Debunking Keen on Bernanke: The issue of debt deflation

By Matt Nolan 12/09/2012

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.