Debt – the core problem of this financial crisis, which also explains how we got in this mess

Summary:  we have a bad case of debt deflation.  Although well-described by economists since the 1930’s, this malady was not taken seriously by the mainstream of the profession.  Now we have it.  This post describes this macroeconomic illness (which will help you better understand events), and possible cures.  The diagnosis is simple; the cures less so.

Preamble

Before we begin this depressing discussion of our current ills, let us remember the dismal odds accepted and surmounted by the Founding Fathers.  We can hope to earn similar praise from our descendants as John Hancock gave to George Washington in his letter of 9 October 1777, in which Hamilton stated his satisfaction that Washington had done everything possible at the battle of Germantown:

“Something must still be left to Fortune. It is not in Mortals to command Success. But permit me to say, Sir, you have done more on this Occasion, You have deserved it.”
— From The Writings of George Washington from the Original Manuscript Sources, 1745-1799, Volume 9 , John C. Fitzpatrick, Editor (page 351).  This is a quote from Act I, Scene 2 of the play Cato by Joseph Addison.

The core of our crisis

We borrowed too much.  As I explained here, there are only four ways to solve this problem.

1. grow out of the debt
2. inflate the debt away
3. default on the debt
4. socialize the debt — spread it out over a larger population, such as having the government assume the loans

Debt deflation is path #3.  The US government is attempting to switch the economic train to track #4.

As I described here, the debt deflation was initiated by the Fed’s tight money policy during the rise in commodity prices (that was just the spark, of course).  While this should be obvious to anyone reading the newspapers, it remains contraversal among economists — and is evidently not widely known among educated Americans.  The responses to my posts predicting that we would slide into debt-deflation, and those saying that we have done so, ranged from incredulous to hostile.

“Rising loan defaults and failure of financial institutions do not describe anything “deflationary”.
… (one of the less-abusive comments)

We are suffering from a paradigm crisis

Why is our bout of debt deflation so surprising?  For 30 years one explanation (perhaps the standard one) of the US great depression has been that the Fed did not adequately respond to the deflationary effects of the 1929-1932 loan defaults and bank failures. Chairman Bernanke is an expert on the history of this period. Perhaps his best-known speech on the topic is “Money, Gold, and the Great Depression” (2 March 2004). Excerpt:

However, in 1963, Milton Friedman and Anna J. Schwartz transformed the debate about the Great Depression. That year saw the publication of their now-classic book, A Monetary History of the United States, 1867-1960. The Monetary History, the name by which the book is instantly recognized by any macroeconomist, examined in great detail the relationship between changes in the national money stock–whether determined by conscious policy or by more impersonal forces such as changes in the banking system–and changes in national income and prices.

… The banking crisis (of the 1930’s) had highly detrimental effects on the broader economy. Friedman and Schwartz emphasized the effects of bank failures on the money supply. Because bank deposits are a form of money, the closing of many banks greatly exacerbated the decline in the money supply. Moreover, afraid to leave their funds in banks, people hoarded cash, for example by burying their savings in coffee cans in the back yard. Hoarding effectively removed money from circulation, adding further to the deflationary pressures.

But, to oversimplify, this explanation conflicts with core Keynesian theory.  Keynes did not consider aggregate debt levels to be an important macroeconomic parameter; and his successors did not remedy this oversight.  So US household debt levels grew and grew, with mainstream economists complacent or asleep.

From this perspective, our problems result from a Thomas Kuhn-type paradigm crisis in economics, a conceptual blindness to the danger of rising debt.  There was an alternative theory, which now plays itself out in our daily news.  We must understand it in order to have any chance of weathering this storm.

Debt Deflation

For a clear explanation of our illness I recommend reading “Debt-deflation: concepts and a stylised model“, Goetz von Peter, BIS, April 2005 (56 pages).  The following four sectors are taken from that paper.

