The uncertain course of debt deflation

This post is written jointly with Tomas Hirst.

I have been re-reading Irving Fisher's "Debt deflation". Short and immensely readable, it remains one of the best explanations of financial crashes and depression in economics literature. But I am puzzled. What is going on at the moment doesn't quite fit, somehow.

On the face of it, much of what has happened over the last six years fits all too well with Fisher's description of debt deflation. He identifies two prime causes of booms and busts - what he calls the "debt disease" and the "dollar disease". Over-indebtedness before the crash results in debt deflation after the crash - the "debt disease". And shortage of money in circulation leads to apparent over-production and crashing prices - the "dollar disease". The disastrous deflationary spiral experienced by the US in the Great Depression, and by several Eurozone countries at present, can be adequately explained by these two factors.

But what is happening in countries such as the US and UK is much less straightforward. We had a crash, followed by sharp deleveraging in the private sector, distress selling, price crashes and bankruptcies. But then we propped it all up. Governments intervened to arrest the deflationary slide by taking distressed private debt on to public balance sheets, and central banks flooded the place with new money to prevent catastrophic price falls. The sharp deleveraging stopped and the price level stabilised - in fact in the UK the general price level actually rose. And yet we seem to be experiencing a number of features of Fisher's debt deflation spiral.

Fisher identifies a chain of nine linked stages in debt deflation:

1) Debt liquidation causing distress selling leading 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....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 society leads the concerns which are running at a loss to make
6) A reduction in trade, in output and in employment of labour. These losses, bankruptcies and unemployment lead to
7) Pessimism and lack of confidence, which in turn lead to
8) Hoarding and slowing down still more the velocity of circulation.
The above 8 changes cause
9) Complicated disturbances in the rates of interest, in particular a fall in the nominal (money) rates of interest and a rise in the real (commodity) rates.

Now it is easy to see where in this sequence governments and central banks intervened. Clearly it was between stages 2 and 3 - exactly where Fisher says that reflation might interfere with the process. Bernanke and Geithner may not have read Fisher, but they did what he suggested. Consequently we have not seen a general fall in the price level and we have not had a spate of bankruptcies. But that's where the good news ends.

There is no doubt that the financial crisis did severely disrupt trade, output and employment, despite the reflationary efforts of governments and central banks. And it is still doing so. Employment in Western nations is well below what it was before the crisis: in the US this shows itself as a stubbornly high unemployment rate, while in the UK it takes the form of substitution of full-time employment with part-time, short-term and casual work. Output is also significantly lower than before, to the extent that the UK's OBR pessimistically forecasts that it cannot return to its previous level. And both domestic sales and exports are reduced. The feeble nature of the economic recovery is the reason why Western central banks are still reflating their economies six years after the crisis.

Evidently the reflation did not fully prevent stage 6 from occurring. And it seems to have had no effect at all on the subsequent stages. Pessimism and lack of confidence is evident throughout the economy: people are worried about their savings, their jobs and their incomes. People and businesses are cutting spending and saving like crazy: they are paying off debt and hoarding cash and other assets. Investors are moving their funds to safe havens - highly-rated government debt, traditional safe haven currencies such as the Swiss franc, government-insured deposit accounts. Even UK local authorities are under-spending their budgets and building up reserves. Yet the crisis itself is long over and did not cause the catastrophic deflation of the 1930s. What on earth is going on?

There is no doubt the prompt intervention of the authorities prevented a repeat of the 1930s disaster. We did not repeat the mistakes of the early 1930s, except in the Eurozone where the Euro straitjacket forced countries to maintain tight monetary and, latterly, fiscal policy, precipitating the classic deflationary spiral. Or - did we? Six years on, monetary policy is so loose it is practically in pieces and central banks are resorting to increasingly esoteric and untested tools to find ways of depressing interest rates further (actually this amounts to the "complicated disturbances in rates of interest" that Fisher mentions, though not for the same reasons). But fiscal policy is another matter. In contrast to 2009, when governments worldwide collaborated to give substantial fiscal stimulus to the global economy as a whole, the general policy stance of Western governments now is that fiscal policy must be progressively tightened in order to reduce public deficits and - as the IMF puts it - "get public finances on to a more sustainable path". In other words, we are VOLUNTARILY undertaking debt deflation in the public sector. The only Western government that hasn't so far adopted fiscal austerity as a general policy is the US. But it clearly intends to. Even Obama talks about reducing the deficit, though whether he means short-term spending cuts or longer-term structural reform is unclear. 

