It's the Debt, Stupid. Steve Keen nails it.

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Farmer Brown's picture
Farmer Brown
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It's the Debt, Stupid. Steve Keen nails it.


Bernanke's blind spot

Steve Keen

Published 6:27 AM, 31 Aug 2010

Bernanke’s recent Jackson Hole speech didn’t contain one reference to the key force driving the American economy right now: private sector deleveraging (here’s the previous year’s speech for comparison’s sake). The reason the US economy is not recovering from this crisis is because all sectors of American society took on too much debt during the false boom of the last two decades, and they are now busily getting themselves out of debt any way they can.

Debt reduction is now the real story of the American economy, just as real story behind the apparent free lunch of the last two decades was rising debt. The secret that has completely eluded Bernanke is that aggregate demand is the sum of GDP plus the change in debt. So when debt is rising demand exceeds what it could be on the basis of earned incomes alone, and when debt is falling the opposite happens.

I’ve been banging the drum on this for years now, but it’s a hard idea to communicate because it’s so alien to the way most economists (and many people) think.

For a start, it involves a redefinition of aggregate demand. Most economists are conditioned to think of commodity markets and asset markets as two separate spheres, but my definition lumps them together: aggregate demand is the sum of expenditure on goods and services, plus the net amount of money spent buying assets (shares and property) on the secondary markets. This expenditure is financed by the sum of what we earn from productive activities (largely wages and profits) plus the change in our debt levels. So total demand in the economy is the sum of GDP plus the change in debt.

Below is a simple numerical example that makes this case easier to understand: imagine an economy with a nominal GDP of $1,000 billion which is growing at 10 per cent a year, due to an inflation rate of 5 per cent and a real growth rate of 5 per cent, and in which private debt is $1,250 billion and is growing at 20 per cent a year.

Aggregate private sector demand in this economy – expenditure on all markets, including asset markets – is therefore $1,250 billion: $1,000 billion from expenditure from income (GDP) and $250 billion from the change in debt. At the end of the year, private debt will be $1,500 billion. Expenditure is thus 20 per cent above the level that could be financed by income alone.

Now imagine that the following year, the rate of growth of GDP continues at 10 per cent, but the rate of growth of debt slows from 20 to 10 per cent. GDP will have grown to $1,100 billion, while the increase in private debt this year will be $150 billion –10 per cent of the initial $1,500 billion total and therefore $100 billion less than the $250 billion increase the year before.

Aggregate private sector demand in this economy will therefore be $1,250 billion, consisting of $1,100 billion from GDP and $150 billion from rising debt – exactly the same as the year before. But since inflation has been running at 5 per cent, aggregate demand will be 5 per cent lower than the year before in real terms. So simply stabilising the debt to GDP ratio results in a fall in demand in real terms, and some markets – commodities and/or assets – must take a hit.

Putting this example in a table, we get the following illustration:



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

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

Its key point can be grasped just by considering the GDP and the change in debt for the two years 2008 and 2010: in 2007-2008, GDP was $14.3 trillion while the change in private sector debt was $4 trillion, so aggregate private sector demand was $18.3 trillion. In calendar year 2009-10, GDP was $14.5 trillion, but the change in debt was minus $1.9 trillion, so that aggregate private sector demand was $12.6 trillion. The turnaround in two years in the change of debt has literally sucked almost $6 trillion out of the US economy.


Farmer Brown's picture
Farmer Brown
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Re: It's the Debt, Stupid. Steve Keen nails it.

While I know I risk crashing the servers over at by adding yet more to this incredibly popular thread, I would be remiss not to post this follow-up piece by Keen which he posted on his site yesterday.  

Besides refuting come silly criticisms of his first piece, he also applies his model of aggregate demand to US GDP and private debt numbers.  

His result?  US aggregate demand has shrunk 15% this year and shrank 12.3% in 2009.  Well now, that sure seems much more in line with reality than the BS put out by the government.  Here goes:—and-the-us-flow-of-funds/

GDP plus Change in Debt—and the US Flow of Funds

My recent post “What Bernanke doesn’t understand about deflation” has hit a chord, with a number of sites around the world reproducing it—including John Mauldin’sOutside the Box column. But it has raised a couple of queries in people’s minds too:

  1. Does my definition that “aggregate demand equals GDP plus the change in debt” involve double-counting?
  2. My figures for the USA are difficult to reconcile with the published US Flow of Funds data.

On the second point first, I produce an aggregate level of private sector debt in the USA from Table L1 of the Flow of Funds (on page 60 of the June 2010 PDF, and in ltab1d.prn in the data archive) by adding together debt data for the following sectors:

  • Household
  • Non-financial corporations
  • Nonfarm non-corporate
  • Farm
  • Financial Corporations

US Flow of Funds Table L1, row 1 (column 1 in the file ltabs1d.prn)





































This omits some of the debt included in the aggregate debt level in the same table—notably government debt and debt owed by the “rest of the world”. In the interests of making it easier to reconcile my table with the data in the Flow of Funds, here’s the same exercise applied simply to the very first row in Table L1 (and the first column in ltab1d), “Total credit market debt owed by:”

I also transform the data to monthly by interpolation, and the way my data is stored the figure I give for 2006 corresponds to the figure stored for the end of the quarter 200504 by the Fed. I’ve highlighted these numbers in the two tables here to make that more obvious.