(1)  Introduction

In this paper we explore the concept of debt-deflation. We propose a stylised model to illustrate its key features, including unexpected losses, distress selling, and distributional effects. These features reflect the central place that financial distress occupies in traditional accounts of deflation. The term debt-deflation was coined by Irving Fisher {“The Debt-Deflation Theory of Great Depression“, Econometrica, 1933}, and refers to the way debt and deflation destabilise each other. The issue of stability arises because the relation runs both ways: deflation causes financial distress, and financial distress in turn exacerbates deflation. The former was known for centuries, but the latter was, in our view, a key insight of the debt-deflation literature. This ‘feedback’ from financial distress to deflation can occur through several channels:

Fisher (1933) argued that borrowers attempting to reduce their burden of debt (‘indebtedness’) engage in distress selling to raise money for repaying debt. But repayment in aggregate causes a contraction in the money supply and price level deflation.

Minsky (1982) elaborated the concept to incorporate the asset market. He recognised that distress selling reduces asset prices, causing losses to agents with maturing debts. This reinforces distress selling and reduces consumption and investment spending, which deepens deflation.

Bernanke (1983) observed that debt-deflation involves wide-spread bankruptcy, impairing the process of credit intermediation. The resulting credit contraction depresses aggregate demand.

Note that these channels involve features that are quite uncommon in today’s mainstream macroeconomics: among them are losses and distress selling, the idea that debt and deflation destabilise each other, and the notion that the quantity of money endogenously contracts through the repayment of debt. Note also that some standard methods, including the representative agent and log-linearisation, are not well-suited for exploring this territory. This may explain the shortage of formal work on debt-deflation.

(2)  Irving Fisher:  the level of prices

Fisher sets out a monetary theory of how financial distress exacerbates deflation. Fisher’s argument starts with a state of ‘over-indebtedness’. Agents seek to reduce indebtedness by ‘liquidating’ debt. The first and most important steps in Fisher’s ‘chain of consequences’ are,

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.

Fisher views price level deflation as “the root of almost all the evils” that he elaborates in six further steps. Note that, rather than taking deflation as given, he explains it as the consequence of agents’ attempt to reduce their indebtedness.9 They do so by distress selling, to raise the money for repaying bank loans. Repayment in aggregate reduces the quantity of money, or ‘deposit currency’, which causes deflation. Since deflation is known to increase indebtedness, Fisher’s channel closes the loop of debt-deflation,

… and if the over-indebtedness with which we started was great enough, the liquidation of debts cannot keep up with the fall of prices which it causes. In that case, liquidation defeats itself. While it diminishes the number of dollars owed, it may not do so as fast as it increases the value of each dollar owed. Then, the very effort of individuals to lessen their burden of debts increases it, because of the mass effect of the stampede to liquidate in swelling each dollar owed.

Then we have the great paradox which, I submit, is the chief secret of most, if not all, great depressions: The more the debtors pay, the more they owe. The more the economic boat tips, the more it tends to tip. It is not tending to right itself, but is capsizing. But if the over-indebtedness is not sufficiently great to make liquidation thus defeat itself, the situation is different and simpler. It is then more analogous to a stable equilibrium; the more the boat rocks the more it will tend to right itself.

— ”The Debt-Deflation Theory of Great Depressions”, Econometrica, October 1933

Fisher’s theory was largely ignored by contemporaries …

(3)  Hyman Minsky:  asset prices

Minsky’s elaboration of debt-deflation incorporates the asset market. He recognised that distress selling reduces asset prices, which (1) reinforces distress selling, and (2) worsens deflation. Regarding the first channel, Minsky wrote,

Fisher does not identify the ways a unit can get cash to repay loans that fall due. […] Once a situation exists where debt payments cannot be made either by cash from operations or refinancing, so that assets have to be sold, then the requirements imposed by the debt structure can lead to a fall in the prices of assets. In a free market, the fall in asset prices can be so large that the sale of assets cannot realize the funds needed to fulfill commitments.
— “Debt-Deflation Processes in Today’s Institutional Environment”, Banca Nazionale del Lavoro Quarterly Review, December 1982

In other words, when distress selling reduces asset prices, the resulting losses exacerbate indebtedness, and may lead to further distress selling. As in Fisher, distress selling can be self-defeating. The asset market and distress selling feed back on each other.

