Debt deflation

First identified by Fisher (1933) as the cause of the Great Depression in the 1930s, debt deflation is a cumulative process of declining output and prices set in train by an excessive level of private debt coinciding with low rates of inflation.

Fisher (ibid., p. 339) emphasized the importance of disequilibrium in this process, noting that even if we assume that economic variables tend towards equilibrium, "[n]ew disturbances are, humanly speaking, sure to occur, so that, in actual fact, any variable is almost always above or below the ideal equilibrium".

Given the starting positions of a higher than equilibrium level of debt and a lower than equilibrium inflation rate, debtors are forced to undertake distress sales at reduced prices, which causes both deflation and a fall in the amount of money in circulation as debts are paid off. The reduction in debt is less than the fall in nominal GDP, leading to an increase in the real debt burden even though nominal debt levels fall - a situation that Fisher (ibid., p. 344, italics in original) described as "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."

Fisher's (1933) thesis was ignored by neoclassical authors on the grounds 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 [. . .] pure redistributions should have no significant macro-economic effects" (Bernanke, 2000, p. 24). However, debt deflation was taken up by Minsky in his Financial Instability Hypothesis, with Minsky citing Fisher's work before his first citation of Keynes (see for example Minsky, 1963).

A key aspect of Minsky's interpretation of Fisher (1933) was the emphasis upon endogenous money, and the role of rising debt in causing aggregate demand to rise during "normal" times: "For real aggregate demand to be increasing [. . .] it is necessary that current spending plans [. . .] be greater than current received income [. . .]. It follows that over a period during which economic growth takes place, at least some sectors finance a part of their spending by emitting debt" (Minsky, 1982, p. 6). Conversely, a debt deflation can be seen as a period when deleveraging by debtors implies that current spending plans are lower than received income, leading to economic contraction driven by insufficient aggregate demand.

The data appear to support Fisher's and Minsky's arguments about the pivotal role of deleveraging in causing the Great Depression. Private debt peaked in mid 1929 at 163 billion US dollars and fell to a temporary trough of 124 billion US dollars by mid 1934 (it fell again between 1937 and 1939, and again sharply from mid 1943 till 1945), reducing aggregate demand below income according to Minsky's argument. The fall in debt between mid 1929 and mid 1932 was, however, proportionately smaller than the fall in nominal GDP (from 97.5 billion to 55.2 billion US dollars), so that the debt-to-GDP ratio actually rose, from 175 per cent in 1930 to 235 per cent in 1932, thus confirming "Fisher's paradox".

The economic crisis that began in 2007 is also alleged to be a debt deflation (Keen, 2013, pp. 19-21). Aggregate private debt in the United States peaked at 42.5 trillion US dollars in January 2009, and fell to 38.8 trillion US dollars by July 2011, while the annual growth in debt went from a peak of 14.2 trillion US dollars per annum in August 2007 to a trough of −2.8 trillion US dollars per annum in March 2010; US nominal GDP was respectively 14.2 and 14.3 trillion US dollars on those dates. On Minsky's metric that rising debt enables spending to exceed income (and vice versa during a depression), this implies that aggregate private sector expenditure peaked at 18.4 trillion US dollars in August 2007, after which it fell to 11.5 trillion US dollars by March 2010.

The key differences between the Great Depression and the post-2007 crisis (currently generally referred to as the Great Recession) appear to be the much smaller rate of defla- tion, and the much larger and faster government response to the Great Recession.

The annual rate of inflation was below zero in the United States between early 1930 and late 1933, with the peak rate of deflation being 10.67 per cent in mid 1932. In con- trast, deflation during the Great Recession was short-lived: in the United States the con- sumer price index fell between January and September 2009, with the peak annual rate of deflation being 2 per cent. This may reflect both the scale of the government response (discussed below), and the different sectoral composition of private debt in the United States: in 1929, 125 percentage points of the 175 per cent private-debt-to-GDP ratio were held by non-financial businesses (with households and financial businesses accounting for roughly 25 per cent each); in 2009, business debt peaked at 82 per cent of GDP, well below the 1929 figure and lower than both household and financial sector debt (97 per cent and 123 per cent respectively). There was thus less direct pressure on businesses for "distress selling" in the Great Recession, though arguably there could be a more persis- tent problem with lower demand from an over-geared household sector in future years.

The US government deficit-financed spending during the Great Depression reached 6.5 per cent of GDP in mid 1931, and then fell to below 4 per cent by mid 1932, fol- lowed by another rise to a peak of 8.6 per cent with the New Deal in 1934. By contrast, US government deficit-financed spending began at over 2.5 per cent of GDP when the crisis began in late 2007, and rose to 14 per cent of GDP in mid 2009. This huge and sustained government stimulus, combined with Federal Reserve monetary operations, clearly buoyed aggregate demand in line with Minsky's arguments in favour of "Big Government" as a stabilizing force during an economic crisis.

See also:

Consumer price indices; Deleveraging; Endogenous money; Financial instability hypothesis; Minsky, Hyman Philip.