One of the reasons I am partial to Australians is that they are critical thinkers, not easily cowed by authority or conventional wisdom.
In the US, one of the reasons that Fed chair Ben Bernanke is given so much deference (aside from the fact that we treat people in positions of power with kid gloves) is that he is regarded as an expert on the Great Depression, and has also studied Japan’s Lost Decade.
Steve Keen, author of Debunking Economics and professor at the University of Western Sydney, has taken a look at some of Bernanke’s writings on the Great Depression and finds them wanting, Serious wanting. I’ve read some of Bernanke’s work on Jaoan, and quite a few of his speeches, and was bothered by some of the assumptions and omissions. Keen tears into Bernanke with a gusto that I find refreshing.
This is a long excerpt from a much longer and worthwhile post (hat tip reader Tom):
A link to this blog….reminded me of Bernanke’s book Essays on the Great Depression, which I’ve been aware of for some time but have yet to read. I’ll make amends on that front early this year; fortunately, an extract from Chapter One is available as a preview on the Princeton site (I couldn’t locate the promised eBook anywhere!; in what follows, when I quote Bernanke it is from the original journal paper published in 1995, rather than this chapter).
To put it mildly, Bernanke’s analysis is not promising.
The most glaring problem on first glance is that, despite Bernanke’s claim in Chapter One “THE MACROECONOMICS OF THE GREAT DEPRESSION: A Comparative Approach” that he will survey “our current understanding of the Great Depression”, there is only a brief, twisted reference to Irving Fisher’s Debt Deflation Theory of Great Depressions, and no discussion at all of Hyman Minsky’s contemporary Financial Instability Hypothesis.
While he does discuss Fisher’s theory, he provides only a parody of it–in which he nonetheless notes that Fisher’s policy advice was influential:
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.
He then readily dismisses Fisher’s theory, for reasons that are very instructive:
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 1995, p. 17)
This is a perfect example of the old (and very apt!) joke that an economist is someone who, having heard that something works in practice, then ripostes “Ah! But does it work in theory?”.
It is also–I’m sorry, there’s just no other word for it–mind-numbingly stupid. A debt-deflation transfers income from debtors to creditors? From, um, people who default on their mortgages to the people who own the mortgage-backed securities, or the banks?
Well then, put your hands up, all those creditors who now feel substantially better off courtesy of our contemporary debt-deflation…
What??? No-one? But surely you can see that in theory…
The only way that I can make sense of this nonsense is that neoclassical economists assume that an increase in debt means a transfer of income from debtors to creditors (equal to the servicing cost of the debt), and that this has no effect on the economy apart from redistributing income from debtors to creditors. So rising debt is not a problem.
Similarly, a debt-deflation then means that current nominal incomes fall, relative to accumulated debt that remains constant. This increases the real value of interest payments on the debt, so that a debt-deflation also causes a transfer from debtors to creditors–though this time in real (inflation-adjusted) terms.
Do I have to spell out the problem here? Only to neoclassical economists, I expect: during a debt-deflation, debtors don’t pay the interest on the debt–they go bankrupt. So debtors lose their assets to the creditors, and the creditors get less–losing both their interest payments and large slabs of their principal, and getting no or drastically devalued assets in return. Nobody feels better off during a debt-deflation (apart from those who have accumulated lots of cash beforehand). Both debtors and creditors feel and are poorer, and the problem of non-payment of interest and non-repayment of principal often makes creditors comparatively worse off than debtors (just ask any of Bernie Madoff’s ex-clients).
Having dismissed–and barely even comprehended–the best contemporary explanation of the Great Depression, Bernanke is now trapped repeating history. It is painfully obvious that the real cause of this current financial crisis was the excessive build-up of debt during preceding speculative manias dating back to the mid-1980s. The real danger now is that, on top of this debt mountain, we are starting to experience the slippery slope of falling prices.
In other words, the cause of our current financial crisis is debt combined with deflation–precisely the forces that Irving Fisher described as the causes of the Great Depression back in 1933.
Fisher was in some senses a predecessor of Bernanke: though he was never on the Federal Reserve, he was America’s most renowned academic economist during the early 20th century. He ruined his reputation for aeons to come by also being a newspaper pundit and cheerleader for the Roaring Twenties stock market boom (and he ruined his fortune by putting his money where his mouth was and taking out huge margin loan positions on the back of the considerable wealth he earned from inventing the Rolodex).
Chastened and effectively bankrupted, he turned his mind to working out what on earth had gone wrong, and after about three years he came up with the best explanation of how Depressions occur (prior to Minsky’s brilliant blending of Marx, Keynes, Fisher and Schumpeter in his Financial Instability Hypothesis [here’s another link to this paper]). In his Econometrica paper, Fisher argued that the process that leads to a Depression is the following:
“(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)…
In its own way, this is a very simple process to both understand and to model…
So why didn’t Bernanke–and other neoclassical economists–understand Fisher’s explanation and develop it?
Because an essential aspect of Fisher’s reasoning was the need to abandon the fiction that a market economy is always in equilibrium.
The notion that a market economy is in equilibrium at all times is of course absurd: if it were true, prices, incomes–even the state of the weather–would always have to be “just right” at all times, and there would be no economic news at all, because the news would always be that “everything is still perfect”. Even neoclassical economists implicitly acknowledge this by the way they analyse the impact of tariffs for example, by showing to their students how, by increasing prices, tariffs drive the supply above the equilibrium level and drive the demand below it.
