Has Debt-Deflation Begun?

Has Debt-Deflation Begun? Published in November 20th, 2008 Posted by Steve Keen in Uncategorized

Today’s CPI data from the US Bureau of Labor Statistics reveals that consumer prices fell by 1 percent in the month of September. This is the steepest monthly fall in the index since January 1938, and comes after two previous monthly falls (of 0.4 and 0.14 percent). It is therefore possible that a debt-deflationary process is underway.

Monthly Change in US CPI since 1924

There is no doubt that we are in a debt-induced economic crisis; America may now have entered a deflationary crisis as well. The combination of the two is the motive force that sets in train a Depression, as Irving Fisher explained in 1933, in his academic paper “The Debt-Deflation Theory of Great Depressions” (Econometrica, 1933, Volume 1, pp. 337-357).

According to Fisher, the steps that lead from a debt crisis, to falling prices, and a Depression are:

“(1) Debt liquidation leads to distress selling and to

(2) Contraction of deposit currency, as bank loans are paid off, and to a slowing down of velocity of circulation. This contraction of deposits and of their velocity, precipitated by distress selling, causes

(3) A fall in the level of prices, in other words, a swelling of the dollar. Assuming, as above stated, that this fall of prices is not interfered with by reflation or otherwise, there must be

(4) A still greater fall in the net worths of business, precipitating bankruptcies and

(5) A like fall in profits, which in a “capitalistic,” that is, a private-profit society, leads the concerns which are running at a loss to make

(6) A reduction in output, in trade and in employment of labor. These losses, bankruptcies, and unemployment, lead to

(7) Pessimism and loss of confidence, which in turn lead to

(8) Hoarding and slowing down still more the velocity of circulation. The above eight changes cause

(9) Complicated disturbances in the rates of interest, in particular, a fall in the nominal, or money, rates and a rise in the real, or commodity, rates of interest.” (Econometrica, 1933, Volume 1, p. 342)

This process is starkly apparent in the US data. After 1930, everyone in the USA was trying to reduce debt–but the debt to GDP ratio rose nonetheless.

US Debt to GDP Ratio 1925-1935

The ratio rose because prices fell by up to 10 percent per annum, and real GDP also collapsed by as much as 13 percent in one year (the GDP data is yearly and therefore understates the steepness of the fall in output). Attempts by individuals to pay down their debts were swamped by prices and incomes that fell faster still. The phenomenon that, as he put it, “the more debtors pay, the more they owe”, deserves to be named “Fisher’s Paradox” in his honour.

Falling Prices and Falling Output

That train of events is now quite possibly unfolding in the USA right now–and from a level of debt that is twice as high (relative to its GDP) as it was in 1929.

America's modern debt bubble dwarfs the one that caused the Great Depression

Fisher’s explanation of how the Great Depression came about was one of the great, neglected contributions to economic theory. There are two reasons why it was neglected–one tragic, the other scandalous.

The tragedy was that, prior to the Great Depression, Fisher was the pre-eminent academic cheerleader for the boom of the Roaring Twenties, and he had also invested his fortune in margin-loan-financed stock purchases. His reputation was destroyed when, in the middle of the market crash, he made the following pronouncement (which was duly reported in the New York Times):

“Stock prices have reached what looks like a permanently high plateau.

I do not feel that there will soon, if ever, be a fifty or sixty point break below present levels, such as Mr. Babson has predicted. I expect to see the stock market a good deal higher than it is today within a few months.”

His fortune was destroyed by the margin calls that came with the collapse. Having made a tidy sum by inventing the Rolodex and selling it to the Rand Corporation, his paper worth (in 2000 dollar terms) was well over $100 million. He lost the lot and was only saved from bankruptcy by his wife’s sister’s wealth, and her forgiveness of his debts to her on her deathbed.

In a reverse of the old parable about “the boy who cried wolf”, Fisher’s accurate diagnosis of the causes of the Great Depression was tainted by his previous failure to see it coming, and by his misleading assurances to the public that there was nothing to worry about.

The scandal is that, after he dramatically revised his approach to economics and came up with a cogent explanation of the process that could cause a Depression, his work was ignored by the economics profession because it was incompatible with the concept of equilibrium. I will cover this issue in much more detail in my next Debtwatch Report in December, but here is a quick precis.

The dominant economic theory of the 1920s assumed that the economy was always in overall equilibrium, and would tend back to equilibrium from any disturbance. Fisher subscribed to this belief, and developed the application of this theory to finance.

In the early 1930s, chastened and effectively bankrupted, Fisher came to appreciate that a misguided belief in equilibrium was the reason he had failed to anticipate the Great Depression. He reasoned that, even if the economy did in fact tend towards equilibrium, in the real world “New disturbances are, humanly speaking, sure to occur, so that, in actual fact, any variable is almost always above or below the ideal equilibrium”.

The world therefore had to be analysed using disequilibrium thinking–and using this insight, he developed the debt-deflation analysis, in which he reasoned that the “two dominant factors” that cause a Depression are “over-indebtedness to start with and deflation following soon after”.

Following Fisher’s lead would thus have required the economics profession to abandon the practice it had developed–of analysing the economy as if it were always in equilibrium–and take on a new, challenging approach of modelling disequilibrium processes.

Faced with this choice, the economics profession did what it has always to date done–it obfuscated and bifurcated. The dominant majority of the profession ignored Fisher’s arguments, and stuck with the familiar tools of equilibium analysis; only a minority (most notably Hyman Minsky) heeded Fisher’s warning.

Today, economists trained in the majority tradition—who almost certainly didn’t study Fisher in their university courses, and who certainly didn’t follow his guidance in their economic analysis—continue to analyse the economy using models that presume it tends towards equilibrium.

Worse still, these models ignore completely the issue that Fisher emphasised was the most important one—the level of private debt. And economists who believe in them occupy all the official positions in Treasuries and Central Banks around the world. Politicians following their advice can be forgiven for not realising that they are being misled, because even those economists themselves don’t realise it (though they are beginning to appreciate this lesson the hard way–see Australia’s RBA Governor Glenn Stevens’s comment yesterday that the current financial crisis has taught Central Bankers that they “could have a more conservative attitude to debt build-up”.

The economic crisis we are now experiencing is in no small measure a product of that academic decision to ignore debt, and to model the economy as if it is always in equilibrium. Had economics instead followed Fisher’s lead, our economic managers would have been attuned to the dangers of excessive debt, and aware of the tendency for the economy to undergo bouts of debt-financed exuberance that drive it far from equilibrium–and potentially to the brink of a debt-deflation.

With the apparent development of a deflationary trend in America, we may now have taken the first step over that precipice.