Debt-deflation and austerity20 November, 2012 at 21:24 | Posted in Economics | 4 Comments
Some of my readers have asked me if there really is any difference between solving the liquidity trap by lowering real wages via inflation or by lowering nominal wages. Are they not equivalent measures?
No, they are not!
As John Maynard Keynes wrote in General Theory (1936):
The method of increasing the quantity of money in terms of wage-units by decreasing the wage-unit increases proportionately the burden of debt; whereas the method of producing the same result by increasing the quantity of money whilst leaving the wage-unit unchanged has the opposite effect. Having regard to the excessive burden of many types of debt, it can only be an inexperienced person who would prefer the former … If a sagging rate of interest has to be brought about by a sagging wage-level … there is … a double reason for putting off investment and thus postponing recovery.
Or as Irving Fisher – the originator of the debt-deflation theory – wrote in Debt-Deflation Theory of Great Depressions (Econometrica, 1933):
In summary, we find that: (1) economic changes include steady trends and unsteady occasional disturbances which act as starters for cyclical oscillations of innumerable kinds; (2) among the many occasional disturbances, are new opportunities to invest, especially because of new inventions; (3) these, with other causes, sometimes conspire to lead to a great volume of over-indebtedness; (4) this in turn, leads to attempts to liquidate; (5) these, in turn, lead (unless counteracted by reflation) to falling prices or a swelling dollar; (6) the dollar may swell faster than the number of dollars owed shrinks; (7) in that case, liquidation does not really liquidate but actually aggravates the debts, and the depression grows worse instead of better, as indicated by all nine factors; (8) the ways out are either laissez faire (bankruptcy) or scientific medication (reflation), and reflation might just as well have been applied in the first place.
Austerity policies will only bring our economies deep into the kind of debt-deflationary depressions that Fisher and Keynes warned us of in the 1930s.