whatbernankedoesntunderstandaboutdeflation

8/8/2019 WhatBernankeDoesntUnderstandAboutDeflation

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SteveKeensDebtwatch WhatBernankedoesntunderstandaboutdeflation August29,2010

www.debtdeflation.com/blogs Page1of5

What Bernanke doesnt understand about deflation

BernankesrecentJacksonHolespeechdidntcontainonereferencetothekeyforcedrivingthe

Americaneconomyrightnow:privatesectordeleveraging.ThereasontheUSeconomyisnotrecovering

fromthiscrisisisbecauseallsectorsofAmericansocietytookontoomuchdebtduringthefalseboom

ofthelasttwodecades,andtheyarenowbusilygettingthemselvesoutofdebtanywaytheycan.

DebtreductionisnowtherealstoryoftheAmericaneconomy,justasrealstorybehindtheapparent

freelunchofthelasttwodecadeswasrisingdebt.ThesecretthathascompletelyeludedBernankeis

thataggregatedemandisthesumofGDPplusthechangeindebt.Sowhendebtisrisingdemandexceedswhatitcouldbeonthebasisofearnedincomesalone,andwhendebtisfallingtheopposite

happens.

Ivebeenbangingthedrumonthisforyearsnow,butitsahardideatocommunicatebecauseitsso

alientothewaymosteconomists(andmanypeople)think.Forastart,itinvolvesaredefinitionof

aggregatedemand.Mosteconomistsareconditionedtothinkofcommoditymarketsandassetmarkets

astwoseparatespheres,butmydefinitionlumpsthemtogether:aggregatedemandisthesumof

expenditureongoodsandservices,PLUSthenetamountofmoneyspentbuyingassets(sharesand

property)onthesecondarymarkets.Thisexpenditureisfinancedbythesumofwhatweearnfrom

productiveactivities(largelywagesandprofits)PLUSthechangeinourdebtlevels.Sototaldemandin

theeconomyisthesumofGDPplusthechangeindebt.

Iverecentlydevelopedasimplenumericalexamplethatmakesthiscaseeasiertounderstand:imagine

aneconomywithanominalGDPof$1,000billionwhichisgrowingat10percentayear,duetoan

inflationrateof5percentandarealgrowthrateof5percent,andinwhichprivatedebtis$1,250billion

andisgrowingat20%ayear.

Aggregateprivatesectordemandinthiseconomyexpenditureonallmarkets,includingasset

marketsistherefore$1,250billion:$1,000billionfromexpenditurefromincome(GDP)and$250

billionfromthechangeindebt.Attheendoftheyear,privatedebtwillbe$1,500billion.Expenditureis

thus20percentabovethelevelthatcouldbefinancedbyincomealone.

Nowimaginethatthefollowingyear,therateofgrowthofGDPcontinuesat10percent,buttherateof

growthof

debt

slows

from

20

to

10

percent.

GDP

will

have

grown

to

$1,100

billion,

while

the

increase

in

privatedebtthisyearwillbe$150billion10percentoftheinitial$1,500billiontotalandtherefore

$100billionlessthanthe$250billionincreasetheyearbefore.

Aggregateprivatesectordemandinthiseconomywillthereforebe$1,250billion,consistingof$1,100

billionfromGDPand$150billionfromrisingdebtexactlythesameastheyearbefore.Butsince

inflationhasbeenrunningat5percent,aggregatedemandwillbe5percentlowerthantheyearbefore

inrealterms.SosimplystabilisingthedebttoGDPratioresultsinafallindemandinrealterms,and

somemarketscommoditiesand/orassetsmusttakeahit.


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Puttingthisexampleinatable,wegetthefollowingillustration:

Variable/Year Year1 Year2NominalGDP 1000 1100GrowthrateofNominalGDP 10% 10%Realgrowthrate 5% 5%InflationRate 5% 5%PrivateDebt 1250 1500GrowthrateofPrivateDebt 20% 10%ChangeinPrivateDebt 250 150NominalAggregatedemand(GDP+ChangeinDebt) 1250 1250NoticethatnominalGDPremainsconstantacrossthetwoyearsbutthismeansthatrealoutputhasto

fall,sincehalfoftherecordedgrowthinnominalGDPisinflation.SoevenstabilisingthedebttoGDP

ratiocauses

afall

in

real

aggregate

demand.

Some

marketswhether

they're

for

goods

and

services

or

assetslikesharesandpropertyhavetotakeahit,andtheeconomywillgointoarecession.Itsfar

worseifdebtlevelsactuallyfall,butatthesametime,thatsnecessarytoweanthisexampleeconomy

offitsdependenceondebt.

