"Keynes' savings paradox, Fisher's debt deflation and the banking crisis
The world economy is experiencing a downward spiral in output and international trade that has not been seen since the Great Depression of the 1930s. The most striking feature of this downward spiral is the breathtaking speed at which industrial production, world trade and GDP is declining in the world since the end of 2008.
How can such a rapid deceleration of economic activity be explained? The answer has to do with different deflationary spirals that feed on themselves and amplify each other.
Four deflationary spirals
There are four deflationary spirals presently at work in the world economy, i.e. the Keynesian savings paradox, Fisher’s debt deflation, the cost cutting deflation, and the bank credit deflation. Each of these deflationary spirals can be dealt with when they occur in isolation. They become lethal when they interact with each other.
Keynesian savings paradox.
When one individual desires to save more, and he is alone to do so, his decision to save more (consume less) will not affect aggregate output. He will succeed to save more, and once he has achieved his desired level of savings he stops trying to save more.
When the desire to save more is the result of a collective lack of confidence (animal spirits) the individual tries to build up savings when all the others do the same. As a result, output and income decline and the individual fails in his attempt to increase savings. He will try again, thereby intensifying the decline in output, and failing again to build-up savings. There is thus a coordination failure: if the individuals could be convinced that their attempts to build up savings will not work when they all try to do it at the same time, they would stop trying, thereby stopping the downward spiral.
Somebody must organize the collective action. An individual agent will not do this because the cost of collective action exceeds his private gain.
Fisher’s debt deflation:
When one individual tries to reduce his debt, and he is alone to do so, this attempt will generally succeed. The reason is that his sales of assets to reduce his debt will not be felt by the others, and therefore will not affect the solvency of others. The individual will succeed in reducing his debt.
When the desire to reduce debt is driven by a collective movement of distrust, the simultaneous action of individuals to reduce their debt is self-defeating (Fisher(1933)). They all sell assets at the same time, thereby reducing the value of these assets. This leads to a deterioration of the solvency of everybody else, thereby forcing everybody to increase their attempts at reducing their debt by selling assets.
Here also there is a coordination failure. If individuals could be convinced that their attempts to reduce their debt will no work when they all try to do this at the same time, they would stop trying and the deflationary cycle would also stop. An individual, however, will have no incentive to organize such a collective action.
Cost cutting deflation
When one individual firm reduces its costs by reducing wages and firing workers in order to improve its profits, and this firm is alone to do so, it will generally succeed in improving its profits. The reason is that the cost cutting by an individual firm does not affect the other firms. The latter will not react by reducing their wages and firing their workers.
When cost cutting is inspired by a collective movement of fear about future profitability the simultaneous cost cutting will not restore profitability. The reason is that the workers who earn lower wages and the unemployed workers who have less (or no) disposable income will reduce their consumption and thus the output of all firms. This reduces profits of all firms. They will then continue to cut costs leading to further reductions of output and profits.
There is again a coordination failure. If firms could be convinced that the collective cost cutting will not improve profits they would stop cutting their costs. But individual firms have no incentives to do this.
Bank credit deflation:
When one individual bank wants to reduce the riskiness of its loan portfolio it will cut back on loans and accumulate liquid assets. When the bank is alone to do so (and provided it is not too big), it will succeed in reducing the riskiness of its loan portfolio. The reason is that the strategy of the bank will not be felt by the other banks, which will not react. Once the bank has succeeded in reducing the riskiness of its loan portfolio it will stop calling back loans.
When banks are gripped by pessimism and extreme risk aversion the simultaneous reduction of bank loans by all banks will not reduce the risk of the banks’ loan portfolio. There are two reasons for this. First, banks lend to each other. As a result when banks reduce their lending they reduce the funding of other banks. The latter will be induced to reduce their lending, and thus the funding of other banks. Second, when one bank cuts back its loans, firms get into trouble. Some of these firms buy goods and services from other firms. As a result, these other firms also get into trouble and fail to repay their debt to other banks. The latter will see that their loan portfolio has become riskier. They will in turn reduce credit thereby increasing the riskiness of the loan portfolio of other banks.
