What Bernanke doesn’t understand about deflation

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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:

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.

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.

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