What Bernanke doesn’t understand about deflation

Bernanke’s recent Jackson Hole speech didn’t contain one reference to the key force driving the American economy right now: private sector deleveraging (here’s the previous year’s speech for comparison’s sake). The reason the US economy is not recovering from this crisis is because all sectors of American society took on too much debt during the false boom of the last two decades, and they are now busily getting themselves out of debt any way they can.

Debt reduction is now the real story of the American economy, just as real story behind the apparent free lunch of the last two decades was rising debt. The secret that has completely eluded Bernanke is that aggregate demand is the sum of GDP plus the change in debt. So when debt is rising demand exceeds what it could be on the basis of earned incomes alone, and when debt is falling the opposite happens.

I’ve been banging the drum on this for years now, but it’s a hard idea to communicate because it’s so alien to the way most economists (and many people) think. For a start, it involves a redefinition of aggregate demand. Most economists are conditioned to think of commodity markets and asset markets as two separate spheres, but my definition lumps them together: aggregate demand is the sum of expenditure on goods and services, PLUS the net amount of money spent buying assets (shares and property) on the secondary markets. This expenditure is financed by the sum of what we earn from productive activities (largely wages and profits) PLUS the change in our debt levels. So total demand in the economy is the sum of GDP plus the change in debt.

I’ve recently developed a simple numerical example that makes this case easier to understand: imagine an economy with a nominal GDP of $1,000 billion which is growing at 10 percent a year, due to an inflation rate of 5 percent and a real growth rate of 5 percent, and in which private debt is $1,250 billion and is growing at 20% a year.

Aggregate private sector demand in this economy—expenditure on all markets, including asset markets—is therefore $1,250 billion: $1,000 billion from expenditure from income (GDP) and $250 billion from the change in debt. At the end of the year, private debt will be $1,500 billion. Expenditure is thus 20 percent above the level that could be financed by income alone.

Now imagine that the following year, the rate of growth of GDP continues at 10 percent, but the rate of growth of debt slows from 20 to 10 percent. GDP will have grown to $1,100 billion, while the increase in private debt this year will be $150 billion—10 percent of the initial $1,500 billion total and therefore $100 billion less than the $250 billion increase the year before.

Aggregate private sector demand in this economy will therefore be $1,250 billion, consisting of $1,100 billion from GDP and $150 billion from rising debt—exactly the same as the year before. But since inflation has been running at 5 percent, aggregate demand will be 5 percent lower than the year before in real terms. So simply stabilising the debt to GDP ratio results in a fall in demand in real terms, and some markets—commodities and/or assets—must take a hit.

Notice that nominal aggregate demand remains constant across the two years–but this means that real output has to fall, since half of the recorded growth in nominal GDP is inflation. So even stabilising the debt to GDP ratio causes a fall in real aggregate demand. Some markets–whether they’re for goods and services or assets like shares and property–have to take a hit.

Now let’s apply this to the US economy for the last few years, in somewhat more detail. There are some rough edges to the following table—the year to year changes put some figures out of whack, and some change in debt is simply compounding of unpaid interest that doesn’t add to aggregate demand—but in the spirit of “I’d rather be roughly right than precisely wrong”, at your leisure please work your way through the table below.

Its key point can be grasped just by considering the GDP and the change in debt for the two years 2008 and 2010: in 2007-2008, GDP was $14.3 trillion while the change in private sector debt was $4 trillion, so aggregate private sector demand was $18.3 trillion. In calendar year 2009-10, GDP was $14.5 trillion, but the change in debt was minus $1.9 trillion, so that aggregate private sector demand was $12.6 trillion. The turnaround in two years in the change of debt has literally sucked almost $6 trillion out of the US economy.

That sucking sound will continue for many years, because the level of debt that was racked up under Bernanke’s watch, and that of his predecessor Alan Greenspan, was truly enormous. In the years from 1987, when Greenspan first rescued the financial system from its own follies, till 2009 when the US hit Peak Debt, the US private sector added $34 trillion in debt. Over the same period, the USA’s nominal GDP grew by a mere $9 trillion.