There is again a coordination failure. If banks could be convinced that the simultaneous loan cutting does not reduce the risk of their loan portfolio they would stop cutting back on their loans and the negative spiral would stop. They have no individual incentives, however, to engage in collective action.
The four deflationary spirals that we described have the same structure. The actions by economic agents create a negative externality that makes these actions self-defeating. This spiral is triggered by a collective movement of fear, distrust or risk aversion (animal spirits; see Akerlof and Shiller(2009) for a fascinating analysis). Individuals (savers, firms, banks) are unable to internalize these externalities because collective action is costly. There is thus a failure to coordinate individual actions to avoid a bad outcome.
Cyclical movements in optimism and pessimism (animal spirits) have always existed. Why do these now lead to such a breakdown of coordination?
The four deflationary spirals we identified, although similar in structure, are different in one particular dimension. The savings paradox and the cost deflation can be called “flow deflations”. They arise because consumers and firms want to change a flow (savings and profits). The other two involve the adjustment of stocks (the debt levels and the levels of credit). We call them “stock deflations”. Problems arise when the flow and stock deflations interact with each other.
In “normal” recessions such as the ones we have experienced in the postwar period prior to the present crisis, only the flow deflations were in operation. There had not been a preceding period of excessive debt accumulation and unsustainable levels of bank loans. As a result, households, firms and banks were not trying to adjust their balance sheets. The pessimism of households and firms was related to expected shortfalls in income and profits, and led to increased savings and cost cutting. In such an environment in which the stock levels were perceived to be right, there were sufficient automatic equilibrating mechanisms that prevented these two flow deflations from leading to an unstoppable downward spiral. The most important equilibrating mechanism occurred through the banking system.
When banks function normally they have a stabilizing force on the business cycle. The reason is that in a recession the central bank typically reduces the interest rate making it easier for banks to lend. In normal circumstances, when banks are not in the process of cleaning up their balance sheets, they will be willing to transmit this interest rate decline into a reduction of the loan rate. As a result, banks will engage in automatic “distress lending” to firms and households. Households will be less tempted to increase their savings. In addition, private investment by firms will be stimulated, i.e. firms will be willing to dissave, thereby mitigating the deflationary potential provoked by the savings paradox. (In De Grauwe(2009) I show this in the context of a simple IS-LM analysis).
The interest rate decline will also mitigate the cost cutting dynamics. This is so because it improves the profit outlook for firms, giving them lower incentives to go on cutting costs. Thus when the banking system functions normally, there are self-equilibrating mechanisms that prevent the flow deflations from degenerating into uncontrollable downward spirals.
The problem the world economy faces today is that flow and stock deflations interact and reinforce each other. The period prior to the crisis was one of excessive buildups of private debt and banks’ assets. The result of these excessive buildups of private debt and balance sheets is that the stock deflation processes described in the previous section operate with full force. As a result, the equilibrating mechanism that exists in normal recessions does not function. The lower interest rates engineered by central banks are not transmitted by the banking sector into lower loan rates for consumers and firms. In addition, we now are confronted by the interaction of the flow and stock deflations. This interaction amplifies these deflationary processes. This interaction, which is especially strong in the US, can be described as follows. Because of excessive debt accumulation of the past, households desire to reduce their debt levels. Thus they all attempt to save more. As argued earlier, these attempts are self-defeating. As a result, households fail to save more, and thus fail to reduce their debt. This leads them to increase their attempts to save more. The fact that the banks do not pass on the lower deposit rates into lower loan rates makes things worse. There are no incentives for firms to increase their investments (no dissaving). Nothing stops the deflationary spiral.
