Debt deflation
Encyclopedia
Debt deflation is a theory of economic cycles, which holds that recessions and depressions
are due to the overall level of debt shrinking (deflating): the credit cycle
is the cause of the economic cycle.
The theory was developed by Irving Fisher
following the Wall Street Crash of 1929
and the ensuing Great Depression
. Debt deflation was largely ignored in favor of the ideas of John Maynard Keynes
in Keynesian economics
, but has enjoyed a resurgence of interest since the 1980s, both in mainstream economics
and in the heterodox
school of Post-Keynesian economics
, and has subsequently been developed by such Post-Keynesian economists as Hyman Minsky
and Steve Keen
.
. In order to apply this to financial markets, which involve transactions across time in the form of debt – receiving money now in exchange for something in future – he made two further assumptions: The market must be cleared
—and cleared with respect to every interval of time. The debts must be paid.
In view of the Depression, he rejected equilibrium, and noted that in fact debts might not be paid, but instead defaulted on:
He further rejected the notion that over-confidence alone, rather than the resulting debt, was a significant factor in the Depression:
In the context of this quote and the development of his theory and the central role it places on debt, it is of note that Fisher was personally ruined due to his having assumed debt due to his over-confidence prior to the crash, by buying stocks on margin.
.
The Financial Instability Hypothesis of Hyman Minsky
, developed in the 1980s, complements Fisher's theory in providing an explanation of how credit bubbles form: FIH explains how bubbles form, while DD explains how they burst and the resulting economic effects. Mathematical models of debt deflation have recently been developed by Australia
n post-Keynesian economist Steve Keen
.
Debt deflation has been referred to alliteratively as the "D-process" by Ray Dalio
of Bridgewater Associates
, who suggests it as the template for understanding the financial crisis of 2007–2010.
The following decades saw occasional mention of deflationary spirals due to debt in the mainstream, notably in The Great Crash, 1929
of John Kenneth Galbraith
in 1954, and the credit cycle
has occasionally been cited as a leading cause of economic cycles in the post-WWII era, as in , but private debt remained absent from mainstream macroeconomic models.
James Tobin
cited Fisher as instrumental in his theory of economic instability.
The lack of influence of debt-deflation in academic economics is thus described by Ben Bernanke
in :
Bernanke's dismissal of debt deflation is criticized as improperly applying the theory of general equilibrium
– in equilibrium, marginal redistribution of income produces no macroeconomic effects, but financial crises are characterized by not being in equilibrium and markets failing to clear – debt ceasing to grow and instead falling, debtors defaulting, rising unemployment – and thus, it is argued, equilibrium analysis is inapplicable and misleading.
There was a renewal of interest in debt deflation in academia in the 1980s and 1990s, and a further renewal of interest in debt deflation due to the Financial crisis of 2007–2010 and the ensuing Late-2000s recession.
Bernanke's interpretation of debt deflation has been criticized by proponents of debt deflation, notably with his characterization of Fisher's work omitting the fundamental role of debt, leading to deflation, instead skipping debt altogether and starting with deflation:
monetary policy
and the fractional-reserve banking
system.
The first difference between these may be stated as debt-deflation being a demand-side theory, which emphasizes the period after the peak – the end of a credit bubble and contraction of debt causing a fall in aggregate demand
– while the Austrian theory is a supply-side theory, which emphasizes the period before the peak – the growth of debt during the growth phase causing malinvestment. The theories may thus be seen as complementary, addressing different aspects of the issue, and are so-considered by some economists.
In normative respects the theories are sharply different, with proponents of debt deflation generally arguing in the Keynesian, more precisely Post-Keynesian, tradition that government action can be beneficial, notably via debt forgiveness or engineering inflation (to reduce debt burden), or facilitating change in industries and investments, while Austrian economists generally argue that there is nothing to be done, the malinvestments needing to be "worked out of the system".
There have been other theories of economic crisis citing credit, discussed at the relevant section of Austrian business cycle theory.
– returning the price level to the level it was prior to deflation – followed by price stability, which would break the "vicious spiral" of debt deflation. In the absence of reflation, he predicted an end only after "needless and cruel bankruptcy, unemployment, and starvation", followed by "an new boom-depression sequence":
Later commentators do not in general believe that reflation is sufficient, and primarily propose two solutions: debt relief
– particularly via inflation
– and fiscal stimulus.