NowletsapplythistotheUSeconomyforthelastfewyears,insomewhatmoredetail.Therearesome

roughedgestothefollowingtabletheyeartoyearchangesputsomefiguresoutofwhack,andsome

changeindebtissimplycompoundingofunpaidinterestthatdoesntaddtoaggregatedemandbutin

thespiritofIdratherberoughlyrightthanpreciselywrong,atyourleisurepleaseworkyourway

throughthetablebelow.

ItskeypointcanbegraspedjustbyconsideringtheGDPandthechangeindebtforthetwoyears2008

and2010:in20072008,GDPwas$14.3trillionwhilethechangeinprivatesectordebtwas$4trillion,so

aggregateprivatesectordemandwas$18.3trillion.Incalendaryear200910,GDPwas$14.5trillion,but

thechangeindebtwasminus$1.9trillion,sothataggregateprivatesectordemandwas$12.6trillion.

Theturnaroundintwoyearsinthechangeofdebthasliterallysuckedalmost$6trillionoutoftheUS

economy.

Variable\Year 2006 2007 2008 2009 2010GDP 12,915,600 13,611,500 14,337,900 14,347,300 14,453,800ChangeinNominalGDP

6.3% 5.4% 5.3% 0.1% 0.7%

ChangeinRealGDP 2.7% 2.4% 2.5% 1.9% 0.1%InflationRate 4.0% 2.1% 4.3% 0.0% 2.6%PrivateDebt 33,196,817 36,553,385 40,596,586 42,045,481 40,185,976DebtGrowthRate 9.6% 10.1% 11.1% 3.6% 4.4%ChangeinDebt 2,914,187 3,356,568 4,043,201 1,448,895 1,859,505GDP+ChangeinPrivateDebt 15,829,787 16,968,068 18,381,101 15,796,195 12,594,295


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ChangeinPrivateAggregateDemand

0.0% 7.2% 8.3% 14.1% 20.3%

GovernmentDebt 6,556,391.0 6,893,467.0 7,321,592.0 8,615,051.0 10,167,585.0ChangeinGovernmentDebt

478,851.0 337,076.0 428,125.0 1,293,459.0 1,552,534.0

GDP+ChangeinTotalDebt 16,308,638.0 17,305,144.0 18,809,226.0 17,089,654.0 14,146,829.0ChangeinTotalAggregateDemand

0.0% 6.1% 8.7% 9.1% 17.2%

Thatsuckingsoundwillcontinueformanyyears,becausethelevelofdebtthatwasrackedupunder

Bernankeswatch,andthatofhispredecessorAlanGreenspan,wastrulyenormous.Intheyearsfrom

1987,whenGreenspanfirstrescuedthefinancialsystemfromitsownfollies,till2009whentheUShit

PeakDebt,theUSprivatesectoradded$34trillionindebt.Overthesameperiod,theUSAsnominal

GDPgrewbyamere$9trillion.

Ignoringthisgrowthindebtchampioningiteveninthebeliefthatthefinancialsectorwasbeingclever

wheninfactitwasrunningadisguisedPonziSchemewasthegreatestfailingoftheFederalReserve

anditsmanycounterpartsaroundtheworld.

Thoughthis

might

beggar

belief,

there

is

nothing

sinister

in

Bernankes

failure

to

realize

this:

its

afailing

thathesharesincommonwiththevastmajorityofeconomists.Hisproblemisthetheoryhelearntin

highschoolanduniversitythathethoughtwassimplyeconomicsasifitwastheonlywayonecould

thinkabouthowtheeconomyoperated.Inreality,itwasNeoclassicaleconomics,whichisjustoneof

themanyschoolsofthoughtwithineconomics.InthesamewaythatChristianityisnottheonlyreligion

intheworld,thereareotherschoolsofthoughtineconomics.Andjustasdifferentreligionshave

differentbeliefs,sotoodoschoolsofthoughtwithineconomicsonlyeconomiststendtocalltheir

beliefsassumptionsbecausethissoundsmorescientificthanbeliefs.

Letscallaspadeaspade:twoofthekeybeliefsoftheNeoclassicalschoolofthoughtarenowcomingto

hauntBernankebecause

they

are

false.

These

are

that

the

economy

is

(almost)

always

in

equilibrium,

andthatprivatedebtdoesntmatter.

OneofBernankespredecessorswhoalsooncebelievedthesetwothingswasIrvingFisher,andjustlike

Bernanke,hewasoriginallyutterlyflummoxedwhentheUSeconomycollapsedfromprosperityto

Depressionbackin1930.Butultimatelyhecamearoundtoadifferentwayofthinkingthathe

christenedTheDebtDeflationTheoryofGreatDepressions(Fisher1933).

