Keynesian traps and flooding the building

A frequent correspondent sent me a link to Phillip's Economic Computer, a wonderful analogue device designed to illustrate the flow of money within the economy. And that got me thinking...

A very rough and brutal sketch of Keynes' classical account of the savings trap is that if people save too much, rather than consume, then the velocity of money drops, inventory builds up, growth falls (and even goes negative) as businesses cut back on production. A standard account of the liquidity trap by Krugman is here.

How does the Phillip's device help? Well, it points out a truth that is often hard to see, namely that money can only be created or destroyed by the central bank. Credit cannot be 'created' without funding; money cannot disappear. These days, rather little money is stored in mattresses or bank vaults: most of it is in the form of bank deposits, securities, or other investments. And of course those assets are someone else's liabilities, i.e. funding for them. Thus these days your choice is not between putting your cash under the bed and spending it: it is between putting it in a bank - which will lend it to someone else - and spending it. In this sense saving is not quite as bad as in the classical Keynesian account, as it provides funding for corporations and individuals who do want to engage in economic activity. Even buying government bonds is not useless as the government spends the money on something.

Now of course the increase in economic activity provided by a dollar of spending on goods may be rather more than that provided by a dollar of bank deposits. But it is worth noting that the dollar of bank deposits are not useless: the bank has to do something with your money, and that something probably has positive economic value. Anything else would cause funds to build up rather too fast at the bank - something the Phillip's computer would model as water flooding out...

Deprogramming Obama

A nice slant from Salon: the president is a prisoner of the cult of neoliberalism.

The modifier on innovation

There has been a fair amount of discussion recently about financial innovation. Willem Buiter has suggested that new financial products should have a licensing regime akin to drugs, and Felix Salmon has written provocatively on the link (or lack thereof) betweeen innovation and economic growth. This should be read in the context of David Warsh's work on Knowledge and the Wealth of Nations, a work that this post from Science Blogs reminded me of.

So, what do we know? First that certain infrastructures help innovations generate wealth. The ability to profit from a good idea helps, as does the ability to finance development. Hence patents and joint stock companies. Education is necessary, and law which gives certainty of ownership is also helpful.

Next, we know that most innovation does not produce growth. A lot of it isn't harmful, but there are many, many dead ends. Markets are sometimes (but not always) good at sorting out which ideas are useful.

Now to specifically financial innovation. The point of financial innovation is to produce products which meet specific needs better (more cheaply, more accurately), and thus often to lower the cost of finance. Some innovations have worked out: a good example would be the convertible bond, which allows companies to monetise the volatility in their stock price. Others have been more or less useless but benign. Credit spread options are a good example here: in the early days of credit derivatives, these were a competitor with CDS as standard credit risk transfer products. CDS turned out to work rather better, and so credit spread options faded into illiquidity without doing anyone any harm.

Are there genuinely harmful wholesale financial products? I am still not sure that there are. I certainly can't think of one*. If firms are required to keep enough capital against the risk of a product; to value it properly; and to document it carefully, then why should trading be constrained? Isn't product licensing just a route to a less efficient economy?

*Tradable emissions permits come pretty close though.

Update. There is a nice rebuttal of the `innovation causes crises' meme from the Economics of Contempt here.

Too big to succeed

As I write this, Manchester United are on the verge of their champion's league final with Barcelona. I'm cheering for Barca, but I have to admit that Man U are a success. They are one of Europe's great teams, for now at least.

Let's compare them with RBS. If Man U screw up - say Ronaldo goes to Real Madrid, they overpay for Tevez who then breaks a leg, and Rooney gets even fatter and loses it - then Man U's bond holders will probably suffer. Another team - the far more worthy Liverpool for instance - will win the Championship. There will be gnashing of teeth. But the fall of this particular champion won't cause much more than a surge in beer sales as fans drown their sorrows. The problems at RBS, on the other hand, left the UK tax payer with a lot of risk, cost them a lot of money and severely restricted the supply of credit to the UK economy, with hideous economic consequences. We simply could not afford to let RBS fail.

In other words, then, some firms' size is a problem for the economy, and some aren't. (Man U's size and spending power might be a problem for football, but that is a different story.) If you have firms whose size and market position makes them effectively too big to fail, then you already have a problem. Superivising them isn't the issue: stopping them getting that big is.

John Kay takes up the next part of the story in the FT. If large, systemic providers are inevitable, or at least if we have them at the moment, we need to ensure that their functions survive their failure, whatever the cost to shareholders and the restriction on companies' freedom of action.