The reason neoclassical economists cling to the concept of equilibrium is that, for historical reasons, it has become a dominant belief within that school that one can only model the economy if it is assumed to be in equilibrium.
From the perspective of real sciences–and of course engineering–that is simply absurd. The economy is a dynamic system, and like all dynamic systems in the real world, it will be normally out of equilibrium. That is not a barrier to mathematically modelling such systems however–one simply has to use “differential equations” to do so. There are also many very sophisticated tools that have been developed to make this much easier today–largely systems engineering and control theory technology (such as Simulink, Vissim, etc.)–than it was centuries ago when differential equations were first developed.
Some neoclassicals are aware of this technology, but in my experience, it’s a tiny minority–and the majority of bog standard neoclassical economists aren’t even aware of differential equations (they understand differentiation, which is a more limited but foundational mathematical technique). They believe that if a process is in equilibrium over time, it can be modelled, but if it isn’t, it can’t. And even the “high priests” of economics, who should know better, stick with equilibrium modelling at almost all times.
Equilibrium has thus moved from being a technique used when economists knew no better and had no technology to handle out of equilibrium phenomena–back when Jevons, Walras and Marshall were developing what became neoclassical economics in the 19th century, and thought that comparative statics would be a transitional methodology prior to the development of truly dynamic analysis –into an “article of faith”. It is as if it is a denial of all that is good and fair about capitalism to argue that at any time, a market economy could be in disequilibrium without that being the fault of bungling governments or nasty trade unions and the like.
And so to this day, the pinnacle of neoclassical economic reasoning always involves “equilibrium”. Leading neoclassicals develop DSGE (”Dynamic Stochastic General Equilibrium”) models of the economy. I have no problem–far from it!–with models that are “Dynamic”, “Stochastic”, and “General”. Where I draw the line is “Equilibrium”. If their models were to be truly Dynamic, they should be “Disequilibrium” models–or models in which whether the system is in or out of equilibrium at any point in time is no hindrance to the modelling process.
Instead, with this fixation on equilibrium, they attempt to analyse all economic processes in a hypothetical free market economy as if it is always in equilibrium–and they do likewise to the Great Depression…
At first, Fisher was completely flummoxed: he had no idea why it was happening, and blamed “speculators” for the fall (though not of course for the rise!) of the market, lack of confidence for its continuance, and so on… But experience ultimately proved a good if painful teacher, when he developed “the Debt-Deflation Theory of Great Depressions”.
An essential aspect of this new theory was the abandonment of the concept of equilibrium.
In his paper, he began by saying that:
We may tentatively assume that, ordinarily and within wide limits, all, or almost all, economic variables tend, in a general way, to ward a stable equilibrium. In our classroom expositions of supply and demand curves, we very properly assume that if the price, say, of sugar is above the point at which supply and demand are equal, it tends to fall; and if below, to rise.
However, 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.
Therefore in theory as well as in reality, disequilibrium must be the rule:
Theoretically there may be—in fact, at most times there must be— over- or under-production, over- or under-consumption, over- or under spending, over- or under-saving, over- or under-investment, and over or under everything else. 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; emphasis added)
He then considered a range of “usual suspects” for crises–the ones often put forward by so-called Marxists such as “over-production”, “under-consumption”, and the like, and that favourite for neoclassicals even today, of blaming “under-confidence” for the slump. Then he delivered his intellectual (and personal) coup de grâce:
I venture the opinion, subject to correction on submission of future evidence, that, in the great booms and depressions, each of the above-named factors has played a subordinate role as compared with two dominant factors, namely over-indebtedness to start with and deflation following soon after; also that where any of the other factors do become conspicuous, they are often merely effects or symptoms of these two. In short, the big bad actors are debt disturbances and price- level disturbances.
While quite ready to change my opinion, I have, at present, a strong conviction that these two economic maladies, the debt disease and the price-level disease (or dollar disease), are, in the great booms and depressions, more important causes than all others put together…
Thus over-investment and over-speculation are often important; but they would have far less serious results were they not conducted with borrowed money. That is, over-indebtedness may lend importance to over-investment or to over-speculation.
The same is true as to over-confidence. I fancy that over-confidence seldom does any great harm except when, as, and if, it beguiles its victims into debt. (Fisher 1933, pp. 340-341. Emphases added.)
From this point on, he elaborated his theory of the Great Depression which had as its essential starting points the propositions that debt was above its equilibrium level and that the rate of inflation was low. Starting from this position of disequilibrium, he described the 9 step chain reaction shown above.
Of course, if the economy had been in equilibrium to begin with, the chain reaction could never have started. By previously fooling himself into believing that the economy was always in equilibrium, he, the most famous American economist of his day, completely failed to see the Great Depression coming.
How about Bernanke today? Well, as Mark Twain once said, history doesn’t repeat, but it sure does rhyme. Just four years ago, as a Governor of the Federal Reserve, Bernanke was an enthusiastic contributor to the “debate” within neoclassical economics that the global economy was experiening “The Great Moderation”, in which the trade cycle was a thing of the past–and he congratulated the Federal Reserve and academic economists in general for this success, which he attributed to better monetary policy:
“In the remainder of my remarks, I will provide some support for the “improved-monetary-policy” explanation for the Great Moderation.”
Good call Ben. We have now moved from “The Great Moderation!” to “The Great Depression?” as the debating topic du jour.
