With one exception, his key explanations for the crisis are the same as those identified by myself and the handful of other economists who predicted this crisis before it happened:

The roots of the crisis lie in the preceding decade of excess. In it the world enjoyed an extraordinary boom… However, as we later learnt, the global boom was built in large part on a three-layered house of cards.

First, in many Western countries the boom was created on a pile of debt held by consumers, corporations and some governments. As the global financier George Soros put it: “For 25 years [the West] has been consuming more than we have been producing … living beyond our means.”

In the United States, in particular, consumers went on a long, debt-fuelled shopping spree. Household debt rose from about 65 per cent of income in 1983 to nearly 140 per cent of income by 2007. The commentator Bill Gross summarised the US consumption boom as: “For too long it’s been McHouses, McHummers and McFlatscreens, all financed with excessive amounts of McCredit .. What a colossal McStake.”

Australian consumers also spent up big. Between 1996 and 2007 there was a 460 per cent increase in credit card debt, a 340 per cent increase in household debt, a 450 per cent increase in corporate debt and a 200 per cent increase in net foreign debt.

Second, these debts were racked up on the back of skyrocketing asset prices. In several countries, stock prices and house values soared far above their true long-term worth, creating paper wealth that millions of households used as collateral for their growing debts. The value of global financial assets grew from less than 45 per cent of global GDP in 2003 to nearly 490 per cent in 2007…

The finance sector, rather than servicing the needs of the real economy, began to primarily service itself.

The final layer of the house of cards was the huge volume of money funnelled from China, Japan and the Middle East to Western banks and governments. Cheap savings from the East flooded into the West to finance ballooning deficits. From 1999 to 2006 the US current account deficit more than tripled, from $US63.3 billion to $US214.8 billion, balanced by huge surpluses in other countries, especially China.  (the emphases in these and subsequent quotes is my own)

The only element of that with which I disagree is the third point–which I’ll get back to later on.

Rudd also provides some interesting “insider’s” statistics on the size of the collective efforts taken by OECD governments to try to limit the scale of the crisis:

On the fiscal front, governments from the world’s largest 20 economies are expected to collectively pump about $US5 trillion into their economies by the end of next year (or nearly 8 per cent of global GDP since the crisis began). Altogether, the measures are the equivalent of an extraordinary and unprecedented 18 per cent of global GDP.

That’s an extraordinary injection–against which the scale of this crisis should be apparent. Inject an additional 18 per cent of activity into a global economic system over about 3 years, and yet the system still falls by about 6 per cent over that period? Without that intervention, output could have fallen by 25 per cent over 3 years, which is a Depression in anyone’s language.

Where I differ again with the Prime Minister is over whether this government stimulus alone is sufficient to avoid a Depression. Though his case is far more nuanced than most, the “green shoots” phrase nonetheless gets an airing:

We have already begun to see the results. Early signs of “green shoots” have emerged in recent economic data. And this month the International Monetary Fund revised up its forecast for the global recovery, from 1.9 per cent to 2.5 per cent growth next year. An IMF report this month noted “the world economy is stabilising, helped by unprecedented macro-economic and financial policy support”. The truth, however, is the world is still a long way from recovery.

The extent to which Rudd is “levelling” with his audience is also quite welcome:

The average budget deficit for OECD economies increased more than sixfold, from 1.4 per cent of GDP before the crisis in 2007 to 8.8 per cent of GDP in 2010. Public borrowing is required to finance these deficits and is expected to increase from 73.5 per cent of GDP in 2007 to 100.2 per cent in 2010. Among the big advanced economies, net debt will increase from 52 per cent of GDP in 2007 to 79 per cent in 2010.

Australia’s deficit and debt position have inevitably been affected, albeit much less than in other advanced economies. The combined effects of collapses in revenue ($210 billion) and policy interventions to support our economy ($77 billion) are expected to result in a deficit that peaks at 4.9 per cent of GDP in 2009-10. Net public debt is expected to rise to 4.6 per cent of GDP this financial year and peak at 13.8 per cent of GDP in 2013-14. Both are the lowest by an order of magnitude of all major advanced economies.

Clearly, government global action has come at a cost. But as the IMF argued earlier this year: “While the fiscal cost for some countries will be large in the short run, the alternative of providing no fiscal stimulus or financial sector support would be extremely costly in terms of the lost output.”

Without government intervention, global growth, global unemployment and prospects of global financial recovery would be much, much worse.

We never got to see whether Howard or Costello would have provided a reasoned explanation of policies in the light of an economic catastrophe, because they never experienced one–instead, they were amongst the lucky incumbents who held office while the global financial excess that caused this crisis held aloft the illusion of prosperity, and lost office before The Piper called to collect on The Tune.

