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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