Ignoring this growth in debt—championing it even in the belief that the financial sector was being clever when in fact it was running a disguised Ponzi Scheme—was the greatest failing of the Federal Reserve and its many counterparts around the world.

Though this might beggar belief, there is nothing sinister in Bernanke’s failure to realize this: it’s a failing that he shares in common with the vast majority of economists. His problem is the theory he learnt in high school and university that he thought was simply “economics”—as if it was the only way one could think about how the economy operated. In reality, it was “Neoclassical economics”, which is just one of the many schools of thought within economics. In the same way that Christianity is not the only religion in the world, there are other schools of thought in economics. And just as different religions have different beliefs, so too do schools of thought within economics—only economists tend to call their beliefs “assumptions” because this sounds more scientific than “beliefs”.

Let’s call a spade a spade: two of the key beliefs of the Neoclassical school of thought are now coming to haunt Bernanke—because they are false. These are that the economy is (almost) always in equilibrium, and that private debt doesn’t matter.

One of Bernanke’s predecessors who also once believed these two things was Irving Fisher, and just like Bernanke, he was originally utterly flummoxed when the US economy collapsed from prosperity to Depression back in 1930. But ultimately he came around to a different way of thinking that he christened “The Debt Deflation Theory of Great Depressions” (Fisher 1933).

You would think Bernanke, as the alleged expert on the Great Depression—after all, that’s one of the main reasons he got the job as Chairman of the Federal Reserve—had read Fisher’s papers. And you’d be right. But the problem is that he didn’t understand them—and here we come back to the belief problem. The Great Depression forced Fisher—who was also a Neoclassical economist—to realize that the belief that the economy was always in equilibrium was false. When Bernanke read Fisher, he completely failed to grasp this point. Just as a religious scholar from, for example, the Hindu tradition might completely miss the key points in the Christian Bible, Bernanke didn’t even register how important abandoning the belief in equilibrium was to Fisher.

To know this, all you have to do is read Bernanke’s summary of Fisher in his Essays on the Great Depression:

The idea of debt-deflation goes back to Irving Fisher (1933). 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.

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 2000, p. 24)

There’s no mention of disequilibrium there, and though Bernanke went on to try to develop the concept of debt-deflation, he did so while maintaining the belief in equilibrium. Compare this to Fisher himself on how important disequilibrium really is in the real world:

We may tentatively assume that, ordinarily and within wide limits, all, or almost all, economic variables tend, in a general way, toward a stable equilibrium… But the exact equilibrium thus sought is seldom reached and never long maintained. New disturbances are, humanly speaking, sure to occur, so that, in actual fact, any variable is almost always above or below the ideal equilibrium…

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)

We might not be in such a pickle now if economics had started to become more of a science and less of a religion by following Fisher’s lead, and abandoning key beliefs when reality made a mockery of them. But instead neoclassical economics completely rebuilt its belief system after the Great Depression, and here we are again, once more experiencing the disconnect between neoclassical beliefs and economic reality.

For the record, here’s my “GDP plus change in debt” table for the 1930s, to give us some idea of what the next decade or so might hold if, once again, we repeat the mistakes of our predecessors.

Globalization will not allow for a 30’s style deflation across the board. Unless, that is, there is a worldwide finacial collapse. Many basic necessities are not domestically sourced; many that are, are also sold internationally. So, we see what we’re seeing, which is risng prices for food, volatility in oil and declining prices for hard assets and financial instruments of a domestic nature.

Should ther be another large shock to the system with uneven effect upon the rest of the world, we very well could be facing near-impoverishing expense to merely feed ourselves while everything else continues to decline in value.

Keen is one of the few economists who have applied standard non-linear systems methods to economics, i.e. automatic control theory.

Not to the extent that I think he could, but certainly far more than just about anyone else. His derivations are certainly grounded in better reasoning then the silly first order crap you usually see.

The clear description of the effects of deleveraging shown here are an example of that.

That is a very good read - certainly it provides food for thought - thanks for posting it!