The interaction goes further. The deteriorating conditions in the “real economy” feed back on the banking system. Banks’ loan portfolios deteriorate further as a result of increasing default rates. Banks reduce their lending even further, etc. In De Grauwe(2009) it is shown that a banking sector that is in the grips of credit deflation and deleveraging can destabilize the economy and can push the economy into a true deflationary spiral.
The irrelevance of modern macroeconomics
Modern macroeconomics as embodied in Dynamic Stochastic General Equilibrium models (DSGE) is based on the paradigm of the utility maximizing individual agent who understands the full complexity of the world. Since all individuals understand the same “Truth”, modern macroeconomics has taken the view that it suffices to model one “representative individual” to fully represent reality. Thus as a consumer the agent continuously maximizes an intertemporal utility function and is capable of computing the implications of exogenous shocks on his optimal consumption plan, taking full account of what these shocks will do to the plans of the producers. Similarly, producers compute the implications of these shocks on their present and future production plans taking into account how consumers react to these shocks. Thus in such a model coordination failures cannot arise. The representative agent fully internalizes the external effects of all his actions. When shocks occur there can be only one equilibrium to which the system will converge, and agents perfectly understand this (Woodford(2009)).
Deflationary spirals as we have described them in the previous sections cannot occur in the world of the DSGE-models. The latter is a world of stable equilibria. It will not come as a surprise that DSGE-models have not produced useful insight allowing us to understand the nature of the present economic crisis. Yet vast amounts of intellectual energies are still being spent on the further refining of DSGE-models.
Collective action to stop the deflationary spirals
The common characteristic of the different deflationary spirals is a coordination failure. The market fails to coordinate private actions towards an attractive collective outcome. This market failure can in principle be solved by collective action. Such a collective action can only be organized by the government. Let us analyze what this collective action must be to deal with the different forms of deflation.
The key to economic recovery is the stabilization of the banking sector. As argued earlier, a banking sector that is in the grips of credit deflation and deleveraging can destabilize the economy and can push the economy into a true deflationary spiral.
There is no secret about how the bank credit deflation can be stopped. Here are the principles (see Hall and Woodward(2009) for a more detailed analysis). First, bad loans should be separated from good loans, putting the former in separate entities (“bad banks”) to be managed by specialized management teams whose responsibility it is to dispose of these assets. Losses on these bad assets are inevitable, and so is the inevitability that the taxpayer will be asked to foot the bill.
The good loans remain on the balance sheet of the “good bank”. The hope is that this good bank, freed as it is from the toxic assets, will feel liberated and will be willing to take more risk so that the credit flow can start again. One can doubt, however, that a privately run good bank will have sufficient incentives to start lending again. The reason is that extreme risk aversion and a desire to “save the skin” of the shareholders will restrain the managers of the good bank in extending loans. If that is what the managers of the good bank do, the bank credit deflation process described earlier will not stop. This leads to the issue of whether it is not desirable to (temporarily) nationalize the good bank. Such nationalization would take away the paralyzing fear that new bank loans put the bank’s capital (and its shareholders) at risk.
There is a second reason why the government may want to temporarily nationalize the good bank. The bad bank – good bank solution carries the risk of socializing the losses while privatizing the profits. Indeed, the losses of the bad bank will necessarily be borne by the taxpayers. If the good bank remains in private ownership the expected future profits will be handed out to the shareholders. But these profits will be realized only because the toxic assets have been separated and the losses on these assets have been borne by taxpayers. It is therefore more reasonable to make sure that these future profits are given back to the taxpayers.
The resolution of the bank crisis along the lines discussed in the previous paragraphs is a necessary condition for the recovery. It will also make the use of other macroeconomic policies easier and more effective. These other macroeconomic policies must be geared towards resolving the other deflationary processes. Let us discuss these consecutively.
The Keynesian savings paradox
The collective action failure implicit in the Keynesian savings paradox calls for the government to do the opposite of what private agents do, i.e. to dissave. Dissaving by the government is a necessary condition for making it possible for private consumers to succeed in their attempts to save more.
