Why Ben Bernanke Has Underestimated The Danger of Deflation

(MoneyWatch)  With so much blather out there about the Federal Reserve, it would be easy to miss the penetrating insights of Steve Keen. Don't. Instead remember his key point that deleveraging matters most for the American economy today.

Keen is a professor at the University of Western Sydney who seems to benefit from the great distance between himself and his subject. His recent blog post, "What Bernanke doesn't understand about deflation," is one of the most revealing things I've read about the Fed this year. His core point is here:

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.

The alien part involves redefining the way economists conceive of aggregate demand, the force that pushes prices up, or in our current state, very nearly downwards. Basically, Keen argues that it cannot simply be what people earn, but what they borrow as well. (Seems kinda obvious once you think about it, no?) That means that during the boom time, aggregate demand was amplified by credit (but inflation was contained). Now deleveraging -- the ugly term for shedding debt is a signature neologism of the financial/economic crisis -- exerts a shrinking dynamic on demand. So the pressure on prices declines. For economists, for whom nothing exists unless it is quantified, Keen crunches the numbers to show how deleveraging amplifies the downward pressure on prices.

The killer part of the post is Keen's citation of Ben Bernanke's own work to demonstrate that Bernanke "doesn't understand" the impact this has on prices. It does not take much to criticize a Fed chairman's decision. It takes a whole lotta chutzpah to say he "doesn't understand," but Keen makes a persuasive argument in reviewing Bernanke's comments on Irving Fisher's "The Debt Deflation Theory of Great Depressions," a seminal paper on the subject. In essence, Keen argues that Bernanke failed to rid himself of key assumptions of neo-classical economists that turned out to be wrong.

I found myself pretty depressed after reading this post. If Bernanke, a world-famous expert on the Great Depression, has to rethink his assumptions, then Fed action to reinvigorate the economy is far, far off. If it comes at all.

Related:

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• Hey, Ben Bernanke! Either Tell Us How We're Going to Grow, or Do Something - Now
• The Fed: Absent a Double-Dip Or Deflation, We'll Hang The Economy Out To Dry
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• Fed To Maintain Its Balance Sheet - But Not Because The Economy Is Slipping
• Fighting With Itself, The Fed Does Damage to Its Credibility As Economy Suffers
• Bernanke Gives Us the Evidence For Further Action, But No Clear Endorsement Of It
• Draw Ben Bernanke Out on the D-Word: Is Deflation Near