But I propose that when this cycle is repeated in series, it will lead to structural oversupplies of credit and excess productive capacity. This will force price and wage disinflation and decreases in the equilibrium real interest rate(important read) over the longer run. Debt-deflationary spirals and instability become increasingly likely as high debt-to-GDP ratios and the zero bound inexorably are achieved.
Here are some graphs of supporting data. We are particularly interested in the post-1982 numbers. Personal savings rates, real interest rates, non-residential investment as a percentage of GDP, total credit outstanding to GDP, the effective federal funds rate, and consumption as a percentage of GDP. It's helpful to review these as you step through the cycle below, and I apologize again for not being good with charts.
The Proposed Process
1. During a boom, real interest rates and investment's share of GDP naturally increase. Household income also increases. This income is distributed between consumption and savings. This distribution depends on the level of real interest rates: if they're high, more will be saved, and if they're low, more will be consumed.
2. A shock hits the economy, and the business cycle turns down. Investment registers a particularly sharp decline, and household income declines as well. Consumption falls less significantly. Disinflation occurs as slack emerges in capacity utilization.
3. To forestall a deepening recession, short-term interest rates are cut to forcibly depress real interest rates. In Hayek's parlance, this constitutes forced saving. There is an increase in investment beyond what is supported by economic equilibrium, with an associated increase in money supply growth to fund this investment.
Over-leveraged or under-productive enterprises that would normally have been destroyed find respite from the lowered interest rates too. They are able to continue producing goods, adding to surplus output.
In the U.S., which has a low savings rate, decreased real interest rates will also increase consumption, because the lost interest income is outweighed by benefits of cheaper credit, goods, and the wealth effect. Thus, consumption also rises in response to the lowered real interest rates, but not as sensitively.
4. The economy emerges from recession into a fresh boom due primarily to the resurgence in investment, and due partly to increased consumption. Real interest rates, employment, income, inflation, and investment begin to rise again as the business cycle is reignited successfully by monetary policy.
However, we find ourselves with excess money supply and investment lingering from the prior cycle. The artificial overhang of productive capacity and debt outstanding lead to a lower equilibrium real interest rate during this recovery. Thereby, inflation, policy rates, and the real rate of interest fail to recover to prior cyclical highs.
As a second order effect, the lower real interest rates induce households to consume more of their income and save less during this cycle. The savings rate rises more slowly, or even continues to fall, while consumption rises more quickly.
Investment responds to this increased consumption by growing even faster. Total credit outstanding surges to fund this expansion, while inflation fails to respond.
Then, another shock hits the economy.
After this cycle is repeated enough times, we are left with very high consumption, enormous productive capacity, very low savings rates, very low inflation, very low equilibrium real interest rates, and a very large money supply. These conditions are perfect for a debt-deflationary spiral.
A debt-deflationary spiral finally occurs when the zero bound is reached. This section of the story has already been written by Fisher.
Fisher's policy solutions supporting his main recommendation -- "dude, you so do not want to go there" -- are impracticable. Bernanke and the U.S. economy have ably collaborated to demonstrate that in our present disaster.
First, interest rates cannot be cut low enough. The real interest rate rises as the economy tries to force saving. But at the same time equilibrium real interest rates may be very low, and perhaps even negative due to the overhang of productive capacity and credit, making the liquidity trap virtually impossible to escape from. Therefore, there are few appealing investments. Consumers will not be credit-worthy either with declining income, high debt burdens, and job losses. It becomes very difficult to force either investment or consumption through conventional monetary policy.
Quantitative easing, encouraged by Fisher, is also probably not going to succeed because it lacks any transmission mechanism to the real economy during a liquidity trap. Money supply is rightly thought of as a dependent variable. As such, heroic efforts to halt a deflationary spiral by forcible money creation and liquidity provision will fail unless the money is created at incredible pace. This would probably cause unacceptable collateral damage.
My policy prescriptions are different. First, defaults must destroy excess money and productive capacity. This is a painful process that will temporarily exacerbate the debt-deflation spiral and result in increased unemployment, but it is inevitable.
Secondly, future monetary policy must be consistently more constrictive, forcing declines in investment and debt outstanding during expansions. I think it's still a useful tool, but provisioning its use by inflation and employment alone is a recipe for our current disaster.
This will be my last post for awhile. I've got a series of contiguous business trips for my real job from now to the end of March, and expression of this theory is the reason I started the blog. The incredibly good commentary and your readership are extremely flattering and a little addictive. I'll continue commenting elsewhere as long as I'm welcome regardless. If you like my ideas, please promulgate them for me, as I'm not wont to do so myself.