On that front, his analysis of what caused the Great Depression certainly doesn’t imbue confidence. This chapter (first published in 1995 in the neoclassical Journal of Money Credit and Banking [ February 1995, v. 27, iss. 1, pp. 1-28]–the same year my Minskian model of Great Depressions was published in the non-neoclassical Journal of Post Keynesian Economics [Vol. 17, No. 4, pp. 607-635]) considers several possible causes:
A neoclassical, laboured re-working of Fisher’s debt-deflation hypothesis, to interpret it as a problem of “agency”–”Intuitively, if a borrower can contribute relatively little to his or her own project and hence must rely primarily on external finance, then the borrower’s incentives to take actions that are not in the lender’s interest may be relatively high; the result is both deadweight losses (for example, inefliciently high risk-taking or low effort) and the necessity of costly information provision and monitoring)” (p. 17);
Aggregate demand shocks from the return to the Gold Standard and its effect on world money supplies; and
Aggregate supply shocks from the failure of nominal wages to fall–”The link between nominal wage adjustment and aggregate supply is straightforward: If nominal wages adjust imperfectly, then falling price levels raise real wages; employers respond by cutting their workforces” (p. 21).
None of these “causes” includes excessive private debt–the phenomenon that I hope now even Ben Bernanke can see was the cause of the Great Depression–and the reason why he and neoclassical economists like him are no longer discussing “The Great Moderation”.
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This is your best ever post Yves. thankyou so much. We need to get the word out.
I am off to calculate debt and inflation in 1929 vs 2008.
This is Keen’s work, be sure to give credit where credit is due.
Hi Yves,
As an Australian it is nice to hear an american consider us to be critical thinkers. However I think you might romanticising a bit. Steve Keen has attracted a small following in Australia (me included) however he is still seen as somewhat of a whacko. Unfortunately the majority of Australians happily lap up the mainstream media horseshit that is spoon fed to them.
Let me just repeat what BG said: “this is your best post ever [out of a lot of very good ones!
So I went and found Keen’s blog he makes your two main points: Fisher was right and economists like equalibrium.
You add significant color and discuss in detail the failings of Bernake, and rehitting the swedish model drum.
No, Yves, you are a national treasure. Please keep the pressure on.
Fundamental Analyst,
It’s all relative, and it may be due to the fact that people in Australia consume less TV than Americans do. I would get better informed, sharper discussion of current issues at my local pub (characters ranged from a former heroin addict turned researcher, a construction worker, a guy who did data processing, a marketing consultant, the CEO of a large local company, former artist/head of a punk rock band turned entrepreneur, and reasonably senior bureaucrat in the New South Wales government) than I would at ANY cocktail party in New York (average education level a graduate degree).
Fantastic post Yves.
Bernanke should be working in China where his “qualifications” as a depression expert would be far more relevant to the realities on the ground.
The mention of the gold standard is important. This difference alone is enough to completely change the dynamics of monetary-base. In 1933 gold was confuscated to give the dollar hard-backing. Today dollars are electronically created with just a vague charge on future taxpayers as backing.
Hi Yves
Fantastic post. As another aussie (and follower of Keen’s work) I would however tend to agree with Fundamental Analyst that he is seen to be on the lunatic fringe by the conservatives in the local mainstream economic community (led by our own mini-me RBA governor Glenn Stevens). That said, I have an immense amount of time for him and for his intellectual courage and tenacity, and as an electrical / control engineer myself (by training), I find it incredible that the economics profession has not adopted the kind of non-linear dynamical systems analysis techniques that we have been using for years (and which americans like Kalman et al invented and refined in order to put man on the moon).
I can assure readers that even Benanke could not have achieved the moon-shot with a “DGSE” inspired control system for the lunar mission ;) The “equilibrium” thing is a nice assumption, but it is a flawed assumption, as I fear we are now all witnessing first-hand.
Most economists are duds.
As a rejoinder on the eqilibrium issue, let me add that one can very easily design a “control system” for a classic unstable system (e.g. an inverted pendulum – imagine balancing a pencil on the palm of your hand) by linearising the dynamics around a small region (say where theta = 90 degrees, i.e. upright).
The control system would “work” until a disturbance input (which of course we don’t model / consider at all!) comes along and disturbs the position of the pendulum (pencil) too far from the original point. At this time, the control law which may have worked in the linear zone around theta=90 degrees breaks down, and the pendulum (pencil) falls to the floor.
The perils of an equilibrium assumption in a non-equilibrium world!
From Hotairmail
Asset prices cannot rise forever. When they eventually soften they gain their own animal momentum down.
If lending is against those assets, then under the collateralised lending model, lending too has to fall. This adds to the fall in asset prices.
And of course, if borrowers cannot repay and lenders cannot recover enough collateral, that leads to write offs. Even the expectation of such can lead to havoc as we have seen as credit dries up. This adds to the fall in asset prices.
etc
But it all comes back to the asset.
Definitely amongst your best post ma’am! Fantastic and scathing!
Asset -builders or makers try and create excess assets and sell at excess price.
Debt / Leverage has unique upscaling effect on affordability when interest rates or lending standards or both are going down.
At this time Asset builders usually attribute the mirage-like success to their ingenuity.
Sadly – or realistically – debt has even massive down-scaling effect when interest rate go up or lending standards tighten.
If asset builders are savy enough to abstain from debt when such scenario is playing out then they thrive – else they perish.
Till what level do asset prices go down
They go lower than affordability limit of median population after it has paid off its liabilities.
