Part II Deflation
8.1 THE CURE FOR DEBT DEFLATION
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56 The Liquidity Theory of Asset Prices
Meanwhile, monetary growth has progressively collapsed – that is, monetary growth at first slowed, then declined sharply, and finally turned negative. Economic activity and equity prices fall with it. The whole of the process is called debt deflation. The various stages of intensity should be noted. In the early 1930s, the US reached stage 10, whereas the UK only reached stage 6 in the early 1990s. In 2003 Japan went beyond stage 7.
Recapitulating, excessive monetary growth leads to asset-price infla- tion. Persistent asset-price inflation leads to a financial bubble in asset prices. The bubble bursts. Markets fall. The result becomes asymmet- rical when the value of collateral in general falls below the loans being secured. Various degrees of debt deflation follow.
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Debt Deflation 57
r
buy back bonds that it has issued previously;r
extend the range of bonds that it buys, to include, for example, cor- porate bonds;r
extend the type of security, to include, for example, common stocks.It should be stressed that it is wholly within a government’s power to stop the growth of broad money from undershooting.
Increasing printing-press money to offset a decline in fountain-pen money allows people to sell assets to repay a bank loan, without the money supply falling. It slows the downward spiral at its origin. People do not have to either sell assets or reduce their expenditure on goods and services because they are unhappy about the amount of money in their bank account. Further, it helps directly to underpin asset prices and mutes the whole mechanism of debt deflation.2
8.1.2 Fiscal Policy
Easing fiscal policy is another way of increasing government borrow- ing from banks and, therefore, boosting the money supply. This can be done by either cutting taxes or increasing public expenditure. This is the Keynesian remedy for debt deflation. There are two disadvantages. First, the result can be an increase in the national debt to an unsustainable level and, in extreme cases, national debt compounding out of control. The alternative of the government purchasing assets does not suffer from this disadvantage, because the increase in the national debt is backed by holdings of assets. Indeed, there is a good chance that purchases of equities will turn out to be profitable in due course, as capital profits are enjoyed when the stock market rebounds. The final result of the appro- priate debt-management policy may thus be a fall in the national debt.
Second, fiscal policy cannot be eased as quickly as can debt manage- ment. There is a time lag between a decision to ease fiscal policy and the full effect on the amount that the public sector needs to borrow, and from there to the economy.
Unfortunately, many governments, including those of the US, the UK and Japan, appear either to be unaware of, or to disagree with, the cure for debt deflation prescribed by Irving Fisher (see the appendix in this chap- ter). Hopefully, the situation will change, but the uncomfortable conclu- sion at the time of writing is that the pain will probably be prolonged, and
2It also helps banks to replenish capital as they enjoy profits in the bond market, for elaboration, see Pepper (1993, pp. 36–8).
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58 The Liquidity Theory of Asset Prices
the equity market will not recover quickly should debt deflation occur in another country. Bargain hunting should be delayed until either the growth of the money supply has started to recover, or it is likely that the government will follow an appropriate policy to boost monetary growth.
APPENDIX: IGNORANCE OF IRVING FISHER’S PRESCRIPTION
The first evidence that many governments are either unaware of, or disagree with, the cure for debt deflation prescribed by Irving Fisher is that the Japanese, before 2002, failed to boost their money supply.
There is anecdotal evidence (reports by highly respected economists and officials) that one reason why they eased fiscal, rather than money supply, policy was pressure from the US, where the Administration did not want the yen to fall against the dollar. If these reports are correct, the US, too, is ignorant of the cure.
The UK Treasury appears not to understand the cure either. In the late 1970s and early 1980s, when the UK authorities were trying to hit the published targets for the money supply, a policy of overfunding was followed, under which the Bank of England sold more gilt-edged stock (government bonds) than was necessary to cover the government’s need to borrow. In other words, it destroyed printing-press money to offset excessive creation of fountain-pen money. In 1985, Nigel Lawson abolished the policy when he was Chancellor of the Exchequer. His memoirs disclose that he, and presumably Treasury officials, did not understand the effect of overfunding (they focused on the one-off credit effect and ignored the continuing monetary effect).3 If this is correct, they are unlikely to understand underfunding either.
It is also worrying that various countries have institutional barriers to stop a government from printing money excessively (after the German experience in the 1920s under the Weimar Republic); see Chapter 9.
Such barriers may also stop them from employing the cure for debt deflation.
A final cause for concern in the UK is that in 1998 operational respon- sibility for debt management was taken away from the Bank of England and transferred to a newly formed Debt Management Office, to bring the UK into line with practice elsewhere in Europe.
3For elaboration see Pepper and Oliver (2001, Ch 8).
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