Debunking Keen on Bernanke: The issue of debt deflation

From Twitter, and email adverts, I’ve heard the Steve Keen is or was in town discussing economics.  That’s good, everyone should be discussing economics.

As you may have noted earlier both Anti-Dismal and myself have had issues with Keen’s analysis in the past – his criticism of microeconomics is just patently wrong.  However, I intend to give him a fair go in his main field of macroeconomics – and will find media of him discussing his work in New Zealand to discuss.

Before I do this though, I have another area where I have to disagree with him strongly – his unfair slandering of Ben Bernanke in these two “essential posts” on his website.

I ran into these posts when I randomly ran into the article on debt deflation on Wikipedia (an article that also unfairly attacks Bernanke – compared to this one).  I was there because I had heard people going on about how we are experiencing debt deflation – something I found strange given that we aren’t experiencing deflation, or the scale of real declines in asset prices, which really are the key feature of a debt deflation episode.

Keen twice quotes the following passage from page 17 of The Macroeconomics of the Great Depression:  A comparative approach (REPEC).

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.

This makes it sound that Bernanke, and the economics discipline as a whole, doesn’t see wholesale declines in asset prices as any sort of significant issue.  Anyone following what central banks have been implementing over the past decade will know this is patently false, but it is worse than that.  He is also quoting Bernanke viciously out of context.

The article actually makes the case for how important this issue is – and then estimates the impact of this type of episode during the Great Depression and finds that it is very very important.  If we go down the page we find:

However, the debt-deflation idea has recently experienced a revival, which has drawn its inspiration from the burgeoning literature on imperfect information and agency costs in capital markets …

From the agency perspective, a debt-deflation that unexpectedly redistributes wealth away from borrowers is not a macroeconomically neutral event: To the extent that potential borrowers have unique or lower-cost access to particular investment projects or spending opportunities, the loss of borrower net worth effectively cuts off these opportunities from the economy. Thus, for example, a financially distressed
firm may not be able to obtain working capital necessary to expand production, or to fund a project that would be viable under better financial conditions. Similarly, a household whose current nominal income has fallen relative to its debts may be barred from purchasing a new home, even though purchase is justified in a permanent-income sense. By inducing financial distress in borrower firms and households, debt-deflation can have real effects on the economy.

He also then goes on to discuss how it can hit financial stability by knocking out banks.  In the paper he discusses how debt deflation is a major issue, estimates a significant impact, and as an issue it is used to justify the lender of last resort function of a central bank – the very function that the ECB has refused to properly implement, helping to drive the current crisis.

Bernanke also places a link in a footnote to a paper he wrote, describing this very issue (NBR working paper here – and look at the major macroeconomists who helped edit it).

The only reason I can think of why Keen would so blatently misrepresent Bernanke is so that he comes off as smarter and more original than he actually is – that is a very harsh statement I nearly didn’t write, but I find what he’s done here verging on unforgivable … and as readers know, when someone does something like this I tend to get crabby.  If he is going to misquote and insult people, then I’m going to call it like it is. Update:  I’ve changed my mind – that comment by me was unnecessary, and inflamatory.  I should be saying why the misquoting is inappropriate instead of saying such things – my apologises.

Hell, the only reason I picked up on it so quickly was because I’ve recently reread these Bernanke essays when I purchased Essays on the Great Depression for my Kindle – if it wasn’t for that, I probably wouldn’t have even noticed.

But what about debt causing deflation!

This is the true claim to difference – mainstream economists do not say that debt causes deflation, however Keen believes this is the case and quotes Fisher as evidence.

Fisher wasn’t wrong – but he was discussing an economy under the gold standard … so it was an entirely different monetary regime that meant that in the face of this large non-monetary shock, the system created deflation.  Sure enough, we don’t have that sort of system now – and we haven’t seen the mass deflation that we did during the Great Depression.  The monetary regime now is a lot better, and outside of the ECB the lender of last resort function is widely accepted

Perhaps if he gave the writing of monetary policy experts like Bernanke a fairer reading, he may recognise this.