At this point affordability level is way way down in US and EU. So Asset prices have to go way way down and stay there till population is ready to start buying.
I believe and correct if Im wrong Yves, is from an American view point (generalizing of course) that Aussies don’t tend to ideals like blind faith or bowing down to supposed higher status individuals (tall poppy syndrome). The breath and scope of company at a small cocktail/BBQ party is refreshing, where one can discuss or rattle on about almost anything over here. The scale is from top to bottom with little left out.
Sadly in my time here, the Americanization of Aussie, via the usual suspects IE American media and their counterparts has degraded this fine national institution.
BTW to all my fellow Americans, PLEASE do not use the phrase ” its just like America 20 years ago” when asked what you think about the country, when you visit.
I cringe with indignation every time I hear it, for the suffering that will befall me, when asked in polite company, as to the origins of my birth, in the eyes of my compatriots, over a cold one.
Skippy, “the septic one” or “over paid, over sexed and over here”.
On a parallel plain to Dave of 4:40 above consider this regarding ‘equilibrium’ as used in the field of economics: they believe that such states are endogenously generated.
To an economist, an equilibrium states is generated amongst the relationships of a very few primary inputs, and thus generated ‘from within,’ endogenously. You know, supply and demand. They believe this because they can only solve equations for a handful of simple variables, and they believe that only equations make meaningful answers. The issue, however, is that any equilibrium condition happens over a cover set of conditions. In other words, equilibriums are the resultants of larger parameter sets than the principle components. Even if those principle components are determinative over narrow ranges—those simple equations can be solve—and EVEN if the contributing effects of the background parameters are individually small, the shape of the whole space can change radically through changes in the background conditions _alone_. And that is without considering background-primary interactions. All of which don’t exist for economists as they are now (mis)trained.
This is not to say that equilibriums are necessarily exogenous in their formation, that is determined by the background variables rather than the primary ones. It is more that equilbriums are the result of distributed causation, and to consider them endogenous is to force large errors into calculations. One cannot understand the function of any equilibrium condition without examining it in relations to its background context. When this is done, most ‘equilibriums’ are clearly dynamical over a wider range of states than the simple solutions considered in neoclassical paradigms. Once could not possible consider the housing booms in the US or Ireland as anything but uncontrolled bubbles if background conditions were considered. This wretched nonsense of a ‘Great Moderation [sic]’ is impossible to sustain intellectually if one considers the background, which consists of negative real rates in most industrialized countries and massive credit creation while lower labor costs in the industrializing world made nominal interest rates appear unnaturally low. Solving that kind of parameter set requires thought rather then ideology, so we see which has been the strength to now of the economics profession.
I didn’t believe in ‘economic equilibrium’ from the first readings I ever undertook regarding them, and my view of the concept has only grown dimmer in the decades since. And, btw, those economic cycles we keep hearing about aren’t endogenous to economic activity, so there is and never was any possibility that economic changes, good or bad, could end them.
I read Keen’s book, Debunking Economics, a few years back. Great book.
I also highly recommend people read Minsky’s three primary books – John Maynard Keynes, Stabilizing An Unstable Economy, and Can It Happen Again. Great stuff, and they’re showing up more and more on the shelves of the big box book stores.
Re: Neoclassical economics:
“The most serious challenge that the existence of money poses to the [economic] theorist is this: the best developed model of the economy cannot find room for it.”
–Frank Hahn, 1986
Neoclassical economics is about exploring the limit conditions of a pure exchange economy under specific assumptions of given taste, technologies, and endowments. It does not attempt to describe the way actual economies (that include unnecessary things like, oh, time, money, and assets) actually work.
“Some neoclassicals are aware of this technology, but in my experience, it’s a tiny minority–and the majority of bog standard neoclassical economists aren’t even aware of differential equations (they understand differentiation, which is a more limited but foundational mathematical technique). They believe that if a process is in equilibrium over time, it can be modelled, but if it isn’t, it can’t. And even the “high priests” of economics, who should know better, stick with equilibrium modelling at almost all times.”
A bit like saying: Most economists have not learned to read yet. What a state of ignorance the field is in.
Directly comparable is the study of hydrostatics vs. the full Navier-Stokes equations. One is good enough for plumbing, one for modelling flow over a 747 wing. Would you trust your plumber to design an aircraft?
As for equilibrium assumption, in fact, it is worse than that, because they assume a *stable* equilibrium. We known equilibria can be stable or unstable (visualise top of hill vs. bottom of valley). Dave’s discussion of a stabilising control system then does not even apply. (by the way Dave, I believe the inverted pendulum control problem needs the second order terms, linearisation is not enough).
I strongly recommend (Yves esp. if you have time!) to read ‘More Heat than Light’ by Mirovski which is a demolition of the neoclassical formulation, done by way of looking at the historical development alongside physics. Econ has reinvented/borrowed many physics ideas but not understanding the maths has lead to gross errors that are reflected in policy (e.g. mistaking an assumption of equilibrium for a fact.
To which I should add, Keen is a hero, by trying to drag economics kicking & screaming into the 19th century.
‘debt-deflation represented no more than a redistribution from one group (debtors) to another (creditors)’
bernanke (1995)
this man lives in la-la-land, knowing nothing about fractional reserve banking and even less so on real world banking.
how about this: debtors default, banks are holding assets worth less than their liabilities. those banks default due to insolvency and their creditors hold assets worth than their own liabilities. the cycle goes on and on until everything in the world costs in aggregate just as much as the quantity of money available.
