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Can we all agree that whatever the merits of the debt-deflation theory per se that it is an incomplete account of the business cycle? Even if debt deflation is prevented the malinvestment/overinvestment allocation issues remain.

Well, the repayment of debt only pushes the price level down when it is not offset. Presuming that lenders spend the money repayed to them, whether on consumption or further investment, total expenditure will remain steady. Although relative prices may shift, the overall price level ought to change significantly only if output has risen or declined.

I suppose that with free banking, the supply of base money (gold or whatever) wouldn't necessarily change; instead, the supply of banknotes and checkable deposits would change. However, with the present monetary order (where reserve ratios are inflexible), it seems to me that monetary equilibrium cannot be satisfied without increasing the base.

Since the present system doesn't reflexively adjust to changes in demand, it is possible that debt repayment will not be offset by consumption or further investment spending by lenders. In other words, lenders will receive money and hold onto it, and the banking system will be unable to convert this saving into investment. It will be necessary to wait for the Fed to expand the base, and the delay is painful.

In class, Leland repeatedly cited Fisher on debt deflation when explaining how "the rot snowballs." Debt-deflation is a big part of why the rot snowballs, though snowballing may occur without the necessity of bankruptcy. My reduced spending is your reduced income forcing you reduce spending as well.

IMHO Mario is right to note that debt-deflation is incomplete if the time structure of production matters. Plus, of course, it does not explain what it was not meant to explain, namely, why an excess demand for real cash balances emerges in the first place.

Mario is echoing a point made by Schumpeter about Fisher's debt-deflation theory. It is not a theory of the causes of booms and busts. But it is a theory of the consequences of busts and is applicable in principle to all such events. I took this up briefly in my 2008 Cato monetay conference paper.

The question is what forces operate on the other side? How do debt deflations end?

Most of the credit channel literature on the financial accelerator, in which Bernanke was an major contributor as an economist, is a variation on a theme of the debt deflation theory. Somehow a problem occurs and the debt deflation adds to its severity, which is surely true. Unfortunately, the lesson derived from the theory is that bubbles must be repleted or an alternative bubble must be created.

Today I read someone who mildly criticized this approach on, a european economists' blog.

I think it's this one, but the vox site is dead.

Michael Pomerleano, "The deleveraging process is inevitable".

I meant, bubbles must be replenished.

Pietro M.,

Where do you find reference in the credit channel literature that implies that another bubble must be created?

This literature is primarily concerned with explaining the monetary transmission mechanism. There isn't much in the way of normative discussions of monetary policy.


Probably as a joke, Charles Goodhart said, discussing Eichengreen and Mitchener's "The Great depression as a credit boom gone wrong" (BIS WP), that "the current answer seems to be that, should one asset market, in this case the stock market, collapse, then the right response is to recreate another asset price/credit boom in another market, in this case the housing market."

If in 2003 it was common wisdom, in 2009 is more like religion. :-)

As the financial accelerator literature has been pionereed by Bernanke, I think he is performatively showing to the world his normative conclusions of his positive analyses.

Besides, as they often are more or less "keynesians", the maximum likelihood estimator of the normative interpretation of those theories by their authors, for me, is that if there are problems with asset deflation, inflation should be the solution. Moreover, to focus on the short term effects of economic disturbances forgetting about the long run is very keynesian. And asset reflation surely is.

The paper I linked before (from voxeu) says that the author's view of letting bubbles deflate is strange nowadays_ "So as painful as it is, maybe the leveraging process has to proceed and the government should stand-by ensuring only the payment system, and facilitate the deleveraging process. I realize that those conclusions are unconventional."

Another very important contributor to that literature is Joseph Stiglitz. In order to understand whether or not he is an inflationist the reading of Stiglitz/Greenwald "Toward a new paradigm in monetary economics" is a very good read, as it is simple and quite systematic in describing the approach: "The central IMF error is that high interest rates enhance the probability of bankruptcy" (this is not the exact quotation, as I have the book in my language).

Finally, Mishkin, another economist involved in this literature, has explicitly written several papers on how to conduct monetary policy. I unfortunately don't have nothing at hand, but being a Fed employee his speeches can be downloaded from the Fed site. "Second, monetary policy should not try to prick possible asset price bubbles, even when they are of the variety that can contribute to financial instability. Just as doctors take the Hippocratic oath to do no harm, central banks should recognize that trying to prick asset price bubbles using monetary policy is likely to do more harm than good." (this is an imperfect citation: it just says that the Fed shouldn't prick a bubble, I'm not sure I can find a more on topic quotation by him, as I read his speeches and papers a year ago).

I think I may have some more example. Of course, much of the literature is positive and does not explicitly analyze policy issues. When they have, however, you'll never find an asset deflationist.

On average, I may find one "let the bubble crash" economist every one hundred. But I'd bet they are more likely to believe that money is neutral rather than not.

I agree. Debt deflation tells only a part of the story (by the way, it animates Minsky's hypothesis). If I recall correctly, in America's Great Depression Rothbard pretty much dismisses the problem.