Following Hyman Minsky, some argue that the debts assumed at the height of the bubble simply cannot be repaid – that they are based on the assumption of rising asset prices, rather than stable asset prices: the so-called "Ponzi units". Such debts cannot be repaid in a stable price environment, much less a deflationary environment, and instead must either be defaulted on, forgiven, or restructured.
Widespread debt relief either requires government action or individual negotiations between every debtor and creditor, and is thus politically contentious or requires much labor. A categorical method of debt relief is inflation, which reduces the real debt burden, as debts are generally nominally denominated: if wages and prices double, but debts remain the same, the debt level drops in half. The effect of inflation is more pronounced the higher the debt to GDP ratio
is: at a 50% ratio, one year of 10% inflation reduces the ratio by approximately
to 45%, while at a 300% ratio, one year of 10% inflation reduces the ratio by approximately 
to 270%. In terms of foreign exchange
, particularly of sovereign debt, inflation corresponds to currency devaluation. Inflation results in a wealth transfer from creditors to debtors, since creditors are not repaid as much in real terms as was expected, and on this basis this solution is criticized and politically contentious.
In the Keynesian
tradition, some suggest that the fall in aggregate demand
caused by falling private debt can be compensated for, at least temporarily, by growth in public debt – "swap private debt for government debt", or more evocatively, a government credit bubble replacing the private credit bubble. Indeed, some argue that this is the mechanism by which Keynesian economics actually works in a depression – "fiscal stimulus" simply meaning growth in government debt, hence boosting aggregate demand. Note that to replace private debt growth, government debt must grow by the swing in private debt – if private debt moved from 15% annual growth to 5% annual savings, then to exactly compensate, government debt must grow by
more than it previously was. Given the level of government debt growth required, some proponents of debt deflation such as Steve Keen
are pessimistic about these Keynesian suggestions.
Given the perceived political difficulties in debt relief and inefficacy of alternative courses of action, proponents of debt deflation are either pessimistic about solutions, expecting extended, possibly decades-long depressions, or believe that private debt relief (and related public debt relief – de facto sovereign debt repudiation) will result from an extended period of inflation.
And here is the proof from the Fisher equation of exchange:
M = Money Supply (Measured in Dollars)
V = Velocity of Money (Measured in 1 / years)
P = Price Level (Measured in $ / item)
Q = Quantity of Transactions (Measured in items / year)
S = Savings (Measured in Dollars / year)
I = Income (Measured in Dollars / year)
INT = Nominal Annual Interest Rate
RINT = Real Interest Rate
IRATE = Inflation Rate
GDP = Nominal Gross Domestic Product (Measured in dollars / year)
RGDP = Real Gross Domestic Product (Measured in dollars / year)
D = Debt
NI = Noninterest Income (Dollars / year)
TR = Tax Rate
MV = PQ
PQ is normally replaced with nominal GDP. Nominal GDP is simply real GDP multiplied by 1 plus the inflation rate and so.
MV = RGDP * (1 + IRATE)
M under Friedman was considered money supply. But it doesn't take a genius to figure out that the federal reserve can "print" all the money it likes - if the credit that it extends does not make it into the private sector then you get no GDP. And so let us say that M (money supply) should be replaced with D (debt in dollars).
DV = RGDP * (1 + IRATE)
What is DV? At first glance DV should be equal to income. You need income to buy the goods represented by GDP. And so:
DV = I
But not all income is spent, some is saved and some pays taxes. Likewise not all purchases are made out of current income, some purchases are financed with debt. Because the units for GDP (likewise for M*V) are $ / year, we look at the change in debt dD / dt to represent new financing within that year. D represents all previous debt incurred in previous years for reasons that will become apparent.
DV = I * (1 - TR) - S + dD / dt
Income can be broken into two parts, interest income and non-interest income in this way
I = NI + INT * D
Then we will make the assumption that all interest income is taxable.
DV = NI * (1 - TR) + INT * D * (1 - TR) - S + dD / dt
In a closed economy (no foreign trade), the after tax non-interest income per year will equal the savings per year - or put another way savings will always equal investment. What this means is that all other forms of financial liabilities (cash on hand, equities, etc.) are represented in both savings (S) and noninterest income (NI).