Had they held on to power, I have no doubt that they would have–by force of necessity–been undertaking very similar fiscal policies to those Rudd now is (though the additional expenditure may have gone on the military and border patrols rather than ports and schools). Whether they would have presented as reasoned an explanation for their actions I think would have been less likely.

Rudd also revisits the anti-neoliberalism theme of his previous essay:

As I have argued elsewhere, the boom-and-bust economic cycle of the past decade has been an unavoidable consequence of a decade of neo-liberal free market fundamentalism that reinforced a culture of corporate greed and excess in the financial sector. The central principles of this extreme form of capitalism are that markets are self-regulating; that government should get out of the road of the market altogether and that the state itself should retreat to its core historical function of security at home and abroad.

As someone who has long argued that the economic theory that underlies neoliberalism (Neoclassical Economics) is intellectual drivel, I of course support this critique.

Where I beg to differ is Rudd’s dating of this–merely the last decade? We’ve been following Neoclassical-Economics-inspired policies ever since 1975, including under the preceding Australian Labor Party government of Bob Hawke and Paul Keating  (or since 1973 if we include Whitlam’s 25% overnight cut in tariffs). And of course, the last decade wasn’t one of boom and bust around the globe, which was partly the problem: the mild US downturn after the 2000 Stock Market Crash occurred because the huge runup of private debt-financed spending that was the Subprime Crisis overwhelmed the negatives of the DotCom swindle, and of course set us up for the far bigger crash we are now experiencing.

The absence of economic downturns since 1993–and the mildness of the mainly US recession after the DotCom Bubble burst–played a large role into deluding neoclasssical economists like Bernanke into believing that they had tamed the trade cycle in what they termed “The Great Moderation”:

… the low-inflation era of the past two decades has seen not only significant improvements in economic growth and productivity but also a marked reduction in economic volatility…, a phenomenon that has been dubbed “the Great Moderation.” Recessions have become less frequent and milder, and … volatility in output and employment has declined significantly… The sources of the Great Moderation remain somewhat controversial, but … there is evidence for the view that improved control of inflation has contributed in important measure to this welcome change in the economy … (Bernanke, 2004)

Bollocks to all that. The prediction I made in 1995 in my paper “Finance and Economic Breakdown: Modelling Minsky’s Financial Instability Hypothesis” has stood the test of time rather better:

From the perspective of economic theory and policy, this vision of a capitalist economy with finance requires us to go beyond that habit of mind which Keynes described so well, the  excessive reliance on the (stable) recent past as a guide to the future. The chaotic dynamics explored in this paper should warn us against accepting a period of relative tranquility in a capitalist economy as anything other than a lull before the storm. (Keen, 1995)

A Nascent Recovery?

Like most global leaders, Rudd is now speaking as if recovery has already begun. But to give him his due, even here there is a word of caution:

The first phase of Australia’s response to the global crisis has legitimately focused on crisis management, emergency interventions and implementing a strategy for recovery. But we must now deal with two challenges that arise in the context of a possible recovery.

There is also welcome realism that a debt-financed recovery is barely possible and certainly undesirable, and an awareness that deleveraging and deflation are the major risks facing the global economy.

This crisis has shown we have reached the limits of a purely debt-fuelled global growth strategy. Not only will the neo-liberal model of the past not provide growth for the future, its after-effects will make recovery more difficult. Mountains of global public and private debt, global imbalances, and a weakened global financial system will drag on global growth for a long time. As the renowned financial columnist Martin Wolf has written: “Those who expect a swift return to the business-as-usual of 2006 are fantasists. A slow and difficult recovery, dominated by de-leveraging and deflationary risks, is the most likely prospect.”

Since Rudd has properly entertained the prospect that the next decade will be dominated by deleveraging rather than rising debt levels, let’s get a handle on what that might mean for aggregate demand over that decade.

Australia has experienced two previous bouts of deleveraging, in the Depressions of the 1890s and 1930s. In both those previous Depressions, deflation and falling real output drove the debt to GDP ratio higher after the onset of the crisis–something we have yet to experience–after which the painful process of deleveraging began.

In the 1890s, we began with a debt to GDP ratio of just over 100 per cent, which then fell to a low of roughly 40 per cent over a 15 year period. In the 1930s, we started with a lower level of 75 per cent, which fell over a similar period to a low of 25 per cent–but the Second World War clearly accelerated the deleveraging process, which prior to then was running more slowly than after the 1890s Depression.

In the Figure above, these historical episodes are fitted by an exponential decay process. The rate of decay in the 1890s was roughly 4% per year; it began at roughly 3% in the 1930s prior to the War, but over the entire period including the War it fell at an average rate of 8% a year.

There was no policy intervention to accelerate economic recovery in the 1890s, so 4% might be taken to be the endogenous capacity of a Depressed economy to de-lever, whereas 8% can be regarded as a policy-accelerated rate (where however that “policy” was an arms race during a global military conflict). Both these rates are considered as hypotheticals for reduction of our debt levels today.

