Debt deflation

Debt deflation is a theory of economic cycles, which holds that recessions and depressions are due to the overall level of debt shrinking (deflating): the credit cycle is the cause of the economic cycle.

The theory was developed by Irving Fisher following the Wall Street Crash of 1929 and the ensuing Great Depression. Debt deflation was largely ignored in favor of the ideas of John Maynard Keynes in Keynesian economics, but has enjoyed a resurgence of interest since the 1980s, both in mainstream economics and in the heterodox school of Post-Keynesian economics, and has subsequently been developed by such Post-Keynesian economists as Hyman Minsky and Steve Keen.

Fisher's formulation

In Fisher's formulation of debt deflation, when the debt bubble bursts the following sequence of events occurs:

Assuming, accordingly, that, at some point of time, a state of over-indebtedness exists, this will tend to lead to liquidation, through the alarm either of debtors or creditors or both. Then we may deduce the following chain of consequences in nine links:

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.

—(Fisher 1933)

Rejection of previous assumptions

Prior to his theory of debt deflation, Fisher had subscribed to the then-prevailing, and still mainstream, theory of general equilibrium. In order to apply this to financial markets, which involve transactions across time in the form of debt – receiving money now in exchange for something in future – he made two further assumptions:^[1]

(A) The market must be cleared—and cleared with respect to every interval of time.

(B) The debts must be paid. (Fisher 1930, p.495)

In view of the Depression, he rejected equilibrium, and noted that in fact debts might not be paid, but instead defaulted on:

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)

He further rejected the notion that over-confidence alone, rather than the resulting debt, was a significant factor in the Depression:

I fancy that over-confidence seldom does any great harm except when, as, and if, it beguiles its victims into debt.

— (Fisher 1933, p. 339)

In the context of this quote and the development of his theory and the central role it places on debt, it is of note that Fisher was personally ruined due to his having assumed debt due to his over-confidence prior to the crash, by buying stocks on margin.

Subsequent developments

Debt deflation has been studied and developed largely in the Post-Keynesian school.

The Financial Instability Hypothesis of Hyman Minsky, developed in the 1980s, complements Fisher's theory in providing an explanation of how credit bubbles form: FIH explains how bubbles form, while DD explains how they burst and the resulting economic effects. Mathematical models of debt deflation have recently been developed by Australian post-Keynesian economist Steve Keen.

Debt deflation has been referred to alliteratively as the "D-process" by Ray Dalio of Bridgewater Associates, who suggests it as the template for understanding the financial crisis of 2007–2010.

Mainstream interest

Initially Fisher's work was largely ignored, in favor of the work of Keynes.^[2]

The following decades saw occasional mention of deflationary spirals due to debt in the mainstream, notably in The Great Crash, 1929 of John Kenneth Galbraith in 1954, and the credit cycle has occasionally been cited as a leading cause of economic cycles in the post-WWII era, as in (Eckstein & Sinai 1990), but private debt remained absent from mainstream macroeconomic models. James Tobin cited Fisher as instrumental in his theory of economic instability.

The lack of influence of debt-deflation in academic economics is thus described by Ben Bernanke in Bernanke (1995, p. 17):

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's dismissal of debt deflation is criticized as improperly applying the theory of general equilibrium – in equilibrium, marginal redistribution of income produces no macroeconomic effects, but financial crises are characterized by not being in equilibrium and markets failing to clear – debt ceasing to grow and instead falling, debtors defaulting, rising unemployment – and thus, it is argued, equilibrium analysis is inapplicable and misleading.^[1]

There was a renewal of interest in debt deflation in academia in the 1980s and 1990s,^[3] and a further renewal of interest in debt deflation due to the Financial crisis of 2007–2010 and the ensuing Late-2000s recession.^[2]

Bernanke's interpretation of debt deflation has been criticized by proponents of debt deflation, notably with his characterization of Fisher's work omitting the fundamental role of debt, leading to deflation, instead skipping debt altogether and starting with deflation:^[1]

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. Bernanke (1995, p. 17)

Similar theories

For more details on this topic, see Austrian business cycle theory#Similar theories.

Debt deflation is not the only economic theory that cites credit bubbles as a key factor in economic crises; the most noted other theory is Austrian business cycle theory, which posits that economic crises are caused by excess credit growth and the malinvestment (misallocation of resources) that results, with these being caused by central bank monetary policy and the fractional-reserve banking system.