Regarding the second channel, Minsky argues that the fall in asset prices reinforces deflation:

If payment commitments cannot be met from the normal sources, then a unit is forced either to borrow or to sell assets. Both borrowing on unfavorable terms and the forced sale of assets usually result in a capital loss for the affected unit. However, for any unit, capital losses and gains are not symmetrical: there is a ceiling to the capital losses a unit can take and still fulfill its commitments. Any loss beyond this limit is passed on to its creditors by way of default or refinancing of the contracts. Such induced capital losses result in a further contraction of consumption and investment beyond that due to the initiating decline in income. This can result in a recursive debt-deflation process.
— Can It Happen Again? Essays on Instability and Finance (1982)

In other words, losses from the decline of asset values reduce aggregate spending through a wealth effect.

(4)  Ben S. Bernanke:  credit

Both Fisher and Minsky emphasised the consequence of financial distress for macroeconomic variables: aggregate spending, the price level, and asset prices. Another channel of feedback can arise when financial distress affects the banking system.

The banking problems of 1930-33 disrupted the credit allocation process by creating large, unplanned changes in the channels of credit flow. … {This} plus the actual failures, forced a contraction of the banking system’s role in the intermediation of credit. … experience does not seem to be inconsistent with the point that even good borrowers may find it more difficult or costly to obtain credit when there is extensive insolvency. The debt crisis should be added to the banking crisis as a potential source of disruption of the credit system. … The effects of this credit squeeze on aggregate demand helped convert the severe but not unprecedented downturn of 1929-30 into a protracted depression.

   — ”Nonmonetary Effects of the Financial Crisis in Propagation of the Great Depression”, American Economic Review, June 1983.

In other words, financial distress impairs the process of credit intermediation, and a credit contraction in turn depresses aggregate demand.

——– End except from the BIS study ————–

What’s the cure?

We do not know.  The debt deflation — deflation, if you prefer — of the 1930’s was cured by WWII (if you call that a “cure”).  Japan’s bout with deflation in the 1990’s was never really cured, as their quick collapse in this cycle shows.

The standard cure for deflation is debt-fueled fiscal stimulus. This can come in many forms (the difference between fiscal and monetary policy blurs at this extreme).

1. Keynes advocated massive debt-funded public works projects: The General Theory of Employment, Interest and Money (1936).  Build pyramids, or bury money in bottles for people to dig up — it does not matter what.
2. Dropping money from helicopters, as described by Nobel-laureate Milton Friedman in The Optimum Quantity of Money (1969).
3. Just print it, Bernanke tells us.  “{T}he U.S. government has a technology, called a printing press, that allows it to produce as many U.S. dollars as it wishes at essentially no cost.” (source).

Such action, on a sufficient scale, would stabilize the economy, but might be insufficient to restore normal levels of growth. Why that is so will be discussed in another post.

For more information

For an “Economics 101” textbook chapter on Inflation and Deflation:  Oxford University Press’ Economics Course Companion.

Ben S. Bernanke on deflation:

1. “Deflation: Making Sure ‘It’ Doesn’t Happen Here“, speech on 21 November 2002
2. “Conducting Monetary Policy at Very Low Short-Term Interest Rates“, co-author Vincent R. Reinhart (Director, Division of Monetary Affairs), 14 January 2004
3. “Monetary Policy Alternatives at the Zero Bound:  An Empirical Assessment“, co-authors Vincent R. Reinhart (Governor, FRB) and Brian P. Sack (Macroeconomic Advisers), 9 September 2004

Key posts about the financial crisis

1. A solution to our financial crisis, 25 September 2008
2. A picture of the post-WWII debt supercycle, 26 September 2008
3. America has changed. Why do so many foreigners see this, but so few Americans?, 1 October 2008
4. A sitrep on the financial crisis: why has the treatment been so slow, so small?, 8 October 2008
5. The new President will need new solutions for the economic crisis, 9 October 2008
6. Forecasting the results of this financial crisis – part I, about politics, 13 October 2008
7. Forecasting the results of this financial crisis – part II, a new economy for America, 14 October 2008

See all posts about the Financial crisis – what’s happening? how will this end?, and those about solutions to our financial crisis.