S = NI * (1 - TR)
DV = INT * D * (1 - TR) + dD / dt
Solving the differential equation for D
D = exp(t)
dD / dt = exp(t)
exp(t) * V = INT*exp(t)*(1 - TR) + exp(t)
V = INT * (1 - TR) + 1 : Money velocity is equal to the interest rate times one minus the tax rate plus 1.
The interest rate has a real and inflation component, and so breaking up the interest rate into its components gives:
V = (RINT + IRATE) * (1 - TR) + 1
Back to the Fisher equation:
D * ((RINT + IRATE) * (1 - TR) + 1) = RGDP * (1 + IRATE)
RGDP = D * ((RINT + IRATE) * (1 - TR) + 1) / (1 + IRATE)
GDP = D * ((RINT + IRATE) * (1 - TR) + 1)
And so the conclusion is simple, if you want to raise real GDP, you raise the real interest rate on government debt (which the federal reserve controls) and / or you lower the tax rate. This works well enough until you run a huge trade imbalance (like with China) that suppresses real interest rates or if you have a great depression type scenario where the inflation rate is severely negative (massive deflation). In the massive deflation scenario real GDP may show growth while nominal GDP would show contraction.
The way to get around both scenarios is to sell forward year tax receipts. A forward year tax receipt lowers the after tax cost of credit in the private sector while not depriving the bondholder of income (Friedman's permanent income hypothesis). This is the problem with monetary policy as it stands now. In a true great depression massive deflation type scenario even tax cuts don't have any traction because if nominal interest rates are 0, lowering the tax rate would have no effect on either money velocity or GDP.
FO = Outstanding Supply of Forward Year Tax Receipts
FR = Forward Year Tax Receipt Rate of Appreciation
The next thing we express is how the level of debt is related to the level of FYTR's by some constant of multiplication called L
FO = L * D : This constant L is at the discretion of the federal government, how many FYTR's do they want to sell in relation to how much outstanding debt there is. Obviously there are limits to L based upon how much demand there is for them and how they are priced.
And so back to our finance equation:
DV = NI * (1 - TR) + INT * D * (1 - TR) + FR * L * D - S + dD / dt
Note: One thing to be aware of is that the realizable gains from forward year tax receipts can never exceed the total tax receipts in the same year or
FR * L * D < TR * NI
Again, in a closed economy (no foreign trade), the after tax non-interest income per year will equal the savings per year.
S = NI * (1 - TR)
DV = INT * D * (1 - TR) + FR * L * D + dD / dt
Solving the differential equation for D
D = exp(t)
dD / dt = exp(t)
exp(t) * V = INT*exp(t)*(1 - TR) + exp(t)
V + FR * L = INT * (1 - TR) + 1
V = INT * (1 - TR) + 1 + FR * L
Again, the interest rate has a real and inflation component, and so breaking up the interest rate into its components gives:
V = (RINT + IRATE) * (1 - TR) + 1 + FR * L
Back to the Fisher equation:
D * ((RINT + IRATE) * (1 - TR) + 1 + FR * L) = RGDP * (1 + IRATE)
RGDP = [D * (RINT + IRATE) * (1 - TR) + 1 + FR * FO] / [1 + IRATE]
GDP = [D * ((RINT + IRATE) * (1 - TR) + 1) + FR * FO] / [1 + IRATE]
The beauty here is that in a mass deflation scenario both nominal and real gross domestic product hold can be pushed higher by lowering the after tax cost of capital in the private sector. See equations above: even if the inflation rate was say -10%, the FR rate could be set by the federal government to be + 15% - presto real GDP growth, nominal GDP growth, presumably rising employment and deflation to boot.
Depression (economics)
In economics, a depression is a sustained, long-term downturn in economic activity in one or more economies. It is a more severe downturn than a recession, which is seen by some economists as part of the modern business cycle....
are due to the overall level of debt shrinking (deflating): the credit cycle
Credit cycle
The credit cycle is the expansion and contraction of access to credit over the course of the business cycle. Some economists, including Barry Eichengreen, Hyman Minsky, and other Post-Keynesian economists, and some members of the Austrian school, regard credit cycles as the fundamental process...
is the cause of the economic cycle.
