The Debt-Deflation Theory of Great Depressions

IN Booms and Depressions, I have developed, theoretically and statistically, what may be called a debt-deflation theory of great depressions. In the preface, I stated that the results "seem largely new," I spoke thus cautiously because of my unfamiliarity with the vast literature on the subject. Since the book was published its special conclusions have been widely accepted and, so far as I know, no one has yet found them anticipated by previous writers, though several, including myself, have zealously sought to find such anticipations. Two of the best-read authorities in this field assure me that those conclusions are, in the words of one of them, "both new and important."

Partly to specify what some of these special conclusions are which are believed to be new and partly to fit them into the conclusions of other students in this field, I am offering this paper as embodying, in brief, my present "creed" on the whole subject of so-called "cycle theory." My "creed" consists of 49 "articles" some of which are old and some new. I say "creed" because, for brevity, it is purposely expressed dogmatically and without proof. But it is not a creed in the sense that my faith in it does not rest on evidence and that I am not ready to modify it on presentation of new evidence. On the contrary, it is quite tentative. It may serve as a challenge to others and as raw material to help them work out a better product.

Thanks for posting this excellent article. I read every word of it and found it both prescient and ominous.

At least on my initial reading, the only point at which I had some resistance to the author’s ideas was his theory of reflation. My problem is not with the theory; theoretically, it appears logical and a well-founded antidote to the debt-deflation spiral.

However, is reflation workable? IOW, how, practicably, could reflation be implemented in today’s real economy in the U.S.?

Another thing to muse on: the author points to when debtors’ attempts to reduce debt actually increase indebtedness as the point at which the economic boat is more likely to capsize than to right itself. But it is also a fact that you can’t “stimulate” confidence. IOW, now that people have had the pajamas scared off them, the contraction in consumer spending will continue until it ends, IOW regardless of price stability (though I agree that deflation sucks even more confidence out of consumer spending over time).

So it seems to me that there is a point at which the dearth of confidence cannot be restored through reflation.

Then what?

In our current economic picture, it is critical that we include two things that most economists are neglecting.

The first is to consider all the variables, not just the traditional variables. A great example of this is that when thinking of debt, the US national debt comes to mind, some $10T. And while that is bad, it is dwarfed by the markets. One market in particular, derivatives, has debt more than 15 times greater than the US national debt. That is, over $150T! That is more money than exists in the world.

This matters, because this “imaginary money”, created through leverage, drains the market of liquidity that could be used to deficit spend by the US government. If it is not there, the US government automatically has to have a balanced budget, or even a budget surplus. They have no choice in the matter.

If they decide to just “print money”, not backed by debt, it is called “monetizing the debt”, and every dollar translates to inflation, which negates their printing of money. At the consumer level, this could result in monetary deflation at the same time as price inflation.

Which is bad.

Our economy is not necessarily doomed but if Obama enacts the promises he campaigned on it might be.

What should be done? I think the government should simultaneously enact a contract with the American people to eliminate the current debt and to prohibit deficit spending except in cases of national emergencies (limited to war or prolonged recession). How do we pay off the debt? One proposal I think has merit is to contract with Americans who have 401k and IRA accounts. In this proposal each citizen would decide (voluntary) to give up a percentage of their current holdings (would probably need to be 10-15%). This money would go directly to debt reduction, with no possibility of the money being used for other purposes. In return, those participating in the contract would be freed from paying tax when they start withdrawing money from their accounts. This provides the money needed to eliminate the debt and provides a very good investment opportunity for investors. The initial investment would pay back many times over the initial investment of capital since the account could grow and ultimately be used without taxes being levied against it.

This would have a tremendously positive impact on our economy. First, the government would no longer need to borrow money to pay those who underwrite our debt through government issued bonds. This money could then be used to provide businesses with capital for economic expansion and to provide individuals with capital to foster home ownership. Secondly, the money we now pay in interest to satisfy debt could be used for infrastructure such as roads and bridges or for increased tax breaks for research and development in American businesses.

Obviously, without the mandate for balanced budgets this plan would only provide temporary relief. The commitments for both deficit control and investor involvement would need to be codified into law in a way that would prevent revisions later on. I however believe we are on the brink of financial disaster and it is time to consider more daring proposals such as this.

Anyone out there with a background in financial analysis care to provide feedback?

is reflation workable?... you can’t "stimulate" confidence... there is a point at which the dearth of confidence cannot be restored through reflation.

Sorry to respond to a 1-month old post, but I just came across this. Congrats, you officially understand economics better than many central bankers. As I just posted elsewhere...

Krugman and Bernanke studied the Japanese problem of the 90's about a decade ago. Their conclusion was the same as yours - that reinflating does not end the debt deflation spiral because it is not a deflation caused by money supply, it a a deflation caused by collapse of the money multiplier and velocity. In our case, both the multiplier and velocity have been gradually losing momentuum for several years, and the M1 multiplier plunged to 1 in October. So $1T of freshly-printed money adds exactly $0 into price and output increases.

So they admit that reinflating money supply is futile, and that restoring confidence is very difficult. Their approach is instead to undermine confidence in the other direction. Krugman says the Fed needs to "credibly promise to be irresponsible"... in other words to convince the general public that the Fed is about to destroy the dollar, so you should prob just spend them already and buy stuff.

Links:
* http://krugman.blogs.nytimes.com/2008/11/15/macro-policy-in-a-liquidity-trap-wonkish/
* http://krugman.blogs.nytimes.com/2008/12/16/zirp/

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