Change in debt and aggregate demand

Variable\Year 2006 2007 2008 2009 2010
GDP 12,915,600 13,611,500 14,291,300 14,191,200 14,277,300
Change in Nominal GDP % 6.3% 5.4% 5.0% -0.7% 0.6%
Change in Real GDP % 2.7% 2.4% 2.3% -2.8% 0.2%
Inflation Rate % 4.0% 2.1% 4.3% 0.0% 2.6%
Total Debt 41,267,079 45,329,493 50,044,489 52,524,931 52,416,676
Debt Growth Rate % 9.2% 9.8% 10.4% 5.0% -0.2%
Change in Debt 3,468,111 4,062,414 4,714,996 2,480,442 -108,255
GDP + Change in Debt 16,383,711 17,673,914 19,006,296 16,671,642 14,169,045
Change in Aggregate Demand % 0.0% 7.9% 7.5% -12.3% -15.0%

On the first point, since I consider that aggregate demand is spent on both goods & services (which are counted in GDP) and the net sum expended purchasing existing assets (which is not counted in GDP), then there is no double counting. A standard textbook aggregate demand figure is the sum spent buying goods and services (for the expenditure definition), which omits of course the sum spent buying existing assets as well. That would be all well and good if we lived in a world without asset sale—which of course we don’t.
Another reason people see a potential error here is that they think that a loan simply represents the transfer of spending power from a saver to a borrower, so that overall there’s no change in spending power because of a loan: money is simply transferred from one group that will therefore spend less (creditors), to another that will therefore spend more (debtors). This is clearly the thinking that Bernanke applied when he, in common with most all neoclassical economists, dismissed Fisher’s “debt deflation” explanation for the Great Depression:

“Absent implausibly large differences in marginal spending propensities among the groups, it was suggested, pure redistributions should have no significant macroeconomic effects. ” (Bernanke 2000, p. 24)

This is not the case in the real world, for two reasons:

  1. Credit Money is created by banks “out of nothing” by the act of giving a borrower purchasing power (a loan of money) in return for recording a liability by that borrower to the bank (a bank debt). This creates new spending power “ab initio” without removing it from other agents. For the mechanics of this process, see my “Roving Cavaliers of Credit” blog entry (click here for the PDF).
  2. As Schumpeter argues cogently, the endogenous creation of money by the banking sector lending to entrepreneurs is an essential reason that capitalism can grow, and it creates spending power that does not originate in the existing “circular flow of commodities”:

    “From this it follows, therefore, that in real life total credit must be greater than it could be if there were only fully covered credit. The credit structure projects not only beyond the existing gold basis, but also beyond the existing commodity basis.”

    “[T]he entrepreneur needs credit … [T]his purchasing power does not flow towards him automatically, as to the producer in the circular flow, by the sale of what he produced in preceding periods. If he does not happen to possess it … he must borrow it… He can only become an entrepreneur by previously becoming a debtor… his becoming a debtor arises from the necessity of the case and is not something abnormal, an accidental event to be explained by particular circumstances. What he first wants is credit. Before he requires any goods whatever, he requires purchasing power. He is the typical debtor in capitalist society.” (Schumpeter 1934, pp. 101-102)

So there is no double-counting in “aggregate demand equals GDP plus the change in debt”: the rise in debt adds new demand to that generated by the sale of commodities alone (and is a good thing here because it finances a large part of investment); and the increase in debt is spent financing part of investment and consumption (an overlap that could give rise to double-counting) and also on purchases of existing assets (where no overlap is possible).

Bernanke, B. S. (2000). Essays on the Great Depression. Princeton, Princeton University Press.

Schumpeter, J. A. (1934). The theory of economic development : an inquiry into profits, capital, credit, interest and the business cycle. Cambridge, Massachusetts, Harvard University Press.

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Farmer Brown's picture
Farmer Brown
Status: Martenson Brigade Member (Offline)
Joined: Nov 23 2008
Posts: 1503
Re: It's the Debt, Stupid. Steve Keen nails it.

Have no idea why the formatting is all screwy.  My apologies.  Follow the address at the top and read it on his site for a cleaner rendition.  

Damn, with now yet another addition to this thread, the entire interwebnets will surely collapse! (said in my best GWB voice)

Tycer's picture
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Joined: Apr 26 2009
Posts: 617
Re: It's the Debt, Stupid. Steve Keen nails it.

Good stuff Farmer Brown. It takes a bit of re-reading to get it all digested.

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