The theory was developed by Irving Fisher
Irving Fisher
Irving Fisher was an American economist, inventor, and health campaigner, and one of the earliest American neoclassical economists, though his later work on debt deflation often regarded as belonging instead to the Post-Keynesian school.Fisher made important contributions to utility theory and...
following the Wall Street Crash of 1929
Wall Street Crash of 1929
The Wall Street Crash of 1929 , also known as the Great Crash, and the Stock Market Crash of 1929, was the most devastating stock market crash in the history of the United States, taking into consideration the full extent and duration of its fallout...
and the ensuing Great Depression
Great Depression
The Great Depression was a severe worldwide economic depression in the decade preceding World War II. The timing of the Great Depression varied across nations, but in most countries it started in about 1929 and lasted until the late 1930s or early 1940s...
. Debt deflation was largely ignored in favor of the ideas of John Maynard Keynes
John Maynard Keynes
John Maynard Keynes, Baron Keynes of Tilton, CB FBA , was a British economist whose ideas have profoundly affected the theory and practice of modern macroeconomics, as well as the economic policies of governments...
in Keynesian economics
Keynesian economics
Keynesian economics is a school of macroeconomic thought based on the ideas of 20th-century English economist John Maynard Keynes.Keynesian economics argues that private sector decisions sometimes lead to inefficient macroeconomic outcomes and, therefore, advocates active policy responses by the...
, but has enjoyed a resurgence of interest since the 1980s, both in mainstream economics
Mainstream economics
Mainstream economics is a loose term used to refer to widely-accepted economics as taught in prominent universities and in contrast to heterodox economics...
and in the heterodox
Heterodox economics
"Heterodox economics" refers to approaches or to schools of economic thought that are considered outside of "mainstream economics". Mainstream economists sometimes assert that it has little or no influence on the vast majority of academic economists in the English speaking world. "Mainstream...
school of Post-Keynesian economics
Post-Keynesian economics
Post Keynesian economics is a school of economic thought with its origins in The General Theory of John Maynard Keynes, although its subsequent development was influenced to a large degree by Michał Kalecki, Joan Robinson, Nicholas Kaldor and Paul Davidson...
, and has subsequently been developed by such Post-Keynesian economists as Hyman Minsky
Hyman Minsky
Hyman Philip Minsky was an American economist and professor of economics at Washington University in St. Louis. His research attempted to provide an understanding and explanation of the characteristics of financial crises...
and Steve Keen
Steve Keen
Steve Keen is a Professor in economics and finance at the University of Western Sydney. He classes himself as a post-Keynesian, criticizing both modern neoclassical economics and Marxian economics as inconsistent, unscientific and empirically unsupported...
.
Fisher's formulation
In Fisher's formulation of debt deflation, when the debt bubble bursts the following sequence of events occurs:Rejection of previous assumptions
Prior to his theory of debt deflation, Fisher had subscribed to the then-prevailing, and still mainstream, theory of general equilibriumGeneral equilibrium
General equilibrium theory is a branch of theoretical economics. It seeks to explain the behavior of supply, demand and prices in a whole economy with several or many interacting markets, by seeking to prove that a set of prices exists that will result in an overall equilibrium, hence general...
. In order to apply this to financial markets, which involve transactions across time in the form of debt – receiving money now in exchange for something in future – he made two further assumptions: The market must be cleared
Market clearing
In economics, market clearing refers to either# a simplifying assumption made by the new classical school that markets always go to where the quantity supplied equals the quantity demanded; or# the process of getting there via price adjustment....
—and cleared with respect to every interval of time. The debts must be paid.
In view of the Depression, he rejected equilibrium, and noted that in fact debts might not be paid, but instead defaulted on:
He further rejected the notion that over-confidence alone, rather than the resulting debt, was a significant factor in the Depression:
In the context of this quote and the development of his theory and the central role it places on debt, it is of note that Fisher was personally ruined due to his having assumed debt due to his over-confidence prior to the crash, by buying stocks on margin.
Subsequent developments
Debt deflation has been studied and developed largely in the Post-Keynesian schoolPost-Keynesian economics
Post Keynesian economics is a school of economic thought with its origins in The General Theory of John Maynard Keynes, although its subsequent development was influenced to a large degree by Michał Kalecki, Joan Robinson, Nicholas Kaldor and Paul Davidson...
.
