Sense from Krugman on private debt

Flattr this!

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.


 Click here for this post in PDF

Bookmark the permalink.

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.