The prevailing view appears to be that fiscal "reforms" - i.e. public debt deflation - can be conducted despite difficult economic conditions if monetary policy is supportive. But this ignores the fact that fiscal and monetary policies affect the economy in different ways. Monetary policy primarily affects the financial system: fiscal policy primarily affects the "real" economy. Or in US parlance, monetary policy influences Wall Street, fiscal policy Main Street. Obviously there are indirect effects: monetary easing depresses interest rates on variable-rate mortgages and on savings and investments, benefiting homeowners: taxation policy affects the nature and direction of money flows around the financial system. But the direct effects have more impact - and the direct effects of ANTICIPATED fiscal austerity and government spending cuts are sufficient in themselves to explain pessimism, lack of confidence and hoarding among the general public. Never mind that governments actually haven't done much fiscal tightening yet. All that matters is that people think they are going to. Public sector workers are worried about losing their jobs - and with reason, as there have already been significant job losses and further cuts to government departments are planned. Working-age people on low to middle incomes worry about tax rises and benefit cuts. US pensioners worry about cuts to Medicare: UK ones, about means-testing of benefits such as the winter fuel allowance. And there is clearly more to come. The UK government responded to the news that it would miss its deficit reduction target by announcing a further 3 years of cuts and austerity. Really they are stupid. Did they think people would react to that by going on a spending spree? Anybody with any sense surely could have foreseen that people would respond by increasing their savings level. The effect of the UK government's announcement must have been to depress the economic activity of average UK households.

Perversely, the effect of monetary easing can also be to reduce spending and increase savings rates. Pensioners on fixed incomes cut their spending in anticipation of poorer returns on their investments due to depressed interest rates. And people who are suffering erosion of their capital due to negative real interest rates don't necessarily spend the money instead - certainly not if it is money they are saving up for their old age. No, they try to make good the difference. They cut discretionary spending and save even more.

The effect on businesses of anticipated fiscal austerity is slightly different. Businesses generally don't suffer directly from fiscal tightening, unless governments raise corporation taxes. They suffer indirectly, because of demand reduction caused by households suffering reductions in real income and/or opting to save instead of spend. Resilient (or even improved) private sector profitability has been the surprising story of this financial crisis, but it has largely been driven by the ability of some businesses to bleed existing assets (increasing rents) while cutting investment in future projects (holding back innovation causing artificial scarcity). Unfortunately because incomes are being squeezed by a combination of inflation and corporate cost cutting this will likely prove a temporary state of affairs. Indeed we are already seeing a growing number of corporate profit warnings.

The problem then is what companies do with their surpluses. If fiscal policy is still a driver of uncertainty then there is very little incentive for them to start investing as they rationally assume demand will be further undermined. But the alternatives are not very compelling either – sitting on cash (or cash-equivalent assets) with interest rates around zero and above-target inflation mean they are already losing significant amounts in real terms. Moreover, contrary to what a number of investors have been advocating for, committing to paying it out as dividends is also problematic as at best it can only buy time unless the business can achieve meaningful organic growth.

Yet their reluctance to spend is helping to intensify the economic downturn and undermining central bank attempts to reflate. This has created a destructive cycle whereby businesses try to anticipate the demand impact of government cuts by building up surpluses, increasing the actual impact of the cuts when they occur. The burden is then shifted onto central banks to mitigate the shortfalls by trying to reflate the asset base, even as the spillover effects of unorthodox monetary policy erode returns on safe assets and prop up inflation above average wage rises. It hardly makes a compelling case for banks, which are under regulatory pressure to de-risk, to start increasing lending to the real economy. So they too are sitting on what little profits they are able to make, refusing to take on risk and lobbying government in the hope of reducing regulatory threats.