Taking 50% of GDP as a level at which normal economic activity might resume (higher than the 40% level that applied in the 1920s and 25% level of the 40s-60s), this implies that deleveraging could take anywhere between 15 years (at the accelerated 8% rate) and 30 years (at the “natural maximum” 4% rate).

We can get a preliminary handle on what this might mean for economic growth by calculating the percentage of GDP represented by each year’s deleveraging–effectively by converting the percentage reduction in debt each year into a fraction of GDP for that same year (this ignores feedbacks between the rate of change of debt and GDP itself, but it will do as a first pass). In the first year (2009) when debt started at 165% of GDP, a 4% reduction in debt levels is equivalent to a 6% reduction in GDP; the size of this hit then falls as the debt to GDP ratio itself falls.

The following chart shows each year’s deleveraging as a percentage of GDP, at the rates of 4% and 8% per year:

We are currently deleveraging at the 4% rate, and debt has fallen from 165% of GDP in March 2008 to 159% today–a 6% fall as a percentage of GDP, as noted above. At this rate, debt will not fall below 50% of GDP until 2038, and the annual reduction in debt will be equivalent to 3% of GDP until 2028.

To compare this to what happened during the 30s and 40s, the next Figure shows the impact of deleveraging in the 1930s: the actual 3% rate that applied from 1932 till 1939, what a “natural maximum” rate of a 4% fall per year would have meant as a percentage of GDP, and how bad things might have been without a World War if the achieved rate for 1932-45 of an 8% reduction had come via reducing debt rather than increasing GDP via a huge militarisation effort.

Even the worst rate of 1930s deleveraging (including WWII) only just compares to the impact of deleveraging today at the 4% rate–because the debt ratio in 2008 peaked at 2.2 times the peak level in the 1930s. And throughout the 1930s, deleveraging never subtracted more than 3% from GDP–again because debt was so much lower then than it is now.

While Rudd is therefore aware that deleveraging will probably be the defining economic experience of the next decade, I doubt that he is aware of the scale of its potential impact. Though Treasury–if it has had any input into Rudd’s paper–seems more aware of the dangers of deleveraging than the RBA, deleveraging is surely not factored into Treasury’s economic modelling of the post-crisis recovery scenarios on which some of Rudd’s budget predictions are based. These presume a return to real economic growth of 3%+ by 2010, which imply a capacity for the economy to grow at upwards of 7% per annum in real terms, to counteract deleveraging subtracting more than 5% from GDP every year till 2015.

If we rely upon the “natural maximum” process of deleveraging, we face a 30 year period in which changes in debt will cut at least 3% from the growth potential of the economy

This is why I propose a far more radical policy to deal with the crisis than the government stimulus package that Australia and other OECD nations have followed to date. These policies are attempting to address a crisis caused by irresponsible private lending, yet they involve continuing to respect this debt. They attempt to counteract private deleveraging by running up public debt instead. And they drastically underestimate the impact of deleveraging: rather than achieving a return to growth by 2010, these policies alone are likely to result in zero or sub-zero growth for most of the next decade.

That private debt does not deserve respect. It was irresponsibly lent in the first place, and the financial institutions that lent it should pay the price–not the public nor the public purse–via deliberate debt reduction. This of course would bankrupt those financial institutions, but as should be obvious from the US experience, these institutions are effectively bankrupt already.

A Copernican Switch on Savings

I noted above that the one aspect of Rudd’s analysis of the crisis that I disagreed with was the proposition that:

The final layer of the house of cards was the huge volume of money funnelled from China, Japan and the Middle East to Western banks and governments. Cheap savings from the East flooded into the West to finance ballooning deficits.

This is the “Savings cause Loans” perspective of the conventional model of money. As I explained in The Roving Cavaliers of Credit, this model is rather like the pre-Copernican view that the Sun orbits the Earth: it’s easy to understand (we still speak of “sunrise” and “sunset” after all) and also completely wrong. Just as the Earth orbits the Sun, “Loans cause Savings”.

The “excess savings” of the East were thus caused by the excess borrowing of the West. Chinese, Japanese and Middle Eastern accounts accumulated money because Western consumers and firms borrowed up big, and spent that borrowed money buying goods produced in China, Japan and the Middle East. Now that the borrowing binge in the West has come to an end, those “excess savings” in the East should start to diminish.

Conclusion

Rudd’s essay shows a stronger appreciation of the causes of this crisis, and the fragility of the economy in its wake, than I’ve yet seen from any other official source (with the sole exception of the Bank of International Settlements, where Bill White‘s influence appears to remain, even though he is no longer its Economic Adviser–check this story on Bill and his forlorn attempts to raise the alarm during the Bubble).