The first difference between these may be stated as debt-deflation being a demand-side theory, which emphasizes the period after the peak – the end of a credit bubble and contraction of debt causing a fall in aggregate demand – while the Austrian theory is a supply-side theory, which emphasizes the period before the peak – the growth of debt during the growth phase causing malinvestment. The theories may thus be seen as complementary, addressing different aspects of the issue, and are so-considered by some economists.^[4]

In normative respects the theories are sharply different, with proponents of debt deflation generally arguing in the Keynesian, more precisely Post-Keynesian, tradition that government action can be beneficial, notably via debt forgiveness or engineering inflation (to reduce debt burden), or facilitating change in industries and investments, while Austrian economists generally argue that there is nothing to be done, the malinvestments needing to be "worked out of the system".

There have been other theories of economic crisis citing credit, discussed at the relevant section of Austrian business cycle theory.

Solutions

Fisher viewed the solution to debt deflation as reflation – returning the price level to the level it was prior to deflation – followed by price stability, which would break the "vicious spiral" of debt deflation. In the absence of reflation, he predicted an end only after "needless and cruel bankruptcy, unemployment, and starvation",^[5] followed by "an new boom-depression sequence":^[6]

Unless some counteracting cause comes along to prevent the fall in the price level, such a depression as that of 1929-33 (namely when the more the debtors pay the more they owe) tends to continue, going deeper, in a vicious spiral, for many years. There is then no tendency of the boat to stop tipping until it has capsized. Ultimately, of course, but only after almost universal bankruptcy, the indebtedness must cease to grow greater and begin to grow less. Then comes recovery and a tendency for a new boom-depression sequence. This is the so-called "natural" way out of a depression, via needless and cruel bankruptcy, unemployment, and starvation. On the other hand, if the foregoing analysis is correct, it is always economically possible to stop or prevent such a depression simply by reflating the price level up to the average level at which outstanding debts were contracted by existing debtors and assumed by existing creditors, and then maintaining that level unchanged.

Later commentators do not in general believe that reflation is sufficient, and primarily propose two solutions: debt relief – particularly via inflation – and fiscal stimulus.

Following Hyman Minsky, some argue that the debts assumed at the height of the bubble simply cannot be repaid – that they are based on the assumption of rising asset prices, rather than stable asset prices: the so-called "Ponzi units". Such debts cannot be repaid in a stable price environment, much less a deflationary environment, and instead must either be defaulted on, forgiven, or restructured.

Widespread debt relief either requires government action or individual negotiations between every debtor and creditor, and is thus politically contentious or requires much labor. A categorical method of debt relief is inflation, which reduces the real debt burden, as debts are generally nominally denominated: if wages and prices double, but debts remain the same, the debt level drops in half. The effect of inflation is more pronounced the higher the debt to GDP ratio is: at a 50% ratio, one year of 10% inflation reduces the ratio by approximately $50% \times 10% = 5%,$ to 45%, while at a 300% ratio, one year of 10% inflation reduces the ratio by approximately $300% \times 10% = 30%,$ to 270%. In terms of foreign exchange, particularly of sovereign debt, inflation corresponds to currency devaluation. Inflation results in a wealth transfer from creditors to debtors, since creditors are not repaid as much in real terms as was expected, and on this basis this solution is criticized and politically contentious.

In the Keynesian tradition, some suggest that the fall in aggregate demand caused by falling private debt can be compensated for, at least temporarily, by growth in public debt – "swap private debt for government debt", or more evocatively, a government credit bubble replacing the private credit bubble. Indeed, some argue that this is the mechanism by which Keynesian economics actually works in a depression – "fiscal stimulus" simply meaning growth in government debt, hence boosting aggregate demand. Note that to replace private debt growth, government debt must grow by the swing in private debt – if private debt moved from 15% annual growth to 5% annual savings, then to exactly compensate, government debt must grow by 15% + 5% = 20% more than it previously was. Given the level of government debt growth required, some proponents of debt deflation such as Steve Keen are pessimistic about these Keynesian suggestions.^[7]

Given the perceived political difficulties in debt relief and inefficacy of alternative courses of action, proponents of debt deflation are either pessimistic about solutions, expecting extended, possibly decades-long depressions, or believe that private debt relief (and related public debt relief – de facto sovereign debt repudiation) will result from an extended period of inflation.