Debt deflation doesn't follow a predictable sequence: it meanders in an uncertain and unpredictable manner, depending on the situation of each economic agent. So the relationships between Fisher's nine linked stages are complex, and the effect of later stages can be to recycle earlier ones. For example, the effect of private sector hoarding is to reduce economic activity, depressing trade, output and employment and causing bankruptcies. Businesses that aren't highly indebted and are able to cut costs may survive depression of customer demand, but businesses that have significant amounts of debt and/or high fixed costs may go right back to stage 1) - debt liquidation, distress selling and bankruptcy. This includes banks. There have been calls for banks to reduce "forbearance", where they do not foreclose on bad loans, because it maintains businesses that should be allowed to fail, preventing growth of new, more viable businesses. But when the banks have balance sheets stuffed full of loans to zombie businesses and underwater homeowners, their own solvency is at risk if they foreclose on those loans. Forbearance is a self-protective hoarding strategy on the part of banks. Without it, banks would go bankrupt.

The effect of banks desperately hanging on to bad loans in order to avoid bankruptcy is that new lending, particularly to business, is severely curtailed - as Fisher forecast. They cannot afford the risks that these businesses represent. They have quite enough risk on their balance sheets already. But the effect is that small and medium-size businesses, particularly, are starved of the essential finance they need to grow. And as Fisher also forecast, debt deflation in general and hoarding behaviour in particular (including forbearance and lending restriction) has disruptive effects on interest rates. Interest rates on assets perceived as "safe" crash through the floor, while interest rates on finance for productive activity head for the moon.

So the picture we have is one of continuing, though slow, debt deflation and significantly disrupted price mechanisms despite - and to some extent because of - central bank attempts to reflate. It seems that the supportive effect of monetary easing is cancelled out by both the reality and the threat of fiscal austerity. We are locked into the same deflationary spiral as the US of the 1930s, but at a much slower pace. Now, slow may be better - it may avoid the appalling hardship described by Steinbeck and evident in reports from today's Greece. But it does mean that recovery is not going to happen for a very long time.

Whether softening the fiscal stance, delaying public sector financial reforms and allowing reflation to do its job would stop the debt deflation spiral and allow economies to recover I don't know. There are a lot of very worried people out there. It may be that the biggest problem now is not the debt, not the economic problems, but people's hearts and minds. The world is a frightening place at the moment. Everyone is desperately trying to protect what they have rather than risking it in the hopes of better to come. But risk-taking is essential for economic growth. While risk aversion remains the dominant paradigm, there can be no lasting recovery.


  1. I think without the Fed's bailouts and cheap money for banks,the banks would have shrunk the money supply much more than they did. And without the cheap corporate bonds created by QE, companies would have invested less. So the Fed largely prevented deflation. They did the best they could.

    I see house prices rapidly rising in many distressed markets, and employment gradually rising. These two factors will increase risk taking in the US. The cycle is turning and picking up momentum. Most of us are so entranced by serial correlation that we don't see changes until they are well underway. But Europe is still in trouble because the periphery have no plausible way to get Euros to repay their decade of trade deficits.

    1. I agree. The US has handled this the best. Not just the Fed's reflation, but generally supportive fiscal policy, though that is beginning to change. But Europe has taken a much tougher fiscal stance throughout, and in the Eurozone monetary policy is also tight. That's why the Eurozone is in the classic debt deflationary spiral. In my view, if they don't loosen up significantly the spiral will eventually drag down all Eurozone countries including Germany.