Its one weakness is continued reliance upon neoclassical economic models to predict the future course of the economy after this crisis–when those same models ignore the role of private debt (which caused the bubble in the first place) and deleveraging (which will in fact drive the future course of the economy).

We can expect Rudd and Swann to continue with a large scale fiscal stimulus, in the hope that this will end the crisis. The next stage will come when this stimulus fails to achieve the level of growth predicted by neoclassical economic models, and as a result unemployment exceeds forecasts, public debt continues to run up, and deficit reduction strategies get pushed back in time.

So though Rudd is aware of the problem of deleveraging, he hasn’t yet taken developed policies that directly tackle it. But awareness of the problem is a necessary first step in addressing it, and Rudd has taken that first step.

PS Gittins on the Boil

Ros Gittins wrote a far less flattering review of Rudd’s essay in this morning’s SMH (Rudd’s new bogy: fearing the pain of recovery, SMH July 27 2009).

There were a few elements of his argument I agreed with, but most of it I reject. The points he made that I agree with include:

• That Rudd’s definition of neoliberalism is bogus–or at least incomplete. As Gittins puts it:

“The notion that the Libs could be fairly described as “neo-liberal free-market fundamentalists” is laughable.

And yet Rudd boasts about the success of the Hawke-Keating government’s micro-economic reforms and promises more reforms of his own.

Micro-economic reform and neo-liberal mean the same thing. As an ideological warrior, this guy’s a phoney.”

True–as I noted above:

We’ve been following Neoclassical-Economics-inspired policies ever since 1975, including under the preceding Australian Labor Party government of Bob Hawke and Paul Keating (or since 1973 if we include Whitlam’s 25% overnight cut in tariffs).

• The false claim that our national balance sheet is healthy:

“He boasts his intention is to maintain Australia’s position as having “the best national balance sheet of the major advanced economies” (I didn’t know we were a major economy). Really? With a net foreign debt equivalent to 56 per cent of gross domestic product?”

True again. But Gittins himself has rarely (once from memory–see below) acknowledged the parlous state of private debt in general in this economy. Rudd’s essay did discuss that, and he drew the implication of the danger of deleveraging as well, which applies to all debt, whether owed domestically or overseas.

• And finally, the fact that most of Rudd’s reform agenda is no different to anything else proposed at any time in the last two decades–in other words that it’s still reading from the neoliberal script, which of course is written by neoclassical economists:

“First is regulation and competition reform… Next is infrastructure (nothing new here), innovation (the national broadband network “will arguably be the single greatest multiplier of productivity growth”; I certainly hope it isn’t the best we can do), skills (nothing new) and tax reform (waiting for the Henry report). Then comes the “broader reform agenda”: retirement income policy (waiting for Henry), health and ageing (may do something in response to the imminent report) and climate change and water (nothing new).”

But that’s about it. Otherwise

• Rudd had an accurate analysis of what caused the crisis, on which Gittins had no comment; and
• Based on this analysis, Rudd warned of the dangers ahead in deleveraging and deflation, while Gittins seems to have bought the “it’ll all be over by Christmas” sentiment. For instance:

“Rudd fails to explain just why it will be so tough to get the budget back to surplus. It shouldn’t be, when you remember that all the official stimulus spending is once-off and the budget’s “automatic stabilisers” will eventually bring back the revenue they took away.”

and…

“I’m starting to see the motive for all this talk about tough times ahead: you make it sound terrible so that when it turns out it isn’t so bad, voters are more relieved than angry. It’s spin, in other words.”

Yes there was certainly some spin there. But there was also a better appreciation of what caused this crisis than I’d previously seen from an international leader. In practice, Rudd may well have set the grounds for what is needed politically if, as I expect, things turn out to be a lot worse than most neoclassical economists and commentators like Gittins expect.

Anyone who read Gittins’s diatribe before reading Rudd’s essay would probably conclude that it wasn’t worth the effort to do so anyway. That would be a mistake. It’s rare that a major essay in a newspaper actually (a) identifies the cause of this crisis and (b) notes the dangers that lie ahead. The former has happened only once, so far as I can recollect in any of Gittins’s own columns (“It’s not inflation that did us in, it’s the borrowing“, SMH 08/12/2008–see my blog entry on this “Ross Gittins finally comes aboard“), the latter, never.

On that point alone, reading Rudd’s essay is a far more rewarding activity than reading Gittins’s critique.

A link to this blog from a US legal advisory website the Practising Law Institute’s In Brief ( “DEFLATION IN THE REAL WORLD“) reminded me of  Bernanke’s book Essays on the Great Depression, which I’ve been aware of for some time but have yet to read. I’ll make amends on that front early this year; fortunately, an extract from Chapter One is available as a preview on the Princeton site (I couldn’t locate the promised eBook anywhere!; in what follows, when I quote Bernanke it is from the original journal paper published in 1995, rather than this chapter).

