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What Bernanke doesn’t understand about deflation
Extremely good insight by Steve Keen
There was an interesting comment on this article by mannfm11
Extremely good insight by Steve Keen
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.
Putting this example in a table, we get the following illustration:
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:
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.
Bernanke, B. S. (2000). Essays on the Great Depression. Princeton, Princeton University Press.
Fisher, I. (1933). “The Debt-Deflation Theory of Great Depressions.” Econometrica
1(4): 337-357.
Click here to download this post as a PDF file.
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.
Putting this example in a table, we get the following illustration:
| Variable/Year | Year 1 | Year 2 |
| Nominal GDP | 1000 | 1100 |
| Growth rate of Nominal GDP | 10% | 10% |
| Real growth rate | 5% | 5% |
| Inflation Rate | 5% | 5% |
| Private Debt | 1250 | 1500 |
| Growth rate of Private Debt | 20% | 10% |
| Change in Private Debt | 250 | 150 |
| Nominal Aggregate demand (GDP + Change in Debt) | 1250 | 1250 |
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.
| Variable\Year | 2006 | 2007 | 2008 | 2009 | 2010 |
| GDP | 12,915,600 | 13,611,500 | 14,337,900 | 14,347,300 | 14,453,800 |
| Change in Nominal GDP | 6.3% | 5.4% | 5.3% | 0.1% | 0.7% |
| Change in Real GDP | 2.7% | 2.4% | 2.5% | -1.9% | 0.1% |
| Inflation Rate | 4.0% | 2.1% | 4.3% | 0.0% | 2.6% |
| Private Debt | 33,196,817 | 36,553,385 | 40,596,586 | 42,045,481 | 40,185,976 |
| Debt Growth Rate | 9.6% | 10.1% | 11.1% | 3.6% | -4.4% |
| Change in Debt | 2,914,187 | 3,356,568 | 4,043,201 | 1,448,895 | -1,859,505 |
| GDP + Change in Private Debt | 15,829,787 | 16,968,068 | 18,381,101 | 15,796,195 | 12,594,295 |
| Change in Private Aggregate Demand | 0.0% | 7.2% | 8.3% | -14.1% | -20.3% |
| Government Debt | 6,556,391.0 | 6,893,467.0 | 7,321,592.0 | 8,615,051.0 | 10,167,585.0 |
| Change in Government Debt | 478,851.0 | 337,076.0 | 428,125.0 | 1,293,459.0 | 1,552,534.0 |
| GDP + Change in Total Debt | 16,308,638.0 | 17,305,144.0 | 18,809,226.0 | 17,089,654.0 | 14,146,829.0 |
| Change in Total Aggregate Demand | 0.0% | 6.1% | 8.7% | -9.1% | -17.2% |
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.
| Variable\Year | 1929 | 1930 | 1931 | 1932 | 1933 | 1934 | 1935 |
| GDP | 103,600 | 91,200 | 76,500 | 58,700 | 56,400 | 66,000 | 73,300 |
| Change in Nominal GDP | 6.0% | -12.0% | -16.1% | -23.3% | -3.9% | 17.0% | 11.1% |
| Inflation Rate | -1.2% | 0.0% | -7.0% | -10.1% | -9.8% | 2.3% | 3.0% |
| Private Debt | 161,800 | 161,100 | 148,400 | 137,100 | 127,900 | 125,300 | 124,500 |
| Debt Growth Rate | 3.7% | -0.4% | -7.9% | -7.6% | -6.7% | -2.0% | -0.6% |
| Change in Debt | 5,700 | -700 | -12,700 | -11,300 | -9,200 | -2,600 | -800 |
| GDP + Change in Private Debt | 109,300 | 90,500 | 63,800 | 47,400 | 47,200 | 63,400 | 72,500 |
| Change in Private Aggregate Demand | 0.0% | -17.2% | -29.5% | -25.7% | -0.4% | 34.3% | 14.4% |
| Government Debt | 30,100 | 31,200 | 34,500 | 37,900 | 40,600 | 46,300 | 50,500 |
| Change in Government Debt | -100 | 1,100 | 3,300 | 3,400 | 2,700 | 5,700 | 4,200 |
| GDP + Change in Total Debt | 109,200 | 91,600 | 67,100 | 50,800 | 49,900 | 69,100 | 76,700 |
| Change in Total Aggregate Demand | 0.0% | -16.1% | -26.7% | -24.3% | -1.8% | 38.5% | 11.0% |
Bernanke, B. S. (2000). Essays on the Great Depression. Princeton, Princeton University Press.
Fisher, I. (1933). “The Debt-Deflation Theory of Great Depressions.” Econometrica
1(4): 337-357.