The problem with the Bernanke-Mishkin approach is that it does not work.

If there is one lesson from the current bursting of the housing AND stock-market bubbles, is that asset markets reprice despite monetary stimulus (in the current case, without limit, which is exactly what Keynes recommended).

The attempts at reflation are creating new bubbles even as the old ones continue to be unwound.

Suppose that before the bubble bursts, an individual had an income of $1,000, fixed debt payments of $250 (his house payment, for example) and the remainder of his income ($750) to cover his other budgetary expenditures.

If a deflation occurs that cuts his income by 25 percent to $750 his debt burden will have increased to 33 percent of his income from a previous level of 25 percent.

This leaves him with $500 to cover his other budgetary expenditures. But if the prices of these other goods that he purchases have declined on average by 25 percent also, then what previously cost him $750 to buy would now cost $562.50.

Thus, he would have to reduce his non-debt expenditures out of his lower nominal income by $62.50, or by 12.5 percent.

On the other hand, the creditor still will be receiving his $250 from the debtor, and be able to spend it whatever purchases he wishes to undertake at prices that are now 25 percent less than before. His buying power will have increased by one-fourth.

Certainly, the pattern of relative demands may shift due to the debtor having less to spend on some things and the creditor having the purchasing power to demand more of other things.

But I don't see why any major "crisis" need arise from the change in the relative income and spending positions of these market actors.

Am I missing something?

Richard Ebeling

The debt deflation theory of Fisher must always survive the challenge of why was the early 1930s debt deflation special? Deflation was more severe in the depression of 1920-1921. There was no hue and cry in this or many early periods of deflation.

Cole and Ohanian discuss the debt deflation theory of Fisher in some depth in their joint papers on the start of the great depression.

Cole and Ohanian divide the debt deflation effect into a debt burden effect, Fisher’s original view, and a wealth transfer effect - unexpected deflation transfers wealth from debtors to creditors.

On the wealth transfer effect, Cole and Ohanian note that creditors are older and borrowers are younger. The transfer increases the old generation’s consumption, but changes their labour input little since their labour supply is low - many are retired.

The wealth transfer will increase the hours worked and output of the now poorer young generation, which acts to offset the debt burden effect. There is no presumption that Fisher’s debt-deflation inspired wealth redistributions between debtors and creditors reduce aggregate employment and output.

Rothbard addressed the debt-deflation in a footnote. He noted that the creditors of a firm are just as much its owners as are the equity shareholders. The shareholders have less equity in the business to the extent of its debts. Long-term creditors are different types of owners, just as preferred and common stock holders exercise their ownership rights differently. Deflation in itself neither helps nor hampers a business. The creditor–owners and debtor–owners may choose to simply divide their gains (or losses) in different proportions. These are ‘mere intra-owner controversies’.

An appeal to post-contractual opportunism has some limited merit. The bar against this idea is always that put by Barro is his critique of long-term contracts as a rationale for wage rigidity. People do not repeatedly sign long-term contracts that are against their interests. They also have an incentive to find a way to renegotiate contracts if the need arises. Creditors have no interest in persistently bankrupting debtors for no good reason.

Richard is right.

The impact of deflation on debts outside of the banking system is a transfer. Those transfers can impact money demand.

With banks, however, if the bank's debtors can't repay the bank, and the bank fails, then the bank can't repay its depositors. Some deposits serve as money. The money that can't be repaid is gone. The quantity of money falls.

Worry about this happening can result in an increase in the demand for base money and a decrease in the quantity of money through the money multiplier process.

You can set up naive expectations which are probably realistic for some people at some time where deflation leads to a bank failure and causes people to demand more base money for fear of future bank failures.

Even if there were 100% reserves, worry about bankruptcy by those issuing money substitutes (say short term commercial paper) could raise the demand for money proper.

For example, those borrowing cannot pay. Those lending receive partial payment. To avoid this, they cut back lending now and increase the demand for base money.

One can even see this happening with what are not usually money substitutes

Of course, bankruptcy involves real costs. The negotiations, the court activity, actual disruption in operations, an inability of a firm in this situation to finance long term investments.. all of these things hamper production.

Usually, bankruptcy occurs because of a misallocation of resources. Not always, of course. But often. Shutting down operations and liquidating is not a bad idea.

If the reason for the deflation is entirely an incease in the purchasing power of money, disrupting operations is undesirable.

And, of course, there is nothing desirable about the transfers. They serve no useful economic purpose. It is about contracts made for production being simultaneous speculations about the future purchasing power of money. If money had a more stable purchasing power, the disruption would be avoided. Effiency would be enhanced by the use of more long term contracts.

Oh, by the way, the real burden of the national debt is increased. Taxpayers must pay higher real taxes to continue to make payments to goverment bond holders.

Let's see... Oh, in 1920, the price level at the end of the recession was about where it was a few years before The monetary regime at the time normally had wartime inflation reversed after the war. People who borrowed in 1919 were presumably expecting deflation as prices returned to normal. That they didn't go all the way back to pre WW1 level means that the price level was higher than expected.

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