The Financial Instability Hypothesis of Hyman Minsky
Hyman Minsky
Hyman Philip Minsky was an American economist and professor of economics at Washington University in St. Louis. His research attempted to provide an understanding and explanation of the characteristics of financial crises...
, developed in the 1980s, complements Fisher's theory in providing an explanation of how credit bubbles form: FIH explains how bubbles form, while DD explains how they burst and the resulting economic effects. Mathematical models of debt deflation have recently been developed by Australia
Australia
Australia , officially the Commonwealth of Australia, is a country in the Southern Hemisphere comprising the mainland of the Australian continent, the island of Tasmania, and numerous smaller islands in the Indian and Pacific Oceans. It is the world's sixth-largest country by total area...
n post-Keynesian economist Steve Keen
Steve Keen
Steve Keen is a Professor in economics and finance at the University of Western Sydney. He classes himself as a post-Keynesian, criticizing both modern neoclassical economics and Marxian economics as inconsistent, unscientific and empirically unsupported...
.
Debt deflation has been referred to alliteratively as the "D-process" by Ray Dalio
Ray Dalio
Ray Dalio is an American businessman and founder of Bridgewater Associates.-Early Life and Education:...
of Bridgewater Associates
Bridgewater Associates
Bridgewater Associates is an American investment management firm founded by Ray Dalio in 1975 and is reported to be the world's largest hedge fund company with $122 billion in assets under management. The company has 270 clients including pension funds, endowments, foundations, foreign governments...
, who suggests it as the template for understanding the financial crisis of 2007–2010.
Mainstream interest
Initially Fisher's work was largely ignored, in favor of the work of Keynes.The following decades saw occasional mention of deflationary spirals due to debt in the mainstream, notably in The Great Crash, 1929
The Great Crash, 1929
The Great Crash, 1929 is a book written by John Kenneth Galbraith and published in 1954; it is an economic history of the lead-up to the Wall Street Crash of 1929...
of John Kenneth Galbraith
John Kenneth Galbraith
John Kenneth "Ken" Galbraith , OC was a Canadian-American economist. He was a Keynesian and an institutionalist, a leading proponent of 20th-century American liberalism...
in 1954, and the credit cycle
Credit cycle
The credit cycle is the expansion and contraction of access to credit over the course of the business cycle. Some economists, including Barry Eichengreen, Hyman Minsky, and other Post-Keynesian economists, and some members of the Austrian school, regard credit cycles as the fundamental process...
has occasionally been cited as a leading cause of economic cycles in the post-WWII era, as in , but private debt remained absent from mainstream macroeconomic models.
James Tobin
James Tobin
James Tobin was an American economist who, in his lifetime, served on the Council of Economic Advisors and the Board of Governors of the Federal Reserve System, and taught at Harvard and Yale Universities. He developed the ideas of Keynesian economics, and advocated government intervention to...
cited Fisher as instrumental in his theory of economic instability.
The lack of influence of debt-deflation in academic economics is thus described by Ben Bernanke
Ben Bernanke
Ben Shalom Bernanke is an American economist, and the current Chairman of the Federal Reserve, the central bank of the United States. During his tenure as Chairman, Bernanke has overseen the response of the Federal Reserve to late-2000s financial crisis....
in :
- 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.
Bernanke's dismissal of debt deflation is criticized as improperly applying the theory of general equilibrium
General equilibrium
General equilibrium theory is a branch of theoretical economics. It seeks to explain the behavior of supply, demand and prices in a whole economy with several or many interacting markets, by seeking to prove that a set of prices exists that will result in an overall equilibrium, hence general...
– in equilibrium, marginal redistribution of income produces no macroeconomic effects, but financial crises are characterized by not being in equilibrium and markets failing to clear – debt ceasing to grow and instead falling, debtors defaulting, rising unemployment – and thus, it is argued, equilibrium analysis is inapplicable and misleading.
There was a renewal of interest in debt deflation in academia in the 1980s and 1990s, and a further renewal of interest in debt deflation due to the Financial crisis of 2007–2010 and the ensuing Late-2000s recession.
Bernanke's interpretation of debt deflation has been criticized by proponents of debt deflation, notably with his characterization of Fisher's work omitting the fundamental role of debt, leading to deflation, instead skipping debt altogether and starting with deflation:
- 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.