Forward Year Tax Receipts

Recognizing that the federal government issues liabilites (debt) in its own currency and thus can never go bankrupt, another solution is for the federal government to become more like the corporate capital markets with debt issuance at high real interest rates and equity like issuance at even higher real rates of appreciation. The likely candidate for equity like issuance by the federal government is forward year tax receipts. A forward year tax receipt is a receipt for taxes paid in advance that are due some time in the future. Like government debt issuance, forward year tax receipts have a rate of appreciation and a duration. Unlike, government debt, the rate of return is not guaranteed. The realized rate of return is totally dependent on the owner's future income and subsequent tax liability. And so savers are rewarded with a positive real rate of return and debtors can realize an after tax cost of credit that is significantly less. For instance if the federal government sells 30 year debt with a 3% real rate of return and sells forward year tax receipts with a potential 7% real rate of return, then a debtor can realize a -4% cost of credit. At that point inflation is not required nor should it be desired.

And here is the proof from the Fisher equation of exchange:

M = Money Supply (Measured in Dollars) V = Velocity of Money (Measured in 1 / years) P = Price Level (Measured in $ / item) Q = Quantity of Transactions (Measured in items / year) S = Savings (Measured in Dollars / year) I = Income (Measured in Dollars / year) INT = Nominal Annual Interest Rate RINT = Real Interest Rate IRATE = Inflation Rate GDP = Nominal Gross Domestic Product (Measured in dollars / year) RGDP = Real Gross Domestic Product (Measured in dollars / year) D = Debt NI = Noninterest Income (Dollars / year) TR = Tax Rate

MV = PQ PQ is normally replaced with nominal GDP. Nominal GDP is simply real GDP multiplied by 1 plus the inflation rate and so.

MV = RGDP * (1 + IRATE)

M under Friedman was considered money supply. But it doesn't take a genius to figure out that the federal reserve can "print" all the money it likes - if the credit that it extends does not make it into the private sector then you get no GDP. And so let us say that M (money supply) should be replaced with D (debt in dollars).

DV = RGDP * (1 + IRATE)

What is DV? At first glance DV should be equal to income. You need income to buy the goods represented by GDP. And so: DV = I

But not all income is spent, some is saved and some pays taxes. Likewise not all purchases are made out of current income, some purchases are financed with debt. Because the units for GDP (likewise for M*V) are $ / year, we look at the change in debt dD / dt to represent new financing within that year. D represents all previous debt incurred in previous years for reasons that will become apparent.

DV = I * (1 - TR) - S + dD / dt

Income can be broken into two parts, interest income and non-interest income in this way I = NI + INT * D

Then we will make the assumption that all interest income is taxable. DV = NI * (1 - TR) + INT * D * (1 - TR) - S + dD / dt

In a closed economy (no foreign trade), the after tax non-interest income per year will equal the savings per year - or put another way savings will always equal investment. What this means is that all other forms of financial liabilities (cash on hand, equities, etc.) are represented in both savings (S) and noninterest income (NI). S = NI * (1 - TR) DV = INT * D * (1 - TR) + dD / dt

Solving the differential equation for D D = exp(t) dD / dt = exp(t) exp(t) * V = INT*exp(t)*(1 - TR) + exp(t) V = INT * (1 - TR) + 1 : Money velocity is equal to the interest rate times one minus the tax rate plus 1.

The interest rate has a real and inflation component, and so breaking up the interest rate into its components gives: V = (RINT + IRATE) * (1 - TR) + 1

Back to the Fisher equation: D * ((RINT + IRATE) * (1 - TR) + 1) = RGDP * (1 + IRATE)

RGDP = D * ((RINT + IRATE) * (1 - TR) + 1) / (1 + IRATE) GDP = D * ((RINT + IRATE) * (1 - TR) + 1)

And so the conclusion is simple, if you want to raise real GDP, you raise the real interest rate on government debt (which the federal reserve controls) and / or you lower the tax rate. This works well enough until you run a huge trade imbalance (like with China) that suppresses real interest rates or if you have a great depression type scenario where the inflation rate is severely negative (massive deflation). In the massive deflation scenario real GDP may show growth while nominal GDP would show contraction.