There should be a clear distinction in public policy between the requirement for essential activities to survive and the continued existence of particular companies engaged in their provision. There are many services we cannot do without – the electricity grid and the water supply, the transport system and the telecommunications network. These activities are every bit as necessary to our personal and business lives as the banking sector and at least as interconnected. Even a brief hiatus in their supply is intolerable.

But the need to keep the water flowing does not establish a need to keep the water company in business. We do not mind if one chain of high street shops closes its doors, because there are many other places to buy our clothes and groceries. Other industries are different. We cannot contemplate keeping aircraft circling over London while the liquidator of Heathrow Airport Ltd finds the way to his office.

In all industries where there is or might be a dominant position in the supply of essential public services, there needs to be a special resolution regime. The key requirement is that assets that are needed for the continued provision of these services can be quickly separated from the organisations engaged in their supply. The businesses involved must be required to operate in such a way that such a separation is possible.

This implies of course that there is a big difference between the big boys and the rest. The state promises to intervene in their affairs and seize their assets far sooner than it would for a less important player. If this threat is credible, not only would it be good for the economy, it also might encourage firms not to get too large. Lots of small, competitive firms are good.

Update. 2-0. Thank you Barca. The look on Ronaldo's face is priceless.

Hoicked from the comments

In a comment on the non-classical cost benefit analysis post of a few days ago (a title, I think you will agree, of gigantic pretention), Dave said:

I agree with your conclusions: that uncertainty and moral hazard can make CBA unreliable and sometimes it is better to rely on qualitative objectives.

But I disagree with your applying these to systemic risk. Firstly, with systemic risk it is the "worst-case scenario" that is important. If regulators had used the great depression as the worst case scenario, they wouldn't have been far wrong.

Often, though, the worst case scenario can be hard to identify. The worst case scenario in much of finance for instance is that all claims are worthless and all liabilities come due immediately. We might as well all go home if that comes true, and barricade the doors. 'Plausible' worst cases have a nasty habit of turning out to be too optimistic: wasn't it David Viniar from Goldman who said that 2008 was much worse than the most pessimistic scenario they looked at?

Secondly, I can't see how systemic risk regulation would cause bankers to take greater risks. So, I don't see where moral hazard fits in.

Fair enough - bankers are not people riding bikes. (Quite literally, usually - Wall Street tends to view cycling to work as only marginally less strange than coming by elephant.) So probably bankers did not take more risk because they were regulated. Some of them did, however, take as much as they could subject to regulation, because that was the way to maximise returns to shareholders.

Thirdly, how do you take a "moral" position on systemic risk? I don't think this gets you very far.

Well, I think that the key idea of Anglo-Saxon capitalism - that the first and only duty of a firm is to its shareholders - is simply immoral. Of course, like any ethical judgement, you can disagree with that. But I also think, and I'd like to think that I can prove, that a system that has a wider burden of responsibilities, including a responsibility to the financial system, would be less likely to go into crisis, cost the taxpayer less over the cycle, and deliver slower but less volatile growth.

Finally, the main impact of systemic risk regulation would be to encourage smaller banking/trading institutions. I would think that this a good thing in itself. And I disagree with James Kwak that "countercylical measures in a boom dampen economic growth". Surely the opposite is true (in the long run).

Absolutely. We need a lot of small banks, not a small number of large ones. The hard part is how we get to there from here.

Becoming French

Matthew Lynn, in a typically opinionated and wrong-headed piece on Bloomberg, thinks

The British economy is becoming increasingly French.

Why which he means

It will have a huge tax burden to carry, a state that is the dominant actor in the economy, and a system whose resources are managed more by some kind of national plan than the free hand of the market. The government is now explicitly emulating France, with its national champions.

Sadly this leaves out the good parts about the French economy: the generous welfare system; good education and health care; job security (at least for some); rational working hours for many. No, the UK isn't becoming French. It is becoming much worse: French for big companies, but American for ordinary workers. That's like having Italian railways and Swiss fashion.

Systems thinking in the Crunch

Edmund Phelps has a very good article in the FT which harmonises with many of the preoccupations of this blog.

In countries operating a largely capitalist system, there does not appear to be a wide understanding among its actors and overseers of either its advantages or its hazards... Capitalism is not the “free market” or laisser faire – a system of zero government “plus the constable”. Capitalist systems function less well without state protection of investors, lenders and companies against monopoly, deception and fraud.

In order to understand a system, you need to understand its behaviour, and how changing the rules which constrain that behaviour constrain the dynamics. There is no more a 'right' set of rules for something as complicated as a market as a 'right' set for a mobile telephony or a ball game. Some rules produce more efficient or interesting behaviours: some suffer significant disadvantages.

