car spinning even more out of control. Expert drivers (and I’m not one, I hasten to add!) know that in that circumstance they have to do the counter-intuitive thing of turning the wheel in the opposite direction.

The bend we’re in is the process of debt-deleveraging, which as Richard Koo argues, turns conventional economic thinking on its head. But the way we’re going, we’ll behave like amateur drivers in a spin and make a bad situation worse by lowering wages during a debt-deflation.

Finally, one reason why deflation hasn’t been as sharp this time as it was in the Great Depression—even though the private debt level is higher—is that non-financial businesses are actually in less debt now than they were then. Non-financial businesses entered the Great Depression with a debt to GDP ratio of 100 per cent—well above the 75 per cent level that applied at the start of our crisis. So they don’t face the same direct pressure to service debts that led to the “distress selling” Fisher focused upon.

Figure 3: Debt to GDP by Sector

But households are in far worse shape now than in the 1930s, with a peak debt level that is two and a half times as high as it was in 1930. That’s why the crisis now is manifesting itself in stagnant consumer demand. It doesn’t involve the same plunge into deflation as the Great Depression, but it does imply a more drawn out deleveraging, because it’s much harder for households to reduce debt than it is for businesses. Businesses can get out of debt by going bankrupt, sacking workers, and stopping investment. Households have to live with the shame of bankruptcy and the limitations it imposes on behaviour in future, they can’t sack the kids, and it’s impossible to stop consuming completely. So we may face a far more drawn out process of deleveraging than the Great Depression.

To return to Krugman’s point, this is the last environment in which reducing wages makes any sense, however much appeal it might appear to have on a simplistic analysis.

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

Keynes, J. M. (1936). The general theory of employment, interest and money. London, Macmillan.


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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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123 Responses to Sense from Krugman on private debt

  1. RJ says:

    “You calling people stupid when in fact they simply disagree with your arguments.”

    Who have I called stupid. I said this statement was rubbish. This does not equate to calling you stupid. Just barking up the wrong tree on this point.

    And its all opinion. If you are confident of your standing then ignore my post or come back at me.

  2. Aac says:

    Again RJ, you have side stepped the argument. Can you give a reason why 2 to 3% is rubbish and why many others think it’s reasonable.

    “I have not agreed. Interest can be but not debt in total”

    And please explain what you don’t agree with.

    Do you agree that defaults don’t necessarily have to happen in pure credit system. If so then why is net positive financial assets important. Why does the government need to deficit spend on mass to stop defaults.

    You based your whole argument around:

    Net financial assets = Government deficits

    You have agreed that interest can be paid back in your link”

    Which leads to the proof I gave which states that defaults don’t have to happen such that the system collapses.

    In other words I have proved that the MMT equation of Net financial assets = Government deficits has no bearing on whether or not a system collapses under default.

    Which turns your whole argument on its head and all you can say is rubbish – please explain your reasoning. Me thinks you have lost an argument and now you are pounding your chest.

  3. RJ says:


    And you may be right. I will pick this up again if time again tomorrow

  4. Steve Keen says:

    Come back Lyonwiss. I am about to do something about this.

  5. koonyeow says:


    I would like to know your definition of money, preferably with examples of double entry bookkeeping; or you can point me to any of your comments where you have defined money.

    I have not been following threads or comments closely, so I hope that this is not too much that I ask of you.


  6. Steve Keen says:

    RJ, I have tolerated your near dominance of discussion on this list recently because it has always been my practice to let discussions run as freely as possible, only stopping them when there is individual abuse or comments that have the potential for flaming.

    However in your case I am now going to make an exception.

    You post far too often, you are far too strident in what you say, and I am going to have to agree with a comment by Sirius earlier that you have much to learn. We would all benefit–including yourself–if you read far more and blogged far less. I commented that you should buy Debunking Economics II for the bibliography alone: the reason was that seeing that might help you appreciate how much you do not know.

    Since your insistent postings are now leading some other bloggers to leave the list, I am hereby limiting you to one post per day. And I want you to take at least one week’s break during which time you will read the one reference I have already recommended to you: Schumpeter’s Theory of Economic Development. The reason is that one of the many comments you have made about endogenous money directly contradicted Schumpeter’s wisdom in that book. It is time you learnt what you do not know.

  7. mahaish says:

    im not so sure about this steve,

    think its a step too far,

    i think rj raises legitimate issues,

    and just like lyonwiss is passionate about his views


    i think its incumbant upon all of us, to address each other with civility and less tude so to speak.

    rj, for your sake, sometimes saying less has more impact . and perhaps de escalate the language a bit.

    we dont need to be on the attack all the time

    less tude , dude,

    and i think a heart felt acknowledgement on your behalf of the current situation may change the atmosperics a bit.