Click here to download this post as a PDF file.
I’m going to take a stab at this. If I follow this correctly, aggregate demand isn’t demand for what is produced, but demand for all goods and assets. So, let say I have a house, not a new house, but an existing house. I owe $80,000 on it and it is worth $300,000. So, to buy that house, it is either going to take a cash payment of $300,000 or new debt of $220,000 minus the downpayment. If the guy pays cash, then the $300,000 comes out of his bank account, $220,000 minus sales costs goes into mine and the difference goes into the different service providers. The debt ceases to exist, but the cash might show up in some other account where it would be used to buy another asset. If it is used to pay off bank credit, it comes out of the money supply. So to the extent that bank credit is used to inflate the economy, its repayment will deflate the money supply. This would be the phenomenon of asset inflation and deflation, depending on the rising or falling amount of debt.
From an Austrian perspective, generally credit bubbles lead to asset inflation and excessive demand, which leads to excessive capital spending. Once the over extention of credit ceases, as it must by prudent lending standards, the price of assets begin to fall, there is less income to drive excessive consumption, equity disappears and debt is liquidated. Normal consumption remains, but the demand for capital goods falls, leading to a shrinkage in the economy.
The reason for this run down the rabbit hole is GDP and demand in general should be the same, as one implies the other. But financing the purchase of something through credit would remove the subject of demand from the shelves and create price inflation, as the one who borrowed their future income bought what another might have otherwise bought with his money. But, when you throw assets in the game, then you have another side of aggregate demand that has only a passing fancy with what is commonly thought of as aggregate demand, the demand resulting from collateralization of the rising price of assets, brought about by the extention of credit in the first place. New credit has to find a place to sit, regardless of whether it has produced higher prices or not. It still ends up in some account, looking for a new home until it is extinguished. Thus as the supply of credit peaks and starts to shrink, it takes the price of assets that were bid on previously with it, shrinking collateral and causing the liquidation of debt. This liquidation has the wealth effect along with other factors with it that drive down other demand and start the chain reaction.
If I follow you correctly, this is what you are driving toward. The nearing of debt to maximum potential takes with it the wherewithal of retirees and other investors to consume with it. Anything people borrow money to buy or save money to buy starts to lose nominal value. This explains the under 10,000 Nikkei in light of the former 40,000 Nikkei, as there is no longer price pressure to support the values,nor is there the inflation to increase cash flow from the companies. Neither is there the money to pay rents in general, which begins to exert a natural downward force in value along with a diminishing capacity to pay debts against the asset as collateral for a loan. In this situation, we might not see that much price reduction in common commodities that are consumer goods like food, but the commodities used in capital goods and construction, we could see a huge drop. People can only eat so many steaks, loafs of bread, etc and very few eat any more of the staples because they are cheap.
From an Austrian perspective, generally credit bubbles lead to asset inflation and excessive demand, which leads to excessive capital spending. Once the over extention of credit ceases, as it must by prudent lending standards, the price of assets begin to fall, there is less income to drive excessive consumption, equity disappears and debt is liquidated. Normal consumption remains, but the demand for capital goods falls, leading to a shrinkage in the economy.
The reason for this run down the rabbit hole is GDP and demand in general should be the same, as one implies the other. But financing the purchase of something through credit would remove the subject of demand from the shelves and create price inflation, as the one who borrowed their future income bought what another might have otherwise bought with his money. But, when you throw assets in the game, then you have another side of aggregate demand that has only a passing fancy with what is commonly thought of as aggregate demand, the demand resulting from collateralization of the rising price of assets, brought about by the extention of credit in the first place. New credit has to find a place to sit, regardless of whether it has produced higher prices or not. It still ends up in some account, looking for a new home until it is extinguished. Thus as the supply of credit peaks and starts to shrink, it takes the price of assets that were bid on previously with it, shrinking collateral and causing the liquidation of debt. This liquidation has the wealth effect along with other factors with it that drive down other demand and start the chain reaction.
If I follow you correctly, this is what you are driving toward. The nearing of debt to maximum potential takes with it the wherewithal of retirees and other investors to consume with it. Anything people borrow money to buy or save money to buy starts to lose nominal value. This explains the under 10,000 Nikkei in light of the former 40,000 Nikkei, as there is no longer price pressure to support the values,nor is there the inflation to increase cash flow from the companies. Neither is there the money to pay rents in general, which begins to exert a natural downward force in value along with a diminishing capacity to pay debts against the asset as collateral for a loan. In this situation, we might not see that much price reduction in common commodities that are consumer goods like food, but the commodities used in capital goods and construction, we could see a huge drop. People can only eat so many steaks, loafs of bread, etc and very few eat any more of the staples because they are cheap.
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