Great post Yves. Straightforward perspective.
I assume that if we knew the ratio’s of debt disequilibriums and their comparative metrics to this cyclical collapse, and the effect of Ben’s willy-nilly stimulus, sans velocity, we’d have a good handle on the next five or so years, wars not withstanding.
Going against the trend, I might argue that the world is in equilibrium at any given time. The problem is that this equilibirium has only a weak relationship to the future or past equlibria, to the point where saying “markets are perfect equilibria at the any given moment” is true, but as practically useful as saying “there’s always and electromagnetic field somewhere in the universe” (or, to provoke some Austrians, as saying “man acts” :) ).
*****
Five star post, Yves. This is the best intellectual basis for the comparison of today’s circumstance to the GD that I’ve seen.
I fail to see how deflation can be a prime cause of anything. Isn’t deflation the result of something? Ascribing it to something like animal urges begs the question. Overproduction would seem to be the cause in this case.
Not being a student of economics but control systems it is difficult to comment but my basic understanding of economics history suggests that the question about equilibrium is one that the Austrian branch of economics bring up all the time. It seems to me Hicks, Keynes, kaldor and goodwin and Austrian economics all have the same roots. Steve keen as author of debunking economics knows this and I would be very surprised if Ben does not as well. Complexity Economics based on chaos theory is in its infancy. Cybernetics or the study of the interactions between system/economic elements seems to be the way forward.
http://debunking-economics.com/Lectures/Thought/
Bob Dylan: “Lenny Bruce”:
“They said that he was sick ’cause he didn’t play by the rules.
He just showed the wise men of his day to be nothing more than fools.”
Never commented before, but this post is gold.
Super post. Thank you. I’m emailing the link to lots of folks. I’m a little out of date, but at least some years ago, a lot of PhD-level economics was spent proving the existence and uniqueness of equilibrium points.
Yves, your best ever.
The USA will soon resemble Germany in 1937, stagnating, over-indebted, over-muscled, and looking for a spoil for riches.
I think our leaders are pushing us toward war. They’d probably like to see the reserve army of the unemployed join the army. The debt that the government wants to add will drive us to desperation.
Bernanke, Krugman et al., as academic economists, are just fulfilling their roles as cheerleaders for the powers that be.
Yves, best post ever from a lot of great posts,(like someone on here has already said), and on my birthday no less!
Hi Yves,
I’m so glad you are putting this out there. Keen’s fantastic. One of the commenters at Keen’s blog had a classic quote from Bernanke:
In the entire volume (Bernanke, ‘Essays on Great Depression’, 2000, Princeton)there is a single reference to Minsky in Part Two, page 43 – “Hyman Minsky (1977) and Charles Kindleberger (1978) have … argued for the inherent instability of the financial system but in doing so have had to depart from the assumption of rational economic behaviour.” A footnote adds – “I do not deny the possible importance of irrationality in economic life; however it seems that the best research strategy is to push the rationality postulate as far as it will go.”
It strikes me as very funny and telling that Bernanke reads Minsky as departing from “the assumption of rational economic behaviour” with the financial instability hypothesis. I rather thought the whole point and importance of Minsky was that he provided a model with rational actors that generated extreme dis-equilibrium.
I’m struggling to find an analogy for this. (Alice in Wonderland surely would provide something.) I’d say that its like you arrive in Australia see a black swan and the head of your scientific expedition says “Oh look a white swan.” You start to explain the problem of induction in logic and, before you can finish, the scientist gives you a dirty look, points to the black swan and says, “How many white swans do I have to show you before you give up.” In other words, economists have sort of blinded themselves to the assumptions of their models (equilibrium) such that neither experience nor logic can open their eyes.
Bang on the money, Yves.
Great post.
Wicked good!
Bernanke is an idiot and the more this clown and his little band of merry makers do the worse this will get.
This post seems amazing to me. Most interesting reading since The black Swan. I almost can’t believe it could be that simple. Maybe Bernake is a fool. Rumsfeld is. I guess it is hubris. We should try “understanding proverbs and parables the sayings and riddles of the wise”
Yves, Your best ever. Thank you and all that made it possible.
If Bernanke doesn’t understand debt deflation, we are in very serious trouble.
BTW, if any of you haven’t gone over to read the whole post, please do so. Also read Fisher’s Debt-Deflation article, because it’s a good one and you can do both in less than an hour.
Great post Yves.
“It is as if it is a denial of all that is good and fair about capitalism to argue that at any time, a market economy could be in disequilibrium without that being the fault of bungling governments or nasty trade unions and the like.”
I would like to know the economic and social backgrounds of the neoclassical economists.
Their arguments are simply not serious and I think it is because the are idealogues. Or more concisely — they are plutocrats. Neoclassical economics was not developed in the honest pursuit of knowledge. These people simply want to maintain their wealth and power and are looking rationalizations. This garbage is about politics not ecomomics. That is why none of this is surprising. It’s exactly the same with the neoconservatives: reason is irrelevant to them. They simply want everything.
Bernanke in his November 2002 speech said “a broad-based tax cut accommodated by a program of open mkt purchases to alleviate any tendency for interest rates to increase would almost certainly be an effective stimulant to consumption and hence to prices.”
Hence, why we have Obama’s prescript including a tax cut, coupled by a declaration of intent to buy long-dated treasuries to keep interest rates low in December 08.