  8. mahaish says:

    as for some of us contradicting schumpeter, and getting our facts wrong and mouthing off half truths,

    and posting too much

    well thats never ever happened on this blog before has it 😉

    but quasi banning people- this is just how nazi germany got started 😉

    and before anyone grabs the wrong end of the waffle iron,

    im joking about the last comment

  9. Steve Keen says:

    Lyonwiss had already said he was leaving the list Mahaish, Aac has said he was disengaging from debate with RJ, Sirius has done the same, and RJ has posted in the order of a dozen comments a day without showing any signs of self-regulating. I was not prepared to lose one or more long-term members of the list as a consequence of that behavior. I don’t like doing this, which is why I didn’t act prior to Lyonwiss’s comment–though I was sorely tempted to do so.

  10. alainton says:


    Yes it was obvious from context you had missed the ‘not’ out so I didnt ‘call’ you on it – sheesh.

    Today every newspaper headline screams double dip

    The mood has shifted – the heterodox is now mainstream

    Commentators on the airways here (UK) are saying this is the ‘Minsky Moment’ – the language and ideas promoted through this blog you find popping up everywhere whereas a year ago they were deemed semi-crackpot

    The old style neoclassicals are looking defensive and isolated – history has proved them wrong. The more they git their austerity way the more unstable the world economy became until it reached breaking point.

    Something of a desperation for new ideas, its like the early 30s, economics and politics can be reshapen. The rigidities have broken. Poor times but exciting.

    So time for a group hug not a bicker surely. People will be able to say in 20 year time, Yes I/we were there, and we started thinking afresh and rebuilding intellectual foundations.

  11. Lyonwiss says:

    Steve Keen August 19, 2011 at 6:18 am

    Your proposal of limiting the number of posts per day could be helpful, as it limits the large number of short, impulsive and abusive repartees on selected phrases and sentences of other comments, often without proper context, or additional explanation, reference or information.

    Such ill-mannered posts are mainly accusations of ignorance, without helping to reduce the ignorance. They are not just differences of opinion, properly argued and substantiated. Those short posts significantly lower the standard and substance of the conversations on this blog.

    Longer posts with more considered opinions, backed up by references and data are what make your blog “a cut above the rest”. Let’s hope your new policy can restore this quality. Thanks for your effort.

  12. mahaish says:

    ok understood steve,

    i think im going to try throwing a bit of data out just to see, whether it gets some of us off our emperical ivory tower though.

    im not condoning what has transpired recently, far from it,


    i think we need to get a sense of perspective and a sense of humour,

    geese louise its only a blog ,

  13. mahaish says:

    as for short posts,

    well facts are can be very short and obviously inconvenient for some.

  14. RJ says:


    This will be my last post. I am not prepared to continue posting on a site that censors people in this way with no good reason

    You have let personal matters not what I post affect your judgement here.

  15. Steven Shaw says:

    RJ, in Australia it’s private debt that’s the big problem right now. It’s private debt that needs forgiving. I’m not thinking of a bonanza for those who are the most heavily indebted but a way of wiping or reducing those debts without the painful consequences of a typical bankruptcy.

  16. Steve Keen says:

    The good reason RJ is that your didactic and uncompromising style annoys the hell out of more reasonable people. If you can’t adjust your ways, then I am happy to see you go on your way.

  17. mahaish says:

    rj, dont go,

    steves right , you just need to change your approach, and communication style.

    think we can have robust debate, just needs to be a little less in your face.

    a few confidence and goodwill building measures on your part wouldnt go astray,

    put up a post or two, for while and may be steve can re consider down the line

  18. ac says:

    I have enjoyed reading your commentary for a long time. But this prompted my first post!

    “Of course, there’s zero chance of that policy being tried, for at least two reasons. Decentralized wage setting means that there is no mechanism to do it in the first place,” (my italics)

    There is a mechanism: tax rates. Government could cut all income taxes by, say, 25% and make up the lost revenue with printed money. Presto, wage inflation and price inflation. Better targeted than money shoveled into bankrupt banks. Debts erased at households and businesses faster.

    Money spent on imports would be a downside though, but entrepreneurial activity encouraged is a plus.

  19. Steve Keen says:

    Hi ac,

    That wouldn’t cause inflation though, which is the object of a rise in money wages. And I continue to prefer something that directly reduces the private debt–a modern Jubilee that scars the behavior of financiers for as long as possible.

  20. Derek R says:

    It occurs to me that the gov could directly reduce the private debt by giving every citizen a grant of $500 per month (or whatever) with the proviso that it would have to be used to pay down whatever debt the person had before being used for other purposes.

    On its own this would probably just transfer private debt to the public sector. However if it were combined with a tax on interest, payable by the lenders, and set at such a level as to pay for the grants, wouldn’t this allow the debts to be paid without causing inflation?

  21. will5404 says:

    I’d personally like to hear Krugman describe war. After all its merely an exchange of steel shells between soldiers, nothing really changes right? The net amount of bullets on each side stays the same assuming they fire an equal number of rounds at each other.

  22. sirius says:


    Thank you.

  23. Pingback: This Is A Head Scratcher | The Radical Subjectivist

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