In essence, capitalist systems are a mechanism by which economies may generate growth in knowledge – with much uncertainty in the process, owing to the incompleteness of knowledge.

Growth in infrastructure too: roads and factories and such like. The knowledge moreover is encapsulated in conventions, or rules of the system: a mobile phone is useless without a network of towers that it can communicate with. Capitalism attempts to solve a massive collection of coordination problems - and often (as with the worldwide phone system), it succeeds.

Well into the 20th century, scholars viewed economic advances as resulting from commercial innovations enabled by the discoveries of scientists – discoveries that come from outside the economy and out of the blue. Why then did capitalist economies benefit more than others? ... [Hayek] felt free to suppose that, thanks to the specialised insights each acquires, a manager or employee may one day “imagine” a commercial departure – one that could not be inferred or envisioned by people outside the individual’s line of work. Then he portrays a well-functioning capitalist system as a broad-based, bottom-up organism that gives diverse new ideas opportunities to compete for development and, with luck, adoption in the marketplace. That “discovery procedure” makes it far more innovative than the top-down systems of socialism or corporatism.

This is of course an important (and well understood) point. However most wealth, in the general sense, is created not by true blue skies innovation, but by inside-the-system thinking. 3G phones are possible because we already have second generation infrastructure: ABS only makes sense under some assumptions about road surfaces and driving conditions and so on. Thus the role of capitalism is not just to act as an evolutionary force allowing great new ideas to generate wealth. It must also provide infrastructure - pensions, banking, law, transport, health care and the rest - within which incremental development can take place. There are many non-optimal local maxima here: the US healthcare system is a good example. Phelps makes this point less forcefully:

Well-functioning capitalist economies, with their high propensity to innovate, could arise only when serviceable institutions were in place.

Note however that there is an inherent volatility in capitalism.

From the outset, the biggest downside was that creative ventures caused uncertainty not only for the entrepreneurs themselves but also for everyone else in the global economy. Swings in venture activity created a fluctuating economic environment.

You can have slow wealth creation with little variation, or faster wealth creation with significant setbacks. But we do not know how to generate fast low volatility wealth creation, even assuming that this was generally considered to be desirable. Moreover there has never been a broad discussion of how much volatility is tolerable. Is an economy that grows at 4% on average over the long run but suffers vicious multi-year recessions occasionally better or worse than one that grows at 3% with much shallower pullbacks?

Investors have proved terrible at addressing these issues not least because they were reluctant to admit to the possibility of setback which was baked into the dynamics of the system.

But why did big shareholders not move to stop over-leveraging before it reached dangerous levels? Why did legislators not demand regulatory intervention? they had no sense of the existing Knightian uncertainty. So they had no sense of the possibility of a huge break in housing prices and no sense of the fundamental inapplicability of the risk management models used in the banks. “Risk” came to mean volatility over some recent past. The volatility of the price as it vibrates around some path was considered but not the uncertainty of the path itself: the risk that it would shift down.

We urgently need to develop a sense not just of the likely near term path of the economy, but also the possible paths - the kind of thing that it might do. If, as I suspect, highly undesirable paths are still somewhat likely, we need to rewrite the rules to make them much less probable.

Taleb - 3/10 (and that is being generous)

Let's score Nassim Taleb's latest set of ex cathedra pronouncements:

1. What is fragile should break early while it is still small. Nothing should ever become too big to fail.

Fair point. Score one.

2. No socialisation of losses and privatisation of gains.

Exactly. Otherwise moral hazard is enormous and banking is profitable with little risk. Score one.

3. People who were driving a school bus blindfolded (and crashed it) should never be given a new bus.

No. Firstly nearly everyone who knows enough to be helpful was driving (or at least helping to navigate) the bus. And secondly most people even if they did not like the driving, weren't in a position to do anything about it. We cannot afford to get rid of all of our experts, even if they have been wrong in the past. Score zero.

4. Do not let someone making an “incentive” bonus manage a nuclear plant – or your financial risks.

It depends on the bonus. One year bonuses with no clawback based on mark to market profits clearly provide bad incentives. But multiyear bonuses with clawbacks based on realised gains may provide a good incentive. Score half.

5. Counter-balance complexity with simplicity. Complexity from globalisation and highly networked economic life needs to be countered by simplicity in financial products.

No. Balance complexity with appropriate technology. Complex products can be appropriate, simple products can be inappropriate. It depends. Score zero.

6. Do not give children sticks of dynamite, even if they come with a warning . Complex derivatives need to be banned because nobody understands them and few are rational enough to know it.