Similar theories
Debt deflation is not the only economic theory that cites credit bubbles as a key factor in economic crises; the most noted other theory is Austrian business cycle theory, which posits that economic crises are caused by excess credit growth and the malinvestment (misallocation of resources) that results, with these being caused by central bankCentral bank
A central bank, reserve bank, or monetary authority is a public institution that usually issues the currency, regulates the money supply, and controls the interest rates in a country. Central banks often also oversee the commercial banking system of their respective countries...
monetary policy
Monetary policy
Monetary policy is the process by which the monetary authority of a country controls the supply of money, often targeting a rate of interest for the purpose of promoting economic growth and stability. The official goals usually include relatively stable prices and low unemployment...
and the fractional-reserve banking
Fractional-reserve banking
Fractional-reserve banking is a form of banking where banks maintain reserves that are only a fraction of the customer's deposits. Funds deposited into a bank are mostly lent out, and a bank keeps only a fraction of the quantity of deposits as reserves...
system.
The first difference between these may be stated as debt-deflation being a demand-side theory, which emphasizes the period after the peak – the end of a credit bubble and contraction of debt causing a fall in aggregate demand
Aggregate demand
In macroeconomics, aggregate demand is the total demand for final goods and services in the economy at a given time and price level. It is the amount of goods and services in the economy that will be purchased at all possible price levels. This is the demand for the gross domestic product of a...
– while the Austrian theory is a supply-side theory, which emphasizes the period before the peak – the growth of debt during the growth phase causing malinvestment. The theories may thus be seen as complementary, addressing different aspects of the issue, and are so-considered by some economists.
In normative respects the theories are sharply different, with proponents of debt deflation generally arguing in the Keynesian, more precisely Post-Keynesian, tradition that government action can be beneficial, notably via debt forgiveness or engineering inflation (to reduce debt burden), or facilitating change in industries and investments, while Austrian economists generally argue that there is nothing to be done, the malinvestments needing to be "worked out of the system".
There have been other theories of economic crisis citing credit, discussed at the relevant section of Austrian business cycle theory.
Solutions
Fisher viewed the solution to debt deflation as reflationReflation
Reflation is the act of stimulating the economy by increasing the money supply or by reducing taxes, seeking to bring the economy back up to the long-term trend, following a dip in the business cycle...
– returning the price level to the level it was prior to deflation – followed by price stability, which would break the "vicious spiral" of debt deflation. In the absence of reflation, he predicted an end only after "needless and cruel bankruptcy, unemployment, and starvation", followed by "an new boom-depression sequence":
Later commentators do not in general believe that reflation is sufficient, and primarily propose two solutions: debt relief
Debt relief
Debt relief is the partial or total forgiveness of debt, or the slowing or stopping of debt growth, owed by individuals, corporations, or nations. From antiquity through the 19th century, it refers to domestic debts, in particular agricultural debts and freeing of debt slaves...
– particularly via inflation
Inflation
In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time.When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation also reflects an erosion in the purchasing power of money – a...
– and fiscal stimulus.
Following Hyman Minsky, some argue that the debts assumed at the height of the bubble simply cannot be repaid – that they are based on the assumption of rising asset prices, rather than stable asset prices: the so-called "Ponzi units". Such debts cannot be repaid in a stable price environment, much less a deflationary environment, and instead must either be defaulted on, forgiven, or restructured.
Widespread debt relief either requires government action or individual negotiations between every debtor and creditor, and is thus politically contentious or requires much labor. A categorical method of debt relief is inflation, which reduces the real debt burden, as debts are generally nominally denominated: if wages and prices double, but debts remain the same, the debt level drops in half. The effect of inflation is more pronounced the higher the debt to GDP ratio
Debt to GDP ratio
In economics, the debt-to-GDP ratio is one of the indicators of the health of an economy.It is the amount of national debt of a country as a percentage of its Gross Domestic Product ....
is: at a 50% ratio, one year of 10% inflation reduces the ratio by approximately
to 45%, while at a 300% ratio, one year of 10% inflation reduces the ratio by approximately to 270%. In terms of foreign exchangeExchange rate
In finance, an exchange rate between two currencies is the rate at which one currency will be exchanged for another. It is also regarded as the value of one country’s currency in terms of another currency...