YouwouldthinkBernanke,astheallegedexpertontheGreatDepressionafterall,thatsoneofthe

mainreasonshegotthejobasChairmanoftheFederalReservehadreadFisherspapers.Andyoud


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beright.Buttheproblemisthathedidntunderstandthemandherewecomebacktothebelief

problem.TheGreatDepressionforcedFisherwhowasalsoaNeoclassicaleconomisttorealizethat

thebeliefthattheeconomywasalwaysinequilibriumwasfalse.WhenBernankereadFisher,he

completelyfailedtograspthispoint.Justasareligiousscholarfrom,forexample,theHindutradition

mightcompletelymissthekeypointsintheChristianBible,Bernankedidntevenregisterhow

importantabandoningthebeliefinequilibriumwastoFisher.

Toknowthis,allyouhavetodoisreadBernankessummaryofFisherinhisEssaysontheGreatDepression:

The idea of debtdeflation goes back to Irving Fisher (1933).

Fisher envisioned a dynamic process in which falling asset and

commodity prices created pressure on nominal debtors, forcing

theminto

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 exchangerate

considerations to theneed for reflation, advice that (ultimately)

FDRfollowed.

Fishers idea was less influential in academic circles, though,

becauseofthecounterargumentthatdebtdeflationrepresented

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

macroeconomiceffects.(Bernanke2000,p.24)

Theresnomentionofdisequilibriumthere,andthoughBernankewentontotrytodeveloptheconcept

ofdebtdeflation,hedidsowhilemaintainingthebeliefinequilibrium.ComparethistoFisherhimself

onhowimportantdisequilibriumreallyisintherealworld:

We may tentatively assume that, ordinarily and within wide

limits,all,oralmostall,economicvariablestend,inageneralway,

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

actualfact,

any

variable

is

almost

always

above

or

below

the

ideal

equilibrium

Itisasabsurdtoassumethat,foranylongperiodoftime,thevariablesintheeconomicorganization,oranypartofthem,willstayput,inperfectequilibrium,astoassumethattheAtlanticOceancaneverbewithoutawave.(Fisher1933,p.339)

Wemightnotbeinsuchapicklenowifeconomicshadstartedtobecomemoreofascienceandlessof

areligionbyfollowingFisherslead,andabandoningkeybeliefswhenrealitymadeamockeryofthem.

ButinsteadneoclassicaleconomicscompletelyrebuiltitsbeliefsystemaftertheGreatDepression,and


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hereweareagain,oncemoreexperiencingthedisconnectbetweenneoclassicalbeliefsandeconomic

reality.

Forthe

record,

heres

my

GDP

plus

change

in

debt

table

for

the

1930s,

to

give

us

some

idea

of

what

thenextdecadeorsomightholdif,onceagain,werepeatthemistakesofourpredecessors.

Variable\Year 1929 1930 1931 1932 1933 1934 1935GDP 103,600 91,200 76,500 58,700 56,400 66,000 73,300ChangeinNominalGDP 6.0% 12.0% 16.1% 23.3% 3.9% 17.0% 11.1%InflationRate 1.2% 0.0% 7.0% 10.1% 9.8% 2.3% 3.0%PrivateDebt 161,800 161,100 148,400 137,100 127,900 125,300 124,500DebtGrowthRate 3.7% 0.4% 7.9% 7.6% 6.7% 2.0% 0.6%ChangeinDebt 5,700 700 12,700 11,300 9,200 2,600 800GDP+ChangeinPrivateDebt

109,300 90,500 63,800 47,400 47,200 63,400 72,500

ChangeinPrivateAggregateDemand

0.0% 17.2% 29.5% 25.7% 0.4% 34.3% 14.4%

GovernmentDebt 30,100 31,200 34,500 37,900 40,600 46,300 50,500Change

in

GovernmentDebt

100

1,100

3,300

3,400

2,700

5,700

4,200

GDP+ChangeinTotalDebt

109,200 91,600 67,100 50,800 49,900 69,100 76,700

ChangeinTotalAggregateDemand

0.0% 16.1% 26.7% 24.3% 1.8% 38.5% 11.0%

Bernanke,B.S.(2000).EssaysontheGreatDepression.Princeton,PrincetonUniversityPress.

Fisher,I.(1933)."TheDebtDeflationTheoryofGreatDepressions."Econometrica1(4):337357.

whatbernankedoesntunderstandaboutdeflation

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