  • Mathieu Dufresne

    I don’t think you properly get what Keen is arguing. Keen didn’t imply Bernanke tought a fall in asset prices was macroeconomically irrelevant. The point is that Bernanke is building up a straw man of Fisher debt-deflation (or misunderstand) and I think you’re falling in the same trap. Fisher has been quite explicit that deleveraging wasn’t a transfert of spending power from a creditor to a borrower, it’s not a matter of redistribution and marginal spending. Bernanke also misrepresent Fisher’s theory by arguing it starts with a fall in assets price while it’s clear reading Fisher it starts with over indebtness. This distinction can seem unimportant but it matters since it completely changes the conclusion you gonna draw from it about the causes of the crisis (the federal reserve or endogenously generated by the markets).

    • The thing is, I don’t agree with this conception of what Bernanke said – after reading the essays using my mainstream economics glasses, and following conversations with better economists than myself about what Bernanke has done, I feel that he is being taken out of context.

      With that quote Bernanke is effectively saying “hey, if you saw an asset price change you might just say its a transfer and who cares – but guess what, it has an impact on financial stability, and a cyclical impact given the difference between lenders and borrowers”. Fischer describes a cycle – and in that context his “shock” IS a drop in sentiment which pushes down asset prices following a run up in debt. I was reading the paper just yesterday – what he is saying is true, but is also pinned to a different monetary policy regime now. His ideas have been used to justify lenders of last resort – an area where we actually need more policy debate than we have IMO.

      The reason Bernanke focuses on asset prices is because this is the “shock” that kicks off the cycle – yes high levels of debt, overvalued assets, and the interlinkages of the financial market are major devices to describe … but you start with the shock that kicks off the process which is the drop in asset prices.

      If we actually want to describe the system fully, we need a better understanding of expectations – rather than a focus on intermediates such as debt. We can then criticise the mainstream method on the basis of expectations, and with an understanding of “why” we can come up with policy to help – misquoting mainstream thought to attack a strawman doesn’t do this.

      • Mathieu Dufresne

        I still don’t see how you can argue he misquotes Bernanke. It’s a bit weird because as I understand Keen’s position, he’s saying that Bernanke misunderstand/reject Fisher because he thinks debt is only a transfert of spending power, therefore the level of debt doesn’t matter, only it’s distribution. You seem to be saying the exact same thing about Bernanke’s position… and this is precisely the reason why most economists failed to see the crisis coming.
        I think you should read this post from Keen where he explains his position in more details.
        http://www.debtdeflation.com/blogs/2012/07/03/european-disunion-and-endogenous-money/

        • “he’s saying that Bernanke misunderstand/reject Fisher because he thinks
          debt is only a transfert of spending power, therefore the level of debt
          doesn’t matter, only it’s distribution”

          In the Bernanke piece states that at first we may think its just a transfer – but because lender and borrowers are very different, a shock like this can in turn lead to a large number of potentially profitable investments not occuring – and with real debt levels climbing we are also likely to experience a run on banks. He then goes on to estimate the size of this effect.

          The higher the level of debt, the greater the constraint associated with this will be – this has been widely accepted, and has been a driver behind the view that:

          1) A central bank needs to be a lender of last resort,
          2) As part of the LOLR function, they need to incorporate other regulatory functions.

          The GFC occurred AFTER the Fed was seen to fail its LOLR function, the EDC occurred when it became clear the ECB was unwilling to fufil its LOLR function.

          We can’t just say “debt is bad” – we need to understand the market failure, and the underlying drivers that make the system unstable. The work of Fisher helps to do this for sure, and Bernanke’s discussion and description is not in any way against this.

          • I think the point here is that debt IS the underlying driver of the system. My colleague, Lowell Manning, has been working on an updated version of the Fisher equation for the last 5 years. he’s an engineer by trade so doesn’t come at it from the same position as Steve. It’s all interesting stuff and, as yet, not fully explored by mainstream monetary economists (although Michael Kumhof from the IMF is heading this way).

            http://sustento.org.nz/wp-content/uploads/2011/11/The-DNA-of-the-Debt-Based-Economy-4.pdf

            • I would be interested in looking at the work at some point, maybe in the weekend.

              Saying debt is the driver is still strange to me – and I think always will be. It is like saying productivity is the driver. I agree with the importance of cumulative processes – but they still need a fundamental shock to get them rolling!

          • Mathieu Dufresne

            Of course you can’t just say “debt is bad”, but unfortunately, it seems that’s the only thing some people are willing to understand.