To put it mildly, Bernanke’s analysis is not promising.

The most glaring problem on first glance is that, despite Bernanke’s claim in Chapter One “THE MACROECONOMICS OF THE GREAT DEPRESSION: A Comparative Approach” that he will survey “our current understanding of the Great Depression”, there is only a brief, twisted reference to Irving Fisher’s Debt Deflation Theory of Great Depressions, and no discussion at all of Hyman Minsky’s contemporary Financial Instability Hypothesis (and a blogger informed me that his entire reference to Minsky in the book amounted to one discussion and one footnote, which I’ll get to later on).

While he does discuss Fisher’s theory, he provides only a parody of it–in which he nonetheless notes that Fisher’s policy advice was influential:

“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.

He then explains that neoclassical economists in general readily dismissed Fisher’s theory, for reasons that are very instructive:

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 1995, p. 17)

Bernanke himself does try to make sense of Fisher within a neoclassical framework, which I’ll get to below; but the general neoclassical reaction to Fisher that he describes is a perfect example of the old (and very apt!) joke that an economist is someone who, having heard that something works in practice, then ripostes “Ah! But does it work in theory?”.

It is also–I’m sorry, there’s just no other word for it–mind-numbingly stupid. A debt-deflation transfers income from debtors to creditors? From, um, people who default on their mortgages to the people who own the mortgage-backed securities, or the banks?

Well then, put your hands up, all those creditors who now feel substantially better off courtesy of our contemporary debt-deflation…

What??? No-one? But surely you can see that in theory…

The only way that I can make sense of this nonsense is that neoclassical economists assume that an increase in debt means a transfer of income from debtors to creditors (equal to the servicing cost of the debt), and that this has no effect on the economy apart from redistributing income from debtors to creditors. So rising debt is not a problem.

Similarly, a debt-deflation then means that current nominal incomes fall, relative to accumulated debt that remains constant. This increases the real value of interest payments on the debt, so that a debt-deflation also causes a transfer from debtors to creditors–though this time in real (inflation-adjusted) terms.

Do I have to spell out the problem here? Only to neoclassical economists, I expect: during a debt-deflation, debtors don’t pay the interest on the debt–they go bankrupt. So debtors lose their assets to the creditors, and the creditors get less–losing both their interest payments and large slabs of their principal, and getting no or drastically devalued assets in return. Nobody feels better off during a debt-deflation (apart from those who have accumulated lots of cash beforehand). Both debtors and creditors feel and are poorer, and the problem of non-payment of interest and non-repayment of principal often makes creditors comparatively worse off than debtors (just ask any of Bernie Madoff’s ex-clients).

Back to Bernanke’s take on Fisher, rather than the generic neoclassical idiocy on debt-deflation. Firstly, Bernanke’s “summary” of Fisher’s argument starts with asset price deflation: ”Fisher envisioned a dynamic process in which falling asset and commodity prices created pressure on nominal debtors…”.

Sorry Ben, but (to use a bit of crude Australian vernacular), this is an “arse about tit” reading of Fisher.  Fisher’s dynamic process began with excessive debt, not with falling asset prices. You have confused cause and effect in Fisher’s theory: excessive debt and the deleveraging process that engendered lead to falling asset and commodity prices as symptoms (which then amplify the initial problem of excessive debt in a positive feedback process). To make this concrete, Fisher referred to:

“two dominant factors, namely over-indebtedness to start with and deflation following soon after” (Fisher 1933, p. 341)

I hope that’s clear enough that, in Fisher’s argument, overindebtedness is the first factor and deflation the second–and in fact, Fisher argues that overindebtedness causes deflation, if the initial rate of inflation is low enough (he also countenances the situation in which inflation is higher and deflation doesn’t eventuate, which he argues won’t lead to a Depression). Before I discuss Bernanke’s own attempt to express what his misinterpretation of Fisher in neoclassical form, it’s worth setting Fisher’s own causal sequence out in full. In his Econometrica paper, Fisher argued that the process that leads to a Depression is the following:

“(1) Debt liquidation leads to distress selling and to

(2) Contraction of deposit currency, as bank loans are paid off, and to a slowing down of velocity of circulation. This contraction of deposits and of their velocity, precipitated by distress selling, causes

(3) A fall in the level of prices, in other words, a swelling of the dollar. Assuming, as above stated, that this fall of prices is not interfered with by reflation or otherwise, there must be

(4) A still greater fall in the net worths of business, precipitating bankruptcies and

(5) A like fall in profits, which in a “capitalistic,” that is, a private-profit society, leads the concerns which are running at a loss to make

(6) A reduction in output, in trade and in employment of labor. These losses, bankruptcies, and unemployment, lead to

(7) Pessimism and loss of confidence, which in turn lead to

(8) Hoarding and slowing down still more the velocity of circulation. The above eight changes cause

(9) Complicated disturbances in the rates of interest, in particular, a fall in the nominal, or money, rates and a rise in the real, or commodity, rates of interest.” (Econometrica, 1933, Volume 1, p. 342)

(Check this previous blog entry for more on this topic)

In its own way, this is a very simple process to both understand and to model. To understand it, all we have to do is look at the current economic situation in the USA–all nine stages of Fisher’s process are already well under way there. I’ve also modelled the debt component of this process in my papers on financial instability (and the deflation aspect too in other research I’ve yet to publish, but which will be in my forthcoming book for Edward Elgar, Finance and Economic Breakdown [expected publication date is 2011]).