, particularly of sovereign debt, inflation corresponds to currency devaluation. Inflation results in a wealth transfer from creditors to debtors, since creditors are not repaid as much in real terms as was expected, and on this basis this solution is criticized and politically contentious.
In the Keynesian
Keynesian economics
Keynesian economics is a school of macroeconomic thought based on the ideas of 20th-century English economist John Maynard Keynes.Keynesian economics argues that private sector decisions sometimes lead to inefficient macroeconomic outcomes and, therefore, advocates active policy responses by the...
tradition, some suggest that the fall in aggregate demand
Aggregate demand
In macroeconomics, aggregate demand is the total demand for final goods and services in the economy at a given time and price level. It is the amount of goods and services in the economy that will be purchased at all possible price levels. This is the demand for the gross domestic product of a...
caused by falling private debt can be compensated for, at least temporarily, by growth in public debt – "swap private debt for government debt", or more evocatively, a government credit bubble replacing the private credit bubble. Indeed, some argue that this is the mechanism by which Keynesian economics actually works in a depression – "fiscal stimulus" simply meaning growth in government debt, hence boosting aggregate demand. Note that to replace private debt growth, government debt must grow by the swing in private debt – if private debt moved from 15% annual growth to 5% annual savings, then to exactly compensate, government debt must grow by
more than it previously was. Given the level of government debt growth required, some proponents of debt deflation such as Steve KeenSteve Keen
Steve Keen is a Professor in economics and finance at the University of Western Sydney. He classes himself as a post-Keynesian, criticizing both modern neoclassical economics and Marxian economics as inconsistent, unscientific and empirically unsupported...
are pessimistic about these Keynesian suggestions.
Given the perceived political difficulties in debt relief and inefficacy of alternative courses of action, proponents of debt deflation are either pessimistic about solutions, expecting extended, possibly decades-long depressions, or believe that private debt relief (and related public debt relief – de facto sovereign debt repudiation) will result from an extended period of inflation.
Forward Year Tax Receipts
Recognizing that the federal government issues liabilites (debt) in its own currency and thus can never go bankrupt, another solution is for the federal government to become more like the corporate capital markets with debt issuance at high real interest rates and equity like issuance at even higher real rates of appreciation. The likely candidate for equity like issuance by the federal government is forward year tax receipts. A forward year tax receipt is a receipt for taxes paid in advance that are due some time in the future. Like government debt issuance, forward year tax receipts have a rate of appreciation and a duration. Unlike, government debt, the rate of return is not guaranteed. The realized rate of return is totally dependent on the owner's future income and subsequent tax liability. And so savers are rewarded with a positive real rate of return and debtors can realize an after tax cost of credit that is significantly less. For instance if the federal government sells 30 year debt with a 3% real rate of return and sells forward year tax receipts with a potential 7% real rate of return, then a debtor can realize a -4% cost of credit. At that point inflation is not required nor should it be desired.And here is the proof from the Fisher equation of exchange:
M = Money Supply (Measured in Dollars)
V = Velocity of Money (Measured in 1 / years)
P = Price Level (Measured in $ / item)
Q = Quantity of Transactions (Measured in items / year)
S = Savings (Measured in Dollars / year)
I = Income (Measured in Dollars / year)
INT = Nominal Annual Interest Rate
RINT = Real Interest Rate
IRATE = Inflation Rate
GDP = Nominal Gross Domestic Product (Measured in dollars / year)
RGDP = Real Gross Domestic Product (Measured in dollars / year)
D = Debt
NI = Noninterest Income (Dollars / year)
TR = Tax Rate
MV = PQ
PQ is normally replaced with nominal GDP. Nominal GDP is simply real GDP multiplied by 1 plus the inflation rate and so.
MV = RGDP * (1 + IRATE)
M under Friedman was considered money supply. But it doesn't take a genius to figure out that the federal reserve can "print" all the money it likes - if the credit that it extends does not make it into the private sector then you get no GDP. And so let us say that M (money supply) should be replaced with D (debt in dollars).
DV = RGDP * (1 + IRATE)
What is DV? At first glance DV should be equal to income. You need income to buy the goods represented by GDP. And so:
DV = I
But not all income is spent, some is saved and some pays taxes. Likewise not all purchases are made out of current income, some purchases are financed with debt. Because the units for GDP (likewise for M*V) are $ / year, we look at the change in debt dD / dt to represent new financing within that year. D represents all previous debt incurred in previous years for reasons that will become apparent.
