By James H. Nolt
Recently I have blogged about the crisis-prone and debt-burdened global economy. Heavy debt makes many governments and bullish businesses allergic to deflation, i.e., falling prices. Deflation can cause devastating systemic crises when debts are excessive.
Many students of economics will recall, as I do, a point, usually in introductory macroeconomics classes, when the professor introduced whether average price levels matter. Usually it is told something like this: “If all prices and incomes were to double, so that money is worth half as much, does anything really change?” The expected answer is no, because neoclassical economics has developed largely by assuming that money is a neutral facilitator of exchange without any real impact if people are rational and markets are free. Certainly this was almost universally believed during the first half century of neoclassical economics, before John Maynard Keynes and Irving Fisher cast doubt on this proposition during the Great Depression. Yet their insights have largely disappeared from basic textbooks so that few today understand the real importance of money prices.
The value of money is crucial, not just for the rate at which it exchanges for real goods, but for the fact that most financial assets—specifically bonds and fixed-interest loans—are also specified in the money unit. Inflation causes the relative value of money to fall, but because most debts are specified as a fixed quantity of money owed, the falling value of money also means the falling value of debts. This is why creditors, including most banks, hate inflation. Debtors, on the other hand, benefit from inflation because they can pay back loans with money that is worth less than the money they originally borrowed. This is so important, it should be one of the first things taught in economics, yet even most economics PhDs do not think clearly about this, as I illustrated last week.
Conversely, deflation raises the value of money, and thus the value of debts priced in money. Debts become more valuable and debt burdens feel heavier. If a business is selling products at lower and lower prices, then its income is falling relative to the burden of its debt. If a company has been growing fast and loaded up on debt to fuel that fast growth—a typical bull—then deflation is devastating. Its income falls while its accumulated debt does not.
One reason economists tend to overlook the power of debt is that they model the economy in terms of flow variables like income and sales, rather than stock variables like wealth and debt. Flows are things that occur over time. GDP is a flow variable. Like all flow variables, to specify a value for it you must specify a time interval over which you are measuring the flow, usually one year. A stock variable like debt, however, is a total accumulated quantity measured at a point of time. Flow variables are like measuring the quantity of water flowing through the mouth of a river; stock variables are like measuring the total water volume of a lake. Today the total accumulated public and private debt of most countries is three to five times bigger than their annual GDP. Thus when changes in price levels revalue that debt, it can also have a huge impact.
During recent decades as part of the effort to reverse the influence of Keynes, neoclassical economists have emphasized that macroeconomics, the study of the economy as a whole, ought to have solid microfoundations—that is, it should be consistent with perfect market microeconomics. I argue the opposite. Microeconomic pricing and buying decisions of individuals are often greatly impacted by macroeconomic conditions. Even the “laws” of perfect market microeconomics may reverse.
A good example of this is when a heavily-indebted firm with excess capacity faces deflation. According to standard textbook price theory, when prices fall firms ought to cut output. Yet if prices fall, a firm has less revenue with which to pay its accumulated debt and may have a stronger reason to want to pay down its debt in order to avoid bankruptcy. Thus in order to gain revenue it must produce more, not less. If many firms in an industry act the same way, then all are trying to sell more, causing prices to continue to fall. Likewise, workers who have their wages cut may try to work more, perhaps working a second job, rather than default on a home mortgage or car loan. As they work more for less, all workers join the “race to the bottom;” some are working two jobs just to make ends meet while many others are unemployed. If deflation continues, many businesses and workers are forced into bankruptcy.
Even a firm going bankrupt might not stop the downward slide if the bank acquiring its productive equipment does not scrap it but sells it at a steep discount to another capitalist, who can then drive prices down even further because the low cost of acquiring those means of production allows him or her to out-compete existing producers. Thus until prices fall so low that means of production reach their scrap value, the free market may have no good answer to the vicious circle of debt deflation.
The two worst crises of global debt deflation occurred during the last decades of the 19th century and the Great Depression of the 1930s. The 19th century case was not so devastating to most governments, because the relative absence of world wars since 1815 meant that government debt levels were not so high, but there were important exceptions, including Argentina, Egypt, and the Ottoman Empire. The biggest business losses from the debt deflation of the 19th century were railroad and canal companies. They had accumulated debts to undertake their large-scale engineering projects. For example, when deflation and falling railroad freight rates made it debt service difficult, many of railroad and canal companies were bankrupted. The Great Depression of the 1930s had an even broader impact.
There are two solutions to debt deflation other than the free market solution of mass bankruptcy. During the 19th century the first major solution was tried: Creditor banks organized their bankrupted debtors into cartels or even merged them into giant monopolies. A cartel or monopoly uses its pricing power to restrict output and thereby raise price. Instead of desperate debtors producing at maximum capacity and driving prices ever downward, cartels raised and stabilized prices. It was during this period that huge, bank-organized monopolies, cartels, and conglomerates first dominated heavy industries and transportation. The analogous strategy for workers was forming strong industrial unions, which also reversed deflation by raising wages.
The impact of the Great Depression was even more widespread, affecting a great many businesses other than just large companies that could suppress competition easily with the help of their banks. Therefore governments stepped in to form universal cartels enforced by law. This occurred in the U.S. under the National Recovery Act (NRA) until the Supreme Court ruled this cartel system unconstitutional. By then recovery had started, but with the demise of the NRA, a second deep depression hit in 1937. It was not cured until wartime spending and price controls ended this second downturn. Nazi Germany also recovered rapidly under a system of government-sponsored cartels and price controls similar to the NRA. Some other countries used similar means to defeat deflation.
Next week I will discuss why the world economy is again facing the prospect of debt deflation and how this affects political economy today.
James H. Nolt is a senior fellow at World Policy Institute and an adjunct associate professor at New York University.
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