A response to Bezemer & Hudson's "Finance is Not the Economy"

I've been reading Finance is Not the Economy by Dirk Bezemer and Michael Hudson. It's really good. But we need to talk.

You know how, when you look at a graph of debt relative to GDP, the line starts out flat and then suddenly starts going up in the 1980s? Like this graph:

Graph #1: TCMDO Debt relative to GDP

Some people look at a graph like that and say there was an "explosion" of debt in the 1980s. Noah Smith said something like that a while back.

Funny, though. If you look at change in debt relative to GDP, you see a different picture:

Graph #2: Change in TCMDO Debt, relative to GDP

If you put a trend line on this one, it would start low and begin curving up immediately. It would continue curving upward all thru the 1960s and 1970s and into the 1980s. Then, after 1985, a sudden drop.

Why does the first graph run flat when the second graph shows a trend of continuous increase until the mid-80s? I mean, the second graph shows the changes in debt, and the first graph shows the accumulation of those changes. So, why does the first graph run flat?

One word: Inflation.


For near twenty years, beginning in the mid-60s, inflation pushed prices up. It pushed income up. It pushed spending up. And it pushed borrowing up.

Inflation pushed borrowing up. It made new additions to debt bigger. But inflation didn't make existing debt bigger. Inflation only affects new spending.

Inflation also made nominal GDP bigger. All of GDP is new spending, so all of GDP got bigger. Inflation increased the whole of GDP, and new additions to debt, but not existing debt.

When we look at Graph #2 we see big increases before 1980. But those increases don't appear on Graph #1 because the inflation in any given year does not increase the debt of prior years. That's why people say "inflation erodes debt".

Graph #2 goes uphill before the 1980s, but Graph #1 is flat because of inflation.


So anyway: You know how, when you look at a graph of debt relative to GDP, the line starts out flat and then suddenly starts going up in the 1980s? Everybody knows. But no one seems to know it's flat because of inflation. Everyone seems to think there was a magical time before the '80s when the economy grew fast enough to keep the line flat.

Can you see where this goes? It goes to policy. If you think Debt-to-GDP was flat because we used less debt and got more bang for the buck, or if you think it was flat as a result of inflation, it can change how you think about policy. Hey, I'm all in favor of changing policy. But I'm also in favor of avoiding wrong-thinking on the way to developing policy.

Funny thing is, we did use less debt and we did get more bang for the buck, back when there wasn't so much debt. It's true. But it's also true that the line is flat because of inflation.


So I've been reading Finance is Not the Economy by Bezemer and Hudson. Their key idea seems to be that money and credit (and debt) grew in proportion to GDP until the 1980s, and that since the 1980s money and credit (and debt) grow much faster than GDP. The pattern they describe -- a time of stability followed by a time of increase, with the change occurring in the 1980s -- is exactly what we saw in Graph #1 above.

This worries me.


If you look at debt relative to GDP and you want to base policy on it, then you have to take inflation into account. You have to look at "real" debt relative to "real" GDP. Otherwise you cannot be sure what the numbers are telling you.

But every graph of "real debt" that I ever saw was wrong. Everyone inflation-adjusts debt the same way you would inflation-adjust GDP. That's wrong. It's wrong because debt is a stock and GDP is a flow. Debt accumulates over many years. GDP accumulates for one year and starts at zero again the next year.

There's nothing in this year's GDP that is "final spending" from some prior year. Everything in this year's GDP is this year's stuff and can be figured at this year's prices. If you want to figure "real GDP" using base year 2009, you take one year's GDP, divide by that same year's price level, and multiply by the price level for 2009. Done.

That calculation doesn't work for debt. This year's debt includes this year's addition to debt, and last year's addition to debt, and the year before that, and debt from all the way back to the oldest thing that isn't paid off yet. So when you want to figure "real debt" -- when you want to figure the real purchasing power at the time the money was borrowed -- you have to adjust each year's addition to debt separately. If you don't do that, your answer is just plain wrong.

If I was writing the Bezemer and Hudson article, and if I didn't have this fetish about the real purchasing power of additions to debt, I would not have thought twice about it. I would have looked at debt relative to GDP, nominal to nominal. And existing debt from the time of the Great Inflation (and before) would be falsely low, because inflation erodes debt.

If you challenged me on it, I would have said the same thing people always tell me: I would have said the graph of "real debt to real GDP" looks exactly like the graph of "nominal debt to nominal GDP" because inflation cancels inflation.

That's not right, though, because debt is a stock and GDP is a flow. The "real" calculations for stock and flow are different. Stock-inflation divided by flow-inflation does not cancel out.

If you figure nominal debt to nominal GDP, or if you use the wrong "real" calculation, you can expect debt to look flat before the 1980s. I've been reading Finance is Not the Economy and I'm worried that Bezemer and Hudson find debt growing in proportion to GDP before the 1980s because they are using nominal values for debt, like my Graph #1.

Actually, they are. They said so. Their Figure 1 shows "YoY growth in nominal credit to nonfinancial business". They're using nominals. So their key insight, that debt grew in proportion to GDP before the 1980s, may well be mistaken. We won't know until they re-create their graphs with the data correctly converted to real values.


More on the inflation-adjustment of debt:

  •  Illusion, Reality, and the Growth of Debt
  •  By the numbers (2): History is different


EDIT 30 Nov 2016: Revised the first sentence with the word "erode".