DV = I * (1 - TR) - S + dD / dt
Income can be broken into two parts, interest income and non-interest income in this way
I = NI + INT * D
Then we will make the assumption that all interest income is taxable.
DV = NI * (1 - TR) + INT * D * (1 - TR) - S + dD / dt
In a closed economy (no foreign trade), the after tax non-interest income per year will equal the savings per year - or put another way savings will always equal investment. What this means is that all other forms of financial liabilities (cash on hand, equities, etc.) are represented in both savings (S) and noninterest income (NI).
S = NI * (1 - TR)
DV = INT * D * (1 - TR) + dD / dt
Solving the differential equation for D
D = exp(t)
dD / dt = exp(t)
exp(t) * V = INT*exp(t)*(1 - TR) + exp(t)
V = INT * (1 - TR) + 1 : Money velocity is equal to the interest rate times one minus the tax rate plus 1.
The interest rate has a real and inflation component, and so breaking up the interest rate into its components gives:
V = (RINT + IRATE) * (1 - TR) + 1
Back to the Fisher equation:
D * ((RINT + IRATE) * (1 - TR) + 1) = RGDP * (1 + IRATE)
RGDP = D * ((RINT + IRATE) * (1 - TR) + 1) / (1 + IRATE)
GDP = D * ((RINT + IRATE) * (1 - TR) + 1)
And so the conclusion is simple, if you want to raise real GDP, you raise the real interest rate on government debt (which the federal reserve controls) and / or you lower the tax rate. This works well enough until you run a huge trade imbalance (like with China) that suppresses real interest rates or if you have a great depression type scenario where the inflation rate is severely negative (massive deflation). In the massive deflation scenario real GDP may show growth while nominal GDP would show contraction.
The way to get around both scenarios is to sell forward year tax receipts. A forward year tax receipt lowers the after tax cost of credit in the private sector while not depriving the bondholder of income (Friedman's permanent income hypothesis). This is the problem with monetary policy as it stands now. In a true great depression massive deflation type scenario even tax cuts don't have any traction because if nominal interest rates are 0, lowering the tax rate would have no effect on either money velocity or GDP.
FO = Outstanding Supply of Forward Year Tax Receipts
FR = Forward Year Tax Receipt Rate of Appreciation
The next thing we express is how the level of debt is related to the level of FYTR's by some constant of multiplication called L
FO = L * D : This constant L is at the discretion of the federal government, how many FYTR's do they want to sell in relation to how much outstanding debt there is. Obviously there are limits to L based upon how much demand there is for them and how they are priced.
And so back to our finance equation:
DV = NI * (1 - TR) + INT * D * (1 - TR) + FR * L * D - S + dD / dt
Note: One thing to be aware of is that the realizable gains from forward year tax receipts can never exceed the total tax receipts in the same year or
FR * L * D < TR * NI
Again, in a closed economy (no foreign trade), the after tax non-interest income per year will equal the savings per year.
S = NI * (1 - TR)
DV = INT * D * (1 - TR) + FR * L * D + dD / dt
Solving the differential equation for D
D = exp(t)
dD / dt = exp(t)
exp(t) * V = INT*exp(t)*(1 - TR) + exp(t)
V + FR * L = INT * (1 - TR) + 1
V = INT * (1 - TR) + 1 + FR * L
Again, the interest rate has a real and inflation component, and so breaking up the interest rate into its components gives:
V = (RINT + IRATE) * (1 - TR) + 1 + FR * L
Back to the Fisher equation:
D * ((RINT + IRATE) * (1 - TR) + 1 + FR * L) = RGDP * (1 + IRATE)
RGDP = [D * (RINT + IRATE) * (1 - TR) + 1 + FR * FO] / [1 + IRATE]
GDP = [D * ((RINT + IRATE) * (1 - TR) + 1) + FR * FO] / [1 + IRATE]
The beauty here is that in a mass deflation scenario both nominal and real gross domestic product hold can be pushed higher by lowering the after tax cost of capital in the private sector. See equations above: even if the inflation rate was say -10%, the FR rate could be set by the federal government to be + 15% - presto real GDP growth, nominal GDP growth, presumably rising employment and deflation to boot.
See also
- Causes of the Great Depression: Debt deflation