Bernanke-ism is pure Keynesian fiscal stimulus coupled with a mechanism to keep interest rates down. The intended goal of this policy pursuit in 2002 was to stimulate consumption. Does anyone here think Bernanke will get the same result in our post housing bubble economy? Or will this policy approach amount to no more than pushing on a string. Which, when policies push on a string, tend to create further global instabilities and disequilibriums and imbalances. What now, brown cow?
“It is also–I’m sorry, there’s just no other word for it–mind-numbingly stupid. A debt-deflation transfers income from debtors to creditors? From, um, people who default on their mortgages to the people who own the mortgage-backed securities, or the banks?”
In the case of no default, the value of cash for the creditor increases, for the debtor decreases.
It seems to me that the goal of permanent inflation and circulation in the money supply is doomed to failure. If you succeed in improving circulation during recession, you have to mop up the excess during growth.
Good luck to them though.
Yves, thanks for the laugh!
Well then, put your hands up, all those creditors who now feel substantially better off courtesy of our contemporary debt-deflation… What??? No-one? But surely you can see that in theory…
How bout we ask the creditors to stand up and do a little James Brown dance “I feel good, like I knew that I would, now, so good, so good!”
don’t forget to brace yourselves for tomorrows debt-deflation spiral report (PPI)
Lee of 11:37am – You can stumble around over at The History of Economic Thought website for some biographical backgrounds on some of the neoclassicals – the site isn’t complete, but worth some time.
http://homepage.newschool.edu/het/
Not everyone who spent time working on equilibrium theory is/was an apologist for a theory that seemed to sustain the prejudices of certain class interests – Walras was a socialist, e.g. Koopmans’ “Nobel” was, I’m pretty sure, connected to his work on equilibrium theory via linear programming, and he showed (or tried to show?) the circumstances in which market equilibria obtain independent of the “owners” of the factors of production. From what I can gather (I read economomics as a hobby, not for profit), EQ/marginalist analysis was developed to address what classical economics could not do – get from a labor theory of value to prices. So why not start from the facts at hand – the prices at which things exchange? But as Keen pointed out above, “Jevons, Walras and Marshall … thought that comparative statics would be a transitional methodology…” rather than the only way to think about something.
The first economist I ever read who explicity challenged the assumptions of EQ/marginalist analysis was Lester Thurow – to whose work I was directed by the guy who first taught me rational choice theory. I mention this because Anon of 9:42am observed: “I rather thought the whole point and importance of Minsky was that he provided a model with rational actors that generated extreme dis-equilibrium.” What we have here are two fundamentally different ways of thinking about the cumulative effects of individual actors – and even yesterday, when watching Bernanke give his address at the LSE, I heard him give the obligatory huzzah to Adam Smith in answering the polemic from the Human Events “reporter”….
Lastly, for amusement: To those who read the Minksy paper linked by Keen – compare that to Taylor’s paper that Yves Smith linked to the other day:
http://www.aeaweb.org/annual_mtg_papers/2009/retrieve.php?pdfid=387
Talk about ideology obscured by numbers!!! (Moral of the Taylor paper: Do nothing more than’s been done.)
Still, the clearness of Minsky’s presentation invites a clear question. He wrote:
“In particular, over a protracted period of good times, capitalist economies tend to move from a financial structure dominated by hedge finance units to a structure in which there is large weight to units engaged in speculative and Ponzi finance.”
So far so good. Then:
“Furthermore, if an economy with a sizeable body of speculative financial units is in an inflationary state, and the authorities attempt to exorcise inflation by monetary constraint, then speculative units will become Ponzi units and the net worth of
previously Ponzi units will quickly evaporate.”
Can THAT be taken as accurate description of what caused the “financial crises” of our time? Granted, the following seems to be the facts, the empirical confirmation of his theory:
“Consequently, units with cash flow shortfalls will be forced to try to make position by selling out position. This is likely to lead to a collapse of asset values.”
But when/where was the monetarist constraint?
I am clueless about economics, but is this similar to what I have been reading on http://market-ticker.org/ from this Denninger guy?
If this is all true, the question I have is why is the mainstream press not covering this and how can reputable economists be so wrong?
I forgot about the “contraction of deposits” debt liquidation causes.
And excuse me for thinking so backwards: but I have always believed that the markets have been in “disequilibrium” since the dollar went off the gold standard in 1971 and Governor John Connally became Secretary of the US Treasury exclaiming the dollar is “our currency, but your problem.”
On further discussion of monetary and fiscal policy and equilibrium since the 1970’s, it’s the function of both monetarism and keynesianism through their market interventions to move the economy back to the desired disequilibrium level they seek to misnomer as being equilibrium.
a bit late, but if any econ grads are still reading this post, surely dynamic optimization (a standard graduate economics course) teaches one to model disequilibrium? I don’t know, because i haven’t done graduate economics.
Fisher’s text “over-investment and over-speculation are often important; but they would have far less serious results were they not conducted with borrowed money. That is, over-indebtedness may lend importance to over-investment or to over-speculation” is worth reading twice, hence my reposting it here.
The consequences of overinvestment would be far less serious in not conducted with borrowed money.
Precisely, what is being done with all the borrowed monies to monetize the debts on the balance sheet of our zombie banks? Is this not precisely borrowing even more money to put towards the overinvestment made during the housing boom, which by Fisher’s yardstick will only make the consequences of this bust even far more serious than it already is!