So why didn’t Bernanke–and other neoclassical economists–understand Fisher’s explanation and develop it?

Because an essential aspect of Fisher’s reasoning was the need to abandon the fiction that a market economy is always in equilibrium.

The notion that a market economy is in equilibrium at all times is of course absurd: if it were true, prices, incomes–even the state of the weather–would always have to be “just right” at all times, and there would be no economic news at all, because the news would always be that “everything is still perfect”. Even neoclassical economists implicitly acknowledge this by the way they analyse the impact of tariffs for example, by showing to their students how, by increasing prices, tariffs drive the supply above the equilibrium level and drive the demand below it.

The reason neoclassical economists cling to the concept of equilibrium is that, for historical reasons, it has become a dominant belief within that school that one can only model the economy if it is assumed to be in equilibrium.

From the perspective of real sciences–and of course engineering–that is simply absurd. The economy is a dynamic system, and like all dynamic systems in the real world, it will be normally out of equilibrium. That is not a barrier to mathematically modelling such systems however–one simply has to use “differential equations” to do so. There are also many very sophisticated tools that have been developed to make this much easier today–largely systems engineering and control theory technology (such as Simulink, Vissim, etc.)–than it was centuries ago when differential equations were first developed.

Some neoclassicals are aware of this technology, but in my experience, it’s a tiny minority–and the majority of bog standard neoclassical economists aren’t even aware of differential equations (they understand differentiation, which is a more limited but foundational mathematical technique). They believe that if a process is in equilibrium over time, it can be modelled, but if it isn’t, it can’t. And even the “high priests” of economics, who should know better, stick with equilibrium modelling at almost all times.

Equilibrium has thus moved from being a technique used when economists knew no better and had no technology to handle out of equilibrium phenomena–back when Jevons, Walras and Marshall were developing what became neoclassical economics in the 19th century, and thought that comparative statics would be a transitional methodology prior to the development of truly dynamic analysis –into an “article of faith”. It is as if it is a denial of all that is good and fair about capitalism to argue that at any time, a market economy could be in disequilibrium without that being the fault of bungling governments or nasty trade unions and the like.

And so to this day, the pinnacle of neoclassical economic reasoning always involves “equilibrium”. Leading neoclassicals develop DSGE (“Dynamic Stochastic General Equilibrium”) models of the economy. I have no problem–far from it!–with models that are “Dynamic”, “Stochastic”, and “General”. Where I draw the line is “Equilibrium”. If their models were to be truly Dynamic, they should be “Disequilibrium” models–or models in which whether the system is in or out of equilibrium at any point in time is no hindrance to the modelling process.

Instead, with this fixation on equilibrium, they attempt to analyse all economic processes in a hypothetical free market economy as if it is always in equilibrium–and they do likewise to the Great Depression.

Before the Great Depression, Fisher made the same mistake. His most notable contribution (for want of a better word!) to economic theory was a model of financial markets as if they were always in equilibrium.

Fisher was in some senses a predecessor of Bernanke: though he was never on the Federal Reserve, he was America’s most renowned academic economist during the early 20th century. He ruined his reputation for aeons to come by also being a newspaper pundit and cheerleader for the Roaring Twenties stock market boom (and he ruined his fortune by putting his money where his mouth was and taking out huge margin loan positions on the back of the considerable wealth he earned from inventing the Rolodex).

Chastened and effectively bankrupted, he turned his mind to working out what on earth had gone wrong, and after about three years he came up with the best explanation of how Depressions occur (prior to Minsky’s brilliant blending of Marx, Keynes, Fisher and Schumpeter in hisFinancial Instability Hypothesis [here's another link to this paper]). 

Prior to this life-altering experience however, as a faithful neoclassical economist, Fisher portrayed the market for loans as essentially no different from any other market in neoclassical thought: it consisted of independent supply of and demand functions, and a price mechanism that set the rate of interest by equating these two functions–thus putting the market into a state of equilibrium.