One thought that comes to mind after I read the statement regarding most neo-classical economists' view of debtors' deleveraging - that it can be ignored because it represents nothing more than a redistribution between debtors and creditors (the mechanism for which I presume would be the repayment by debtors of their debts by transferring some of their wealth to their creditors in satisfaction of that debt) - strikes me as wrong for the simple reason that there are many, many more ways to deleverage than simply satisfying your debts in full by selling assets at their intrinsic worth (i.e., the FMV they would command in a calm market with no distortions and as between a willing buyer and a willing seller, neither under any compulsion to act).

For example, if a debtor must sell assets at a firesale, then those assets will necessarily be sold at less than their intrinsic worth (as I have defined that term above), which will result in greater changes in aggregate wealth than the mere redistribution of wealth as between debtor and creditor.

Another way that debtors can deleverage is to simply walk away from an encumbered asset and deed it over to the creditor in satisfaction of the debt. If that asset is worth less than the debt, then the creditor suffers a loss of wealth and the apparent "redistribution" now matters.

Lastly (at least in summary form), a debtor can file for bankruptcy, in which case the debtor's unsecured creditors will receive nothing, and the secured creditors, if they are lucky, the value of their security (whether or not that equals the amount of their secured debt). In this case, there is a substantial destruction of nominal wealth inasmuch as, prior to the debtor's discharge, the debt was treated as an asset on the creditor's books and that asset has now simply evaporated. In this case, there is little or no "redistribution" between debtor and creditor, and thus a debtor's deleveraging through bankruptcy will matter quite substantially.

At any rate, just some quick thoughts of my own. Thanks again for posting the article!

Thanks for your comment. Makes sense to me that demand isn’t independent of debt, and that as debt goes up, demand will eventually decrease. The problem is that demand is more inelastic than debt, so we would expect changes in demand to be much slower than the accumulation of debt. IE, the debt will increase first and then demand will shift, not the opposite.

I learned something today, and it’s nice to be able to thank the folks here.

It’s a long-winded explanation of “put it on the credit card “ and everybody knows it from their own experience. It’s been discussed in multiple iterations.Household debt rose to 100% of GDP in the early 30’s, was knocked down to about 20% through the decades of depression and as people paid off debt even through the massive government borrowing era of WW II. It didn’t rise above 50% again until the 80’s but approached 100% again this decade before the crash. With the deceptively named “savings rate “ up to 5% (actually credit repayment) , over the past 2 years, the ratio has sunk back to the low 90%. It’s going to take a long time to melt it down to where demand picks up again.Plus, there’s unlikely to be a baby boom to sustain it as there was in the late 40’s and 50’s, unless it comes from immigrants. That’s the trade-off that Bush meant when he said “now you’re going to pay” upon the failure of comprehensive immigration reform, I’m convinced. Well, supposedly Russia has turned its demographic implosion around and is growing again, so maybe it will happen here too.

Well as our economy deflates prices and wages will necessarily fall also.This may in the end be a good thing as exports of our cheaper goods will rise and you may see an increase in domestic manufacturing as some American companies come back on shore.

Going to be painful for large holders of fixed assets though.

My best advice; get liquid and get your all in debt load down including mortgage debt.

what branch of economics do you subscribe to? I’d like to read more..

reconciles with my thinking based on micro economic observations.. rising house prices = households extracting ‘equity’ (borrowing) to spend more than they earn = aggregate demand above GDP. As you point out, even with GDP buoyant on the back of rampant consumption (those beloved baby boomers) real demand falls if borrowing levels off. Makes sense to me - if growth in borrowing is 0% - how can house prices grow faster than GDP? If debt levels start falling and GDP is not growing, how can house prices not fall?

People seem willing to borrow/consume as much as they can afford to at any time. If there is a surplus in production capacity, firms will not borrow to invest so much and not hire. If there is a surplus of labor then I don’t expect wages to rise and so, borrowings will not rise. The West is also importing a surplus of labor from the East. Governments have little room to borrow more so I don’t see great stimulus/spending/hiring from them.

How does this play out? Will asset prices now settle and grow at about the same rate as wages?

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