Yves,
bg says you are a national treasure!~
tis true…
"As a rejoinder on the eqilibrium issue, let me add that one can very easily design a "control system" for a classic unstable system (e.g. an inverted pendulum – imagine balancing a pencil on the palm of your hand) by linearising the dynamics around a small region (say where theta = 90 degrees, i.e. upright).
The control system would "work" until a disturbance input (which of course we don't model / consider at all!) comes along and disturbs the position of the pendulum (pencil) too far from the original point. At this time, the control law which may have worked in the linear zone around theta=90 degrees breaks down, and the pendulum (pencil) falls to the floor."
This is an excellent analogy of getting out of "equilibrium".
Our system (natural) does not and never will have the capacity to absorb such syphoning of "good" money from its top end like oil has promulgated. And I say the actions of oil (weakened dollar) dried up the M&A and IPO deals on Wall Street thus pushing our cherished financial giants head long into real estate (to satiate the appetite of the firm's stakeholders. The excessive compensation for their CEO's is another topic [not just Financial firm's problem – Meg Whitman's $1.3 billion wealth created by her leading EBay?]).
I am learning that when manipulation is on full throttle Keynesian and Austrian School thinking is the most rational. But when markets are not manipulated to this degree "Chicago" school thinking {Friedman} should dominate. Profounding sad is that the University of Chicago institution (for power reasons) have crippled Friedman's (Stigler, Coase, etc.) work. The golden goblet has fallen!!
We are over-leveraged and are out-of-equilibrium.
I say we go more to the out-of-equilibrium until we have the character to criminally punish these thugs. No pain no gain.
America the king is falling!
"The King in Thule
There lived a king in Thule
Right faithful, to the grave.
He loved a golden goblet
His dying sweetheart gave.
He loved it: nothing dearer
Would not a feasting-go
But soon the cup was lifted
And soon the tears would flow.
His time of death approaching,
He counts his towns out, so.
Wills all away, and gladly.
But not the goblet, no.
The scene: a royal banquet,
His knights around his knee;
The lofty hall, ancestral,
High-castled by the sea.
Then rose the snowy toper;
A toast! to life's last glow!
His sainted cup he catches ,
Flings to the foam below.
He watched it falling, filling;
He saw it settle, sink.
His eyelids ebb; then never
Another drop to drink."
Johann Wolfgang von Goethe
(this poem is a derivative of his original thought – translated from the German language to English).
More on the evolution of the Federal Reserve’s thinking back in 2002:
In June 2002, the Federal Reserve wrote a paper entitled “Preventing deflation: Lessons from Japan’s experience in the 1990’s ~
…the general lesson when inflation and interest rates have fallen to zero and the risk of deflation is hi, stimulus -both monetary and fiscal- should go beyond levels implied by baseline forecasts of economic activity.”
And Bernanke elaborated in November 2002 with his speech “Deflation: Makeing sure it doesn’t happen here” ~ …We conclude that under a paper-money system, a determined government can always generate higher spending adn hence positive inflaiton. …To stimulate aggregate spending when short term rates have reached zero, the fed must expand the scale of its asset purchases or expand the menu of assets it buys…One straightforward extension of current procedures would be to try to stimulate spending by lowering rates further out along the Treasury term structure, that is rates on govt bonds of longer maturities….A more direct method, which I personally prefer, would be for the Fed to announce explicit ceilings for yields on longer-maturity treasury debt. The fed could enforce these interest rate ceilings by committing to make unlimited purchases of securities…a second policy option woudl be for the fed to offer fixed term loans to banks at zero interest with a wide range of private assets deemed eligible as collateral.
…In practice (not theory, note) the effectiveness of anti-deflation policy could be significantly enhanced by cooperation between monetary and fiscal authorities. A broad-based tax cut, for example, accomodated by a program of open market purchases to alleviate any tendency for interest rates to increase would almost certainly be an effective stimulant to consumption and prices.
And there you have folks, the famous “Bernanke Put” under the 30 year treasury. This Put will soon be put to the test no doubt, if they follow through with their monetarist and Keynesian policies to provide sufficient stimulus to more than offset the “baseline forecasts” of declining economic activity.
Yves,
This post made my day (if not my week). This Keen guy is a riot: I don’t care if he’s considered a whacko in certain quarters. He ask questions that happen to be grounded in reality instead of the stratospheric, mind-grinding, grade-AAA bullshit served by Greenspam and followers.
Very refreshing!
You assume that someone takes a position because it is true. This is no more true in so-called capitalist societies than in the former Soviet Union. Economics professors are as much a part of the establishment as bankers, government officials, the media, etc. There are too many billions of dollars of tax revenue to be stolen to let honest men control the spigots.
Sadly, all these guys bought Kool Aid from the same cute little girl on the corner. Krugman, unashamedly calls himself a liberal. I personally don’t care to break bread with anyone who casually refers to th “natural rate” of employment and “excessive” unemployment.
One can expect nothing from these people. All of them are ideologues that protect bonds by putting people out of work. “For their own goo” — you know the have nots get hurt the most. Well, O.K., kind of thought it was in the definition.
So now we get Supply Side gifts.
The rest of us receive lectures on ethics, capitalism, and free markets.
Another game-changer from Yves.
I really do think this is another of those blogposts/comments that ought to make it into the classroom to prevent Bernanke-thought from progressing.
Having said that, I think that Johnb’s 1:50PM comment on Minsky’s prescient observation that is the debt-money nature of the massive over-speculation du jour that is the greatest contribution to the true depth of the current debacle.