However even with this abstraction, he had to admit that there were two differences between the “market for loanable funds” and a standard commodity market: firstly that the loanable fund market involves commitments over time, whereas in standard neoclassical mythology, commodity markets are barter markets where payment and delivery take place instantaneously; and secondly, it is undeniable that sometimes people don’t live up to those commitments over time–they go bankrupt.

Fisher dealt with these differences in the time-honoured neoclassical manner: he assumed them away. He imposed two conditions on his models:

“(A) The market must be cleared—and cleared with respect to every interval of time. (B) The debts must be paid.” ( Irving Fisher, 1930, The Theory of Interest. New York: Kelley & Millman p. 495)

Fisher did discuss some problems with these assumptions, but in keeping with the neoclassical delusion that one couldn’t model processes out of equilibrium, these problems didn’t lead to a revision of his model.

Of course, if Fisher had been a realist, he would have admitted to himself that a model that presumes the economy is always in equilibrium will be a misleading guide to the behaviour of the actual economy. But instead, as seems to happen to all devotees of neoclassical economics, he began to see his model as the real world–and used it to explain the Stock Market bubble of the 1920s as not due to “irrational exuberance”, but due to the wonderful workings of a market economy in equilibrium.

Since Wall Street was also assumed to be in equilibrium, stock prices were justified. And he defended the bubble as representing a real improvement in the living standards of Americans, because: 

“We are now applying science and invention to industry as we never applied it before. We are living in a new era, and it is of the utmost importance for every businessman and every banker to understand this new era and its implications… All the resources of modern scientific chemistry, metallurgy, electricity, are being utilized–for what? To make big incomes for the people of the United States in the future, to add to the dividends of corporations which are handling these new inventions, and necessarily, therefore, to raise the prices of stocks which represent shares in these new inventions.” (Fisher, October 23rd 1929, in a speech to a bankers’ association)

Have you heard that one before: a “new era”? If I had a dollar for every time I saw that twaddle used to justify companies with negative earnings having skyhigh valuations during the Internet Bubble…

Fisher even dismissed the 6% fall in the stock market that had occurred in the day before his speech as due to “a certain lunatic fringe in the stock market, and there always will be whenever there is any successful bear movement going on… they will put the stocks up above what they should be and, when frightened, … will immediately want to sell out.” 

The future, he told the assembled bankers, was rosy indeed:

Great prosperity at present and greater prosperity in view in the future … rather than speculation … explain the high stock markets, and when it is finally rid of the lunatic fringe, the stock market will never go back to 50 per cent of its present level… We shall not see very much further, if any, recession in the stock market, but rather … a resumption of the bull market, not as rapidly as it has been in the past, but still a bull rather than a bear movement.” (Fisher 1929)

Prior to this speech, he had made his fatefully wrong prediction on the future course of the Dow Jones in the New York Times. For the record, his statement was:

“Stock prices have reached what looks like a permanently high plateau. I do not feel that there will soon, if ever, be a fifty or sixty point break below present levels, such as Mr. Babson has predicted. I expect to see the stock market a good deal higher than it is today within a few months.”

Well, so much for all that. The stock market crash continued for three years, unemployment blew out from literally zero (as recorded by the National Bureau of Economic Research) to 25 percent, America’s GDP collapsed, prices fell… the Great Depression occurred.

At first, Fisher was completely flummoxed: he had no idea why it was happening, and blamed “speculators” for the fall (though not of course for the rise!) of the market, lack of confidence for its continuance, and so on… But experience ultimately proved a good if painful teacher, when he developed “the Debt-Deflation Theory of Great Depressions”.

An essential aspect of this new theory was the abandonment of the concept of equilibrium.

In his paper, he began by saying that:

We may tentatively assume that, ordinarily and within wide limits, all, or almost all, economic variables tend, in a general way, to ward a stable equilibrium. In our classroom expositions of supply and demand curves, we very properly assume that if the price, say, of sugar is above the point at which supply and demand are equal, it tends to fall; and if below, to rise.

However, in the real world:

New disturbances are, humanly speaking, sure to occur, so that, in actual fact, any variable is almost always above or below the ideal equilibrium.

Therefore in theory as well as in reality, disequilibrium must be the rule:

“Theoretically there may be—in fact, at most times there must be— over- or under-production, over- or under-consumption, over- or under spending, over- or under-saving, over- or under-investment, and over or under everything else. 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; emphasis added)

He then considered a range of “usual suspects” for crises–the ones often put forward by so-called Marxists such as “over-production”, “under-consumption”, and the like, and that favourite for neoclassicals even today, of blaming “under-confidence” for the slump. Then he delivered his intellectual (and personal) coup de grâce:

I venture the opinion, subject to correction on submission of future evidence, that, in the great booms and depressions, each of the above-named factors has played a subordinate role as compared with two dominant factors, namely over-indebtedness to start with and deflation following soon after; also that where any of the other factors do become conspicuous, they are often merely effects or symptoms of these two. In short, the big bad actors are debt disturbances and price- level disturbances.