      Inevitably, Tomas and I write most about the UK, which is the country we know best. The UK has supportive monetary policy and austere fiscal policy, which in my view are cancelling each other out. So the UK also is in the debt deflationary spiral, just at a slower pace. If it remains on its present trajectory it is in for a very, very long slump. The US should beware of choking off its recovery with a premature tightening of fiscal policy.

    2. "I see house prices rapidly rising in many distressed markets, and employment gradually rising"

      Ah, but who are the buyers and what are the jobs? The home ownership rate is declining in the US. It is big investors buying up the stock from the banks as rentals, and usually with government assistance.

      The jobs coming back are low paid service jobs. Wages as share of national income are on the decline.

  2. You are right when you point out that the main result of intervention has been to slow down and stretch out the resolution of the crisis, rather than solving it. One thing it's important to notice in this respect is how well that suits politicians. During a long drawn out crisis they get to allocate gains and losses, and everyone has to come to them for protection. In the short, sharp liquidations assumed by classical economics, which often used to happen when governments had less influence, markets allocated the gains and losses - politicians had less to do and fewer opportunities to shelter their clients and exact contributions.

    Regarding the US, it's easier to toss off a recommendation as if it were obvious when it's somebody else's economy you are talking about. Many of us don't want to see the US go down the same path as Europe and/or Japan, rapidly aging and mired in debt and unfunded liabilities, and indeed moved here precisely to avoid having our children share that fate. If the alternatives are either throwing ever more money at the current economic structure, or cutting spending and precipitating a sharp restructuring, some of us would rather rely on the US economy's traditional flexibility and ability to adapt creatively.

  3. My short summary of your excellent article: They are all just kicking the can down the road, avoiding responsible decisions. Japan has done it for 20 years now. Stagnation of the real economy for 20 - 30 years will probably occur in the US/UK/EU resulting in structural high unemployment levels that eventually will result in social unrest. The rich will get richer and the poor will get ...... Disincentives to work will become manifest. Printing money and spending it "worked" in the USSR for 70 years. Then it didn't.

  4. The only way we (Europe, the US and Japan) will be able to pull out if this is a great burst of economic activity which absorbs a lot of labour, which props up velocity of money.

    We cannot have a war like last time, as that is not sufficiently labour-intensive. In fact nothing is sufficiently labour-intensive.

  5. Yes to - EU bad, UK better, US best;
    but this is surely bad, better, best in addressing the symptoms~?

    What about the cause (private over-indebtedness)~?

    Which one is doing best to address the cause of the symptoms~?

    1. The parochial economists just look at the symptoms.

      That's all they're able to do.

  6. The whole shooting-match is starting to look and smell like a rather messy, although, co-ordinated attempt at demand limitation via suppression, whilst rescuing the overall structure from collapse. A sort of balancing act if you will ?

    That 147 dollar oil in July 2008 must have sent some shock waves ?

    1. But why limit demand, when the problem is deflation? I think this is related to my previous post about the inflation monster. They are so scared of inflation that they squash any signs of recovery in case inflation "takes off". They say they want recovery, but do they, really?

      I think the role of the 2008 oil price rise in the crisis - or rather in the subsequent recession - is much under-estimated.

    2. But that's the point - we have deflation because the current energy prices, especially oil, are a drag on growth. Energy costs are certainly not in the deflationary camp.

      We the consumers are pretty much in fear of these energy costs rising and this is a major part of the fear you rightly mention.

      Should governments actually do anything substantial to stimulate growth, then the cost of energy will head steeply upwards.

      Without any real buffer of reserve capacity, this will be the reality for a very extended period I believe.

    3. "They say they want recovery, but do they, really?"

      I think the answer is no. The ultimate intent is asset transfers and a type of neofeudalism. Capital wants to extract rent from every asset they can get their hands on.

    4. @cringing2

      I agree to some extent, although, neofeudalism could just be an outcome rather than an aim.

      The growth game is up and those with wealth and ready access to information know this. When there is no more to be gained by investing in industrial growth, then you have to switch to another source of income - rent extraction as you mention is an obvious one, although, control of energy supplies would give you a very strong hand.