The way to get around both scenarios is to sell forward year tax receipts. A forward year tax receipt lowers the after tax cost of credit in the private sector while not depriving the bondholder of income (Friedman's permanent income hypothesis). This is the problem with monetary policy as it stands now. In a true great depression massive deflation type scenario even tax cuts don't have any traction because if nominal interest rates are 0, lowering the tax rate would have no effect on either money velocity or GDP.

FO = Outstanding Supply of Forward Year Tax Receipts FR = Forward Year Tax Receipt Rate of Appreciation

The next thing we express is how the level of debt is related to the level of FYTR's by some constant of multiplication called L

FO = L * D : This constant L is at the discretion of the federal government, how many FYTR's do they want to sell in relation to how much outstanding debt there is. Obviously there are limits to L based upon how much demand there is for them and how they are priced.

And so back to our finance equation: DV = NI * (1 - TR) + INT * D * (1 - TR) + FR * L * D - S + dD / dt

Note: One thing to be aware of is that the realizable gains from forward year tax receipts can never exceed the total tax receipts in the same year or FR * L * D < TR * NI

Again, in a closed economy (no foreign trade), the after tax non-interest income per year will equal the savings per year. S = NI * (1 - TR) DV = INT * D * (1 - TR) + FR * L * D + dD / dt

Solving the differential equation for D D = exp(t) dD / dt = exp(t) exp(t) * V = INT*exp(t)*(1 - TR) + exp(t) V + FR * L = INT * (1 - TR) + 1 V = INT * (1 - TR) + 1 + FR * L

Again, the interest rate has a real and inflation component, and so breaking up the interest rate into its components gives: V = (RINT + IRATE) * (1 - TR) + 1 + FR * L

Back to the Fisher equation: D * ((RINT + IRATE) * (1 - TR) + 1 + FR * L) = RGDP * (1 + IRATE)

RGDP = [D * (RINT + IRATE) * (1 - TR) + 1 + FR * FO] / [1 + IRATE] GDP = [D * ((RINT + IRATE) * (1 - TR) + 1) + FR * FO] / [1 + IRATE]

The beauty here is that in a mass deflation scenario both nominal and real gross domestic product hold can be pushed higher by lowering the after tax cost of capital in the private sector. See equations above: even if the inflation rate was say -10%, the FR rate could be set by the federal government to be + 15% - presto real GDP growth, nominal GDP growth, presumably rising employment and deflation to boot.

See also

• Causes of the Great Depression: Debt deflation

References

1. ^ ^{a b c} Debtwatch No. 42: The economic case against Bernanke, January 24th, 2010, Steve Keen
2. ^ ^{a b} Out of Keynes's shadow, The Economist, Feb 12th 2009
3. ^ (Bernanke 1995, p. 17)
4. ^ For example, Steve Keen first emphasizes the credit bubble and debt-deflation, but also points to financialization (the FIRE economy), citing parts of the Austrian tradition approvingly.
5. ^ Compare: "Let us beware of this dangerous theory of equilibrium which is supposed to be automatically established. A certain kind of equilibrium, it is true, is reestablished in the long run, but it is after a frightful amount of suffering.", Simonde de Sismondi, New Principles of Political Economy, vol. 1 (1819), pp. 20–21.
6. ^ Irving Fisher on Debt, Deflation, and Depression, Brian Griffin, November 05, 2008, Seeking Alpha
7. ^ Can the USA debt-spend its way out?, November 29th, 2008, Steve Keen

• Bernanke, Ben (1995), "The Macroeconomics of the Great Depression: A Comparative Approach", Journal of Money, Credit, and Banking 27 (1): 1–28, doi:10.2307/2077848, JSTOR 2077848, http://fraser.stlouisfed.org/docs/meltzer/bermac95.pdf 
• Fisher, Irving (1933), "The Debt-Deflation Theory of Great Depressions", Econometrica, http://fraser.stlouisfed.org/docs/meltzer/fisdeb33.pdf 
• Eckstein, Otto; Sinai, Allen (1990), "1. The Mechanisms of the Business Cycle in the Postwar Period", in Robert J. Gordon, The American Business Cycle: Continuity and Change, University of Chicago Press, ISBN 9780226304533, http://books.google.com/?id=P2f-icI-fM0C&pg=PA39 
• McKinsey Global Institute (January 2010), Debt and deleveraging: The global credit bubble and its economic consequences, http://www.mckinsey.com/mgi/publications/debt_and_deleveraging/index.asp 

External links

• DebtDeflation, by Steve Keen