While quite ready to change my opinion, I have, at present, a strong conviction that these two economic maladies, the debt disease and the price-level disease (or dollar disease), are, in the great booms and depressions, more important causes than all others put together…

Thus over-investment and over-speculation are often important; but they would have far less serious results were they not conducted with borrowed money. That is, over-indebtedness may lend importance to over-investment or to over-speculation.

The same is true as to over-confidence. I fancy that over-confidence seldom does any great harm except when, as, and if, it beguiles its victims into debt. (Fisher 1933, pp. 340-341. Emphases added.)

From this point on, he elaborated his theory of the Great Depression which had as its essential starting points the propositions that debt was above its equilibrium level and that the rate of inflation was low. Starting from this position of disequilibrium, he described the 9 step chain reaction shown above.

Of course, if the economy had been in equilibrium to begin with, the chain reaction could never have started. By previously fooling himself into  believing that the economy was always in equilibrium, he, the most famous American economist of his day, completely failed to see the Great Depression coming.

How about Bernanke today? Well, as Mark Twain once said, history doesn’t repeat, but it sure does rhyme. Just four years ago, as a Governor of the Federal Reserve, Bernanke was an enthusiastic contributor to the “debate” within neoclassical economics that the global economy was experiening “The Great Moderation”, in which the trade cycle was a thing of the past–and he congratulated the Federal Reserve and academic economists in general for this success, which he attributed to better monetary policy:

“In the remainder of my remarks, I will provide some support for the “improved-monetary-policy” explanation for the Great Moderation.”

Good call Ben. We have now moved from “The Great Moderation!” to “The Great Depression?” as the debating topic du jour.

On that front, his analysis of what caused the Great Depression certainly doesn’t imbue confidence. This chapter (first published in 1995 in the neoclassical Journal of Money Credit and Banking [ February 1995, v. 27, iss. 1, pp. 1-28]–the same year my Minskian model of Great Depressions was published in the non-neoclassical Journal of Post Keynesian Economics [Vol. 17, No. 4, pp. 607-635]) considers several possible causes:

• A neoclassical, laboured re-working of Fisher’s debt-deflation hypothesis, to interpret it as a problem of “agency”–”Intuitively, if a borrower can contribute relatively little to his or her own project and hence must rely primarily on external finance, then the borrower’s incentives to take actions that are not in the lender’s interest may be relatively high; the result  is both deadweight losses (for example, inefficiently high risk-taking or low effort) and the necessity of costly information provision and monitoring)” (p. 17);
• Aggregate demand shocks from the return to the Gold Standard and its effect on world money supplies; and
• Aggregate supply shocks from the failure of nominal wages to fall–”The link between nominal wage adjustment and aggregate supply is straightforward: If nominal wages adjust imperfectly, then falling price levels raise real wages; employers respond by cutting their workforces” (p. 21).

None of these “causes” includes excessive private debt–the phenomenon that I hope now even Ben Bernanke can see was the cause of the Great Depression–and the reason why he and neoclassical economists like him are no longer discussing “The Great Moderation”.

Whle they were doing that, a minority of economists–myself included–were avidly developing both Fisher and Minsky’s theories of Great Depressions. We are known generally as “Post Keynesian” economists, and there Minsky is an intellectual hero.  And how did Ben handle Minsky? I have yet to read all of the Essays, but a blogger who has made the following comment:

In the entire volume (Bernanke, ‘Essays on Great Depression’, 2000, Princeton) there is a single refence to Minsky in Part Two, page 43 – “Hyman Minsky (1977) and Carles Kindleberger (1978) have … argued for the inherent instability of the financial system but in doing so have had to depart from the assumption of rational economic behaviour.” A footnote adds – “I do not deny the possible importance of irrationality in economic life; however it seems that the best research strategy is to push the rationality postulate as far as it will go.”

No need for any comment!!!!!!!

Indeed! Having not properly comprehended the best contemporary explanation of the Great Depression, and dismissed the best modern explanation because it didn’t make an assumption that neoclassical economists insist upon,  Bernanke is now trapped repeating history (incidentally, this comment by Bernanke also gives the lie to the “assumptions don’t matter, it’s only the results that count” nonsense that Friedman dished up as neoclassical economic methodology–neoclassical economists in fact care desperately about their assumptions and are willing to dismiss rival theories simply because they don’t make the same assumptions, regardless of how accurate they are). It is painfully obvious that the real cause of this current financial crisis was the excessive build-up of debt during preceding speculative manias dating back to the mid-1980s. The real danger now is that, on top of this debt mountain, we are starting to experience the slippery slope of falling prices.

In other words, the cause of our current financial crisis is debt combined with deflation–precisely the forces that Irving Fisher described as the causes of the Great Depression back in 1933.