    5. Well, that's exactly what all these wars are about. "Terrorism" and "human rights violations" Aren't even vaguely believable.

    6. Agree.

      I believe we can write a simple rule for energy supplies:

      "For real sustainable growth to occur, then any increased demand for energy must not translate into a proportionate or greater real cost of that energy."

      This is driven by the marginal cost of production and associated declining EROEI. If we break this rule, then boom and bust cycles are unavoidable.

  7. I think it's just mainly a matter of confidence

  8. Debt deflation is only one part of the deflation picture. And you are quite right that the actions of central banks worldwide have been, for the most part, successful in preventing the worst of the immediate effects of the most recent asset bubble burst. However, deflation in the major industrial countries is being stoked by several other factors. First, demographic deflation. For growth, you need people in their 20's and 30's and in Japan and Europe the decline in population is very deflationary (less so in the US because of loose immigration policies). Second, supply-side deflation. I heard an interview recently with a very senior Japanese government economist where he admitted that Japanese companies are simply producing more goods that the people can buy. This is caused by the incredible increase in productivity due to the digital/computer/robotic revolution. Not to be confused with the third and last major contributor to deflation, overcapacity. Government policies rooted in compassion and political self-interest, have led to zombie companies, zombie banks, and even zombie countries, read Greece. There is worldwide overcapacity in many basic industries (e.g. auto manufacturing) that governments will not let market forces reduce. Will the desperate attempts of the central banks to counter this deflation tidal wave succeed? I have no idea, but they certainly have not been successful in Japan, but that may be a very special case.


  10. While it may be that "the actions of central banks worldwide have been, for the most part, successful in preventing the worst of the immediate effects of the most recent asset bubble burst" , it does not necessarily follow that said central bank action(s) can (permanently) prevent the worst of the (natural?) effects of the the most recent (or even the next) asset bubble burst. Indeed, Madame Rothschild is quite correct in stating that "only business itself can restore faith in capitalism". People hoping for a government solution are about to be sorely disappointed.

    How Capitalism Can Repair Its Bruised Image

    by Lynn Forester de Rothschild, E.L. Rothschild
    and Adam S. Posen, Peterson Institute for International Economics
    January 1, 2013

  11. "We had a crash, followed by sharp deleveraging in the private sector, distress selling, price crashes and bankruptcies. But then we propped it all up. Governments intervened to arrest the deflationary slide by taking distressed private debt on to public balance sheets, and central banks flooded the place with new money to prevent catastrophic price falls. The sharp deleveraging stopped and the price level stabilised - in fact in the UK the general price level actually rose. And yet we seem to be experiencing a number of features of Fisher's debt deflation spiral."

    Right, and the reason we are still experiencing those features is because the reflation efforts simply transformed the decline to a decline in real terms. Prices for most things are still falling in terms of gold. Before I get jumped on for using gold as a reference point, it is completely apt given the fact that in the monetary realm it is the hardest 'currency' and thus exhibiting the strength that the dollar would have had policymakers intervened. Carrying on, wages (at least in the US) are also falling in real terms (vis a vis the dollar even, let alone gold). I suspect that corporate profits, even though they are the highest on record have been largely achieved by cutting costs. This means firing people/depressing wages because those are the easiest costs to keep low. Fixed costs, rents, factor prices etc are all things that are subject to the reflation effort, and the only way to minimize costs when these things are all going up is to sack workers.

    On the final sales end, once cost cutting is at its end the only option is to raise final goods prices, but as I've said average wages are declining in real terms. That dynamic is problematic going forward. I haven't done the math, but I suspect these profits are actually declining in real terms, just like stock markets, even though most of them are back up to 2007 again, have still been falling in terms of gold.

    You've done very well in describing that sort of dynamic as it applies to the economy as a whole, and ultimately that what it means is that we have not got rid of the debt deflation phenomenon but merely slowed it down.

