What Bernanke doesn’t understand about deflation

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Variable/Year Year 1 Year 2
Nominal GDP 1000 1100
Growth rate of Nominal GDP 10% 10%
Real growth rate 5% 5%
Inflation Rate 5% 5%
Private Debt 1250 1500
Growth rate of Private Debt 20% 10%
Change in Private Debt 250 150
Nominal Aggregate demand (GDP + Change in Debt) 1250 1250

Notice that nominal aggregate demand remains constant across the two years–but this means that real output has to fall, since half of the recorded growth in nominal GDP is inflation. So even stabilising the debt to GDP ratio causes a fall in real aggregate demand. Some markets–whether they’re for goods and services or assets like shares and property–have to take a hit.

Now let’s apply this to the US economy for the last few years, in somewhat more detail. There are some rough edges to the following table—the year to year changes put some figures out of whack, and some change in debt is simply compounding of unpaid interest that doesn’t add to aggregate demand—but in the spirit of “I’d rather be roughly right than precisely wrong”, at your leisure please work your way through the table below.


Variable\Year 2006 2007 2008 2009 2010
GDP 12,915,600 13,611,500 14,337,900 14,347,300 14,453,800
Inflation Rate 4.0% 2.1% 4.3% 0.0% 2.6%
Private Debt 33,196,817 36,553,385 40,596,586 42,045,481 40,185,976
Change in Debt 2,914,187 3,356,568 4,043,201 1,448,895 -1,859,505
GDP + Change in Private Debt 15,829,787 16,968,068 18,381,101 15,796,195 12,594,295
Government Debt 6,556,391.0 6,893,467.0 7,321,592.0 8,615,051.0 10,167,585.0
Change in Government Debt 478,851.0 337,076.0 428,125.0 1,293,459.0 1,552,534.0
GDP + Change in Total Debt 16,308,638.0 17,305,144.0 18,809,226.0 17,089,654.0 14,146,829.0

That sucking sound will continue for many years, because the level of debt that was racked up under Bernanke’s watch, and that of his predecessor Alan Greenspan, was truly enormous. In the years from 1987, when Greenspan first rescued the financial system from its own follies, till 2009 when the US hit Peak Debt, the US private sector added $34 trillion in debt. Over the same period, the USA’s nominal GDP grew by a mere $9 trillion.


Though this might beggar belief, there is nothing sinister in Bernanke’s failure to realize this: it’s a failing that he shares in common with the vast majority of economists. His problem is the theory he learnt in high school and university that he thought was simply “economics”—as if it was the only way one could think about how the economy operated. In reality, it was “Neoclassical economics”, which is just one of the many schools of thought within economics. In the same way that Christianity is not the only religion in the world, there are other schools of thought in economics. And just as different religions have different beliefs, so too do schools of thought within economics—only economists tend to call their beliefs “assumptions” because this sounds more scientific than “beliefs”.

Let’s call a spade a spade: two of the key beliefs of the Neoclassical school of thought are now coming to haunt Bernanke—because they are false. These are that the economy is (almost) always in equilibrium, and that private debt doesn’t matter.

One of Bernanke’s predecessors who also once believed these two things was Irving Fisher, and just like Bernanke, he was originally utterly flummoxed when the US economy collapsed from prosperity to Depression back in 1930. But ultimately he came around to a different way of thinking that he christened “The Debt Deflation Theory of Great Depressions” (Fisher 1933).

You would think Bernanke, as the alleged expert on the Great Depression—after all, that’s one of the main reasons he got the job as Chairman of the Federal Reserve—had read Fisher’s papers. And you’d be right. But the problem is that he didn’t understand them—and here we come back to the belief problem. The Great Depression forced Fisher—who was also a Neoclassical economist—to realize that the belief that the economy was always in equilibrium was false. When Bernanke read Fisher, he completely failed to grasp this point. Just as a religious scholar from, for example, the Hindu tradition might completely miss the key points in the Christian Bible, Bernanke didn’t even register how important abandoning the belief in equilibrium was to Fisher.

To know this, all you have to do is read Bernanke’s summary of Fisher in his Essays on the Great Depression:

The idea of debt-deflation goes back to Irving Fisher (1933). 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.


There’s no mention of disequilibrium there, and though Bernanke went on to try to develop the concept of debt-deflation, he did so while maintaining the belief in equilibrium. Compare this to Fisher himself on how important disequilibrium really is in the real world:



We might not be in such a pickle now if economics had started to become more of a science and less of a religion by following Fisher’s lead, and abandoning key beliefs when reality made a mockery of them. But instead neoclassical economics completely rebuilt its belief system after the Great Depression, and here we are again, once more experiencing the disconnect between neoclassical beliefs and economic reality.


Variable\Year 1929 1930 1931 1932 1933 1934 1935
GDP 103,600 91,200 76,500 58,700 56,400 66,000 73,300
Change in Nominal GDP 6.0% -12.0% -16.1% -23.3% -3.9% 17.0% 11.1%
Private Debt 161,800 161,100 148,400 137,100 127,900 125,300 124,500
GDP + Change in Private Debt 109,300 90,500 63,800 47,400 47,200 63,400 72,500
Change in Private Aggregate Demand 0.0% -17.2% -29.5% -25.7% -0.4% 34.3% 14.4%
Government Debt 30,100 31,200 34,500 37,900 40,600 46,300 50,500
Change in Government Debt -100 1,100 3,300 3,400 2,700 5,700 4,200
Change in Total Aggregate Demand 0.0% -16.1% -26.7% -24.3% -1.8% 38.5% 11.0%


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206 Responses to What Bernanke doesn’t understand about deflation


  2. Pingback: Debt Deflation | Wealth Alchemy

  3. LightsOut says:

    Hi Steve.

    Thanks for the clarification.
    Thought you might be interested in this BIS paper as a possible way of calibrating your circuit model.


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