A debt-free money system, as advocated by Dennis Kucinich in his comments last week, would have untold value in working our way out of the present mess. Truly the type of outside the box thinking needed to supplant the Bernanke/Krugman’s of the day.
Thanks for this.
The tree of idiocy is watered with error and its fruits are pumpkins of doom.
Sippy
Questions: where does all this buildup in private debt come from? Wouldn’t this buildup lead to rising interest rates, thus discouraging further buildup?
Is the fact that the short end of the yield curve is centrally controlled inhibiting this process? What about the fact that the Fed is universally known as lender of last resort on the long end?
To EVERYBODY
READ Irving Fisher’s “100 % Money” written in 1935 or Maurice Allais’ works on fractionnal reserve banking if you want to understand how to face this major crisis and avoiding Bubble and bursts in the future.
There is a solution !
Fantastic, Yves.
Could someone point to credible charts, tables or statistics on the level of system wide credit market debt outstanding in the 1920’s.
“None of these “causes” includes excessive private debt–the phenomenon that I hope now even Ben Bernanke can see was the cause of the Great Depression–and the reason why he and neoclassical economists like him are no longer discussing “The Great Moderation”
I have believed this for a long time but I can never find the numbers. I am just a citizen dilettante, so forgive me.
The easily found sources total debt on an historic basis show no particular trend upwards during the 20’s, even though anecdotal evidence abounds.
That the source of the bubble and bust cycle is due to excessive credit extension/debt accumulation is a one-sided half-truth. In fact, all financial “assets” are merely pieces of paper laying claim to future flows of revenue from the real productive economy, however that revenue is distributed between profits and wages. A large accumulation of such “assets” relative to real production amounts to extending the claims on the course of current production further out into the future, thereby rendering increasingly uncertain the realization of the premises on which investments were made. But, of course, the point of real investments is that they tend to raise productivity and per capita output, which tends for a while to increase the “value” of capital stocks, while at the same time displacing labor and altering inter-sectoral ratios in the balanced reproduction of the real economy. Hence profits from successful realization of productive investment tend to accumulate into an increasingly inflated stock of financial assets, which further shifts the distribution of income, lowering the rate of profit, (since high “asset” prices equal lower yields), even as wage-based demand lags increased output. Hence excess credit/debt is not the primary cause, but rather the symptom of a prolongation of a successful real investment boom, (as opposed to an asset bubble), beyond its “natural” life. (And of course, excess capital accumulation of “assets” does not necessarily have to take the form of loans and bonds, rather than equities, though the various financial markets will be variously interlinked). Lowered yields, combined with easy credit, deriving from both the excess of confidence and the excess of profits to be recycled, create the temptation toward leverage, to restore the accustomed rate of profit, that prolongs a real productive boom into a financial bubble. But that’s also an expression of the dearth of opportunities for real productive investment. So over-production/underconsumption and excessive credit/debt accumulation are not contrary, but rather inter-linked explanations of the bust, provided one understands their sources in real gains in productivity/output and the shifting distribution of income.
It’s definitely the case that industrial capitalist economies are characterized by long-run dynamic disequilibrium. “General equilibrium” as identifiable with optimum output is a half-truth at best, which, though not utter nonsense, becomes a crippling obfuscation to understanding what has been, is, and will be going on, if treated as an unquestionable a priori assumption for all economic analysis.
I typed out a longer-winded version of this account of the business cycle a few weeks back:
http://interfluidity.powerblogs.com/posts/1230410023.shtml#1628
http://interfluidity.powerblogs.com/posts/1230410023.shtml#1629
Excellent post, excellent blog.
What I don’t understand is why there is not a groundswell to eject Bernanke bodily from his office… before he does even more damage.
rapier wrote:
“Could someone point to credible charts, tables or statistics on the level of system wide credit market debt outstanding in the 1920’s. … The easily found sources total debt on an historic basis show no particular trend upwards during the 20’s, even though anecdotal evidence abounds.”
There is this chart:
http://tinyurl.com/5kz86h
…although this is probably one of the “easily found sources” you refer to. And yes, it does not show much of a trend upward in the 1920’s, not until 1930, which is puzzling. Maybe debt was rising in the late 20’s, but GDP was also quickly rising?
In any case, the above chart is crucial to understanding our current predicament, IMO.
Actually, one addition I’d like to see to this chart is a colored breakdown of the public debt vs private debt.
I recommend actually reading Bernanke’s paper, because Keen is clearly misrepresenting him with an out-of-context quote.
The structure of Bernanke’s argument is: (1) introduce Fisher’s debt deflation idea, (2) mention the neoclassical economics critique of that idea, (3) and discuss how debt deflation is consistent with neoclassical economics under an asymmetric information framework. Unfortunately Keen stops after #2, enabling him to set up a straw man.
Dear Yves,
Thanks for cross-posting my post–much appreciated.
Anonymous is correct that, as first posted, that post did quote Bernanke out of context.
I then edited it to make it clear that what I was reacting to predominantly was the neoclassical mindset from which Bernanke comes, rather than his personal contribution. Unfortunately those alterations were lost in a transfer to a new ISP which was going on at the same time, but I’ll re-do them shortly.
I still regard Bernanke’s own take on Fisher and debt-deflation was vey deficient however–which I made clear in the now lost modified post, and will do so again today.
Cheers, Steve Keen