    Where I disagree is with the notion that slow is perhaps better. All slow means is that instead of this process taking 5 years to play out it takes 20 or 25 years to play out. At the end of it, all we've done is completely stifle and constrict the productive capacity of an entire generation of youths because all of the resources and opportunity they could have used has been siphoned into propping up institutions, and indeed an economic system, that slowly met its end anyway. Why not allow it to end quickly so that a generation with their entire lives ahead of them, and probably in the best position to 'clean it up' and learn from the mistakes of the past, can get to work?

    Ultimately, that is what we're talking about here. Because as this post sort of dances around, the debt deflation pressures have not ended, and cannot be 'solved' by reflation efforts. You simply trade one set of problems for another, namely a decline in real terms instead of nominal terms.

  12. Nice article Frances.

    Another factor stoking inflation is that wage increases over the last 12 months have been around 3.5% (I think). Given that productivity improvements at the moment are pathetic (for some strange reason), that means an inflation rate of about 3.5% BEFORE any other factors come into play.

    If I’m right there, then that’s a replay of the inflation spike in the 1970s. I.e. as I pointed out in a comment after one your recent posts, wage increases in the 1970s were way beyond what the country could afford. In contrast, wage demands between about five and one year ago were very subdued.

    In short, there is no rhyme or reason behind wage demands.

    1. The real driver of productivity growth is and always has been mechanisation of process. That generally but not exclusively, requires an increase in energy consumption be it by water wheel, wood, coal, oil, gas or nuclear. Some may recognise a small problem there ?

      We could of course work harder, longer and for less, however, we have tried that by off shoring manufacturing to low cost countries. That tempoary fix has only succeeded in wrecking our own manufacturing base and generated a large pool of unemployed.

      We could of course ourselves work harder, longer and for much less and return to the dark days of the satanic mills ?

      There are some tough and pressing choices over wealth distribution to be made in the near future if we are to avoid ... who knows what?

    2. Let's say I'm a psychotherapist. I've adopted a new methodology from recent research that allows me to fix my patients in half as many sessions as it took me with the old practices. And now you're telling me I need an extra nuclear power plant to do that? Hello?!

    3. " wage increases in the 1970s were way beyond what the country could afford"

      A country is not a business. "Affordability" is not relevant to the macro economy other than in resource terms. Money is not a resource.

      What happened in the 70s was caused by a range of factors. But one that has been written out of history is the capital strike. The bond markets pulled off a hoax over governments.

    4. @Ralph:

      A replay of the inflation spike in the 1970s? You should check out this interview which covers some of the points you're pointing towards in a bit more detail

      James Dines: Owning 'Wealth In The Ground' Is Your Best Bet to Survival

  13. People's ability to worry is finite, so at some point you get to a Peak Worry moment and then it reverses. We may be close if the US doesn't do something too stupid.

  14. The system will purge rotten policy makers, sooner or later. International finance cannot indefinitely deal with non functioning ideas. A global economy waits, a few stupid central bankers will not get in the way of all this potential profit.

  15. Maybe Thorium nuclear power will provide us with the cheap energy needed in the future. An ageing society, especially in many Western economies, and the debt overhang bear down on economic growth. The working day for all should only be 4 hours, to reflect huge advances in technology. Some of this extra leisure time has been enforced on some people anyway,
    and others are doing "non jobs" in the public sector to keep them off benefits. Debt is not the future, as there is just not enough growth to keep paying it back, unless a fabulous new energy source is found, and that is not the only constraint. We live in very interesting times, and for sure the next 40 years will be very different from the last, with less emphasis on buying consumer tat, and more time for leisure. House prices will fall substantially in real terms as well, because the ability of the banking system to create more debt is limited, and the ability of an ageing society to take on more of it is too. The real growth will come in places like India, China, Russia and Brazil, although they still have a long way to go before their average citizen is as well off as someone in the West.

  16. I loved reading this piece! Well written! :)

    rescue my pension


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