A well-functioning banking sector reduces the need for dissaving by the government. When the banking sector works well, the consumers’ attempts to save more leads to a lower interest rate and induces firms to invest more (they dissave). As a result, the required dissaving by the government is reduced correspondingly.
Fisher’s debt deflation
Government action is required to solve the coordination failure implicit in the debt deflation process. This can be done by taking over private debt and substituting it with government debt. In doing so, the government makes it possible for the private sector to reduce its debt level. The private sector will then stop attempting (unsuccessfully) to reduce its debt level. The debt deflation process can stop.
The issue that arises here is whether the substitution of private by government debt will not lead to unsustainable government debt levels. There are two aspects to this issue. Let us first look at the debt levels of the public and private sectors in the eurozone. These are shown in figure 1. The most remarkable feature of this figure is how low the government debt is relative to private debt. In addition, the government debt is the only one that has declined (as a percent of GDP) during the last 10 years. This contrasts with the debt of households and especially the debt of financial institutions that has increased significantly and that stood at 250% of GDP in 2008. This is three times higher than the debt of the government which stood at approximately 70%. We conclude that more than the public debt, the private sector’s debt has become unsustainable. The process of substitution of private debt by public debt can go on for quite some time before it reaches the levels of unsustainability of the private debt.
Figure 1
Source: European Commission
The second dimension to the sustainability issue of government debt arises from the question of what will happen in the absence of a government takeover of the private debt. The answer is that in that case the debt deflation process is not likely to stop soon. As a result, output and income are likely to go down further. This will negatively affect tax revenues and will increase future budget deficits, forcing governments to increase their debt. Refusing to stop the debt deflation dynamics by issuing government debt today will not prevent the government debt from increasing in the future. The same problem of sustainability of the government debt will reappear.
To conclude it is useful to formulate a methodological note. The effectiveness of fiscal policies has been very much analyzed by economists. It appears from the empirical evidence that fiscal policy is limited in its effect to boost the economy. This evidence, however, is typically obtained from equilibrium models estimated during “normal” business cycle movements (see e.g; Wieland(2009), Cogan, et al. (2009)). In the context of the flow and stock deflations that are disequilibrium phenomena and that at the core of the present economic downturn, fiscal policy becomes an instrument to stabilize an economy that otherwise can become unstable. This feature is absent from modern macroeconomic models that are intrinsically stable. The evidence obtained from these models may not be very relevant to gauge the effectiveness of fiscal policies in the present context.
Paul de Grauwe is professor of economics, Catholic University of Leuven.
References
Akerlof, G., and Shiller, R., (2009), Animal Spirits: How Human Psychology Drives the Economy and Why It Matters for Global Capitalism, Princeton University Press, 264pp.
Cogan, J, Tobias, C, Taylor, J, and Wieland, V., (2009), “New Keynesian versus Old Keynesian Government Spending Multipliers”, CEPR Discussion Paper 7236, March 2009.
De Grauwe, P. (2009), Keynes’ Savings Paradox, Fisher’s Debt Deflation and the Banking Crisis, http://www.econ.kuleuven.be/ew/academic/intecon/Degrauwe/PDG-papers/Work_in_progress_Presentations/Flow-Stock%20Deflations.pdf
Fisher, I, (1933), The Debt-Deflation Theory of Great Depressions, Econometrica, 1, October, pp. 337-57.
Hall, R., and Woodward, S., (2009), The right way to create a good bank and a bad bank, www.voxeu.org/index.php
Minsky, H., (1986), Stabilizing an Unstable Economy, McGraw Hill, 395pp.
Wieland, V., (2009), The fiscal stimulus debate: “Bone-headed” and “Neanderthal”? http://www.voxeu.org/index.php?q=node/3373
Woodford, Michael (2009), “Convergence in Macroeconomics: Elements of the New Synthesis”, American Economic Journal: Macroeconomics, Vol. 1, No. 1, 267-279"
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