            Since expectations are non-deterministics they are inherently unpredictable. There’s no way you can start with individual preferences, aggregate them up and predict the outcome. The best you can do is to hypothetize a unexplained shock of an arbitrarily chosen magnitude and then arbitrarily adjust the parameters (sticky prices, bounded rationnality) until it fits the datas. There’s no way it’s gonna help predicting anything, at best, you can use a good heuristic to anticipate a shock and get a weak predictive power out of it. However, the predictive power comes from the heuristic itself and not from the model. Using the heuristic alone will be at least just as good, if not better (which seems to be the opinion of a lot of people who succesfully invest on the markets).

            The elementary particles also have a non-deterministic behaviour but still, we can manage to predict the trajectory of a canon ball. How can we manage to build a predictive model of a system composed of non-deterministic components? The key is to work at a higher level of aggregation, where you can see deterministic properties emerging from the interaction of non-deterministic constituants and identify causal mechanisms. Still, complex dynamic systems are not “solvable” and the preditive power will necessarily diminish exponentionnaly over time. The predictive power of the model will depend on the quality of the empirical datas you’re working with, the extent at which you understand and capture the different causal mechanisms and the robustness of the model (there’s often a tradeoff between the later two).

            This takes us back to Keen and the debt issue. The dynamics of debt is the most important causal mechanisms required to understand the current crisis. The people who actually predicted or felt that a major crisis was incoming used a simple heuristic, they looked at the level of debt. Still, the vast majority of economists failed to see it coming because they didn’t understood the most important causal mechanism. In the link I gave above, Keen explains why. He as built a dynamic model (I mean truely dynamic) which in my opinion represent the best foundation of future macro-modelling. His analysis of the dynamics of debt is far from beiing simplistic and is strongly supported by the datas.

            In any case, if you want to criticize his views on macro, it wouldn’t harm to have an idea about the work he has done, since it’s probably totally different from what you might expect. I suggest watching his last seminar is a good start, I only saw the begining so far but Keen says : “This is probably the most detailed seminar I have given on my views on monetary macroeconomics.” It may require a bit of intellectual effort since he doesn’t only say debt is bad during 2 hours…

            http://www.debtdeflation.com/blogs/2012/09/12/new-zealand-seminar-schumpeter-minsky-endogenous-money/

            • “There’s no way it’s gonna help predicting anything, at best, you can use
              a good heuristic to anticipate a shock and get a weak predictive power
              out of it. However, the predictive power comes from the heuristic itself
              and not from the model”

              This is a similar set of logic to the large scale economic models – and while I think there is definite use in it, the limits when it comes to justifying policy need to be kept in mind.

              Bernanke is looking at structural determinants with that point in mind – which is misquotation why I found the point unfair.

              “Still, complex dynamic systems are not “solvable” and the preditive
              power will necessarily diminish exponentionnaly over time. The
              predictive power of the model will depend on the quality of the
              empirical datas you’re working with, the extent at which you understand
              and capture the different causal mechanisms and the robustness of the
              model”

              I do not disagree with this at all – but if we are looking at “policy” which inherently changes the nature of the system, we need a more reductionist explanation.

              “In any case, if you want to criticize his views on macro, it wouldn’t
              harm to have an idea about the work he has done, since it’s probably
              totally different from what you might expect”

              Given this post isn’t about attacking his macro – which I start by saying I intend to look at before I write about – I wouldn’t say we disagree here.

              This doesn’t stop the fact that he quoted Bernanke out of context to make a point that was unfair.

              And the importance of a structural interpretation when looking at policy is vitally essential – and arguments that demean this fact are little better than stating “debt is bad”. Yes, we can get a lot of useful description out without structure – but we shouldn’t kid ourselves about the nature of our knowledge.

              This is why I’m sympathetic about explanations that say economists think they knew more than they did – some did act that way. But the basic economic framework has actually provided a surprisingly useful and transparent way of understanding the crisis – and the work of people like Bernanke has helped to achieve that … the actual work rather than the out of context quotations.

  • Sorry for the late comment:

    First, even though we aren’t experiencing deflation, that doesn’t mean that some of the dynamics identified by Fisher aren’t occurring, or weren’t occurring before governments stepped in.

    Second, it is worth noting that the ‘redistribution between heterogeneous agents’ is still at odds with Keen’s approach, and he has recently argued against Krugman’s conceptually similar ‘patient versus impatient agents’ approach:

    http://www.debtdeflation.com/blogs/2011/03/04/%E2%80%9Clike-a-dog-walking-on-its-hind-legs%E2%80%9D-krugman%E2%80%99s-minsky-model/