No. It is enough to ensure that risk takers genuinely bear the consequences of their actions and that there is sufficient capital in the system for the risks being taken. If you ban dynamite, tunneling gets much more expensive. You just want to be sure it is civil engineers not terrorists who have the dynamite. Score zero.

7. Only Ponzi schemes should depend on confidence.

Nonsense. No one knows what a financial system that is not confidence sensitive might be like. That is an unsolved problem in finance. Score zero (with the judge contemplating taking away a mark for idiocy).

8. Do not give an addict more drugs if he has withdrawal pains. Using leverage to cure the problems of too much leverage is not homeopathy, it is denial.

It depends. Allowing firms to increase leverage is insane, and no regulator I know is permitting that (unless you could accounting games which result in over-stating capital). But governments can and should increase their borrowing at times like these. Score half.

9. Citizens should not depend on financial assets or fallible “expert” advice for their retirement. Economic life should be definancialised. We should learn not to use markets as storehouses of value: they do not harbour the certainties that normal citizens require.

So what, prey, do you suggest people use to save for retirement? Given I know of no asset whatsoever that does not fluctuate in value, this is a real question. Score zero.

10. Make an omelette with the broken eggs. Finally, this crisis cannot be fixed with makeshift repairs, no more than a boat with a rotten hull can be fixed with ad-hoc patches. We need to rebuild the hull with new (stronger) materials; we will have to remake the system before it does so itself. Let us move voluntarily into Capitalism 2.0 by helping what needs to be broken break on its own, converting debt into equity, marginalising the economics and business school establishments, shutting down the “Nobel” in economics, banning leveraged buyouts, putting bankers where they belong, clawing back the bonuses of those who got us here, and teaching people to navigate a world with fewer certainties.

The sheer cliche density of that paragraph alone deserve a minus five.

Transatlantic Coup

Simon Johnson has an excellent article in the current issue of The Atlantic magazine. His basic premise, as an ex-IMF chief economist, is that crony capitalism is a fundamental part of many emerging market crises, and it is only when the cronies are forced to take some pain that the crisis can be resolved. Furthermore he argues that this kind of coup, whereby power has been seized by a small group who manipulate the economy for personal profit, took place in the US during the Clinton and Bush years. Thus the Quiet Coup of the article's title. Go and read the whole thing: it is quite persuasive.

Editing Harvard

Greg Mankiw writes some complacent nonsense:

At Harvard, we have not instituted any radical reforms in the introductory economics curriculum in response to recent events. We have had some guest speakers, such as John Campbell and Andrei Shleifer, give excellent and well received lectures about the current crisis to assure students that, despite all the uncertainties, economists really are on the case and that the tools of economics are useful in trying to figure out what is going on. But nothing in the current situation makes the basic lessons of economics irrelevant. And the basic lessons are where education needs to begin.

Let's rewrite it, to make more reasonable:

At Harvard, we have realised the economics has been singularly unhelpful in predicting recent economic events, or in providing advice on how to deal with them. In response to this, we have instituted radical reform in economics teaching and research, reaching out to mathematicians, physicists, computer scientists, systems biologists and others who seem to have useful things to say about interacting systems like the economy. We believe that the tools of economics are rather unhelpful in trying to figure out what is going on, and we are urgently trying to improve them.

Update. Harvey Mansfield has a nice summary of what is required:

What has happened in the last few months should give them [i.e. economists] pause. It should make them consider the necessity of looking at economics from the outside, at how it looks and behaves as a whole. There's no way to do this from within economics--no way to formulate an equation that will correctly predict the failure of equations to predict. The idea of prediction itself has to come into question. Prediction is designed to reduce the role of chance in our lives, eliminating unpleasant surprise and replacing it with gratitude and satisfaction. But somehow it doesn't have this effect.

Towards Core Stability

No, not a post on my recent engagement with Pilates. Instead I am going to be a little Englander for a moment. This isn't out of prejudice: it is more a consideration of self sufficiency.

What's the problem with being an exporter? It is that if your clients stop buying, your economy runs into a wall. Look at Japan.

The problem with being an importer is that it is easy to import inflation.

A measure of self sufficiency therefore has some interest. The problem for the UK is that, with a few exceptions (cars, killing machines) we killed out manufacturing industry, making progress towards self sufficiency very difficult. It also makes our natural shortage of material much worse from a country risk perspective.

Therefore part of any long term financial stability plan should be the revival of manufacturing, especially engineering-based manufacturing, at the expense of financial services. It isn't impossible: Thatcher only killed manufacturing in the 1980s, and there are still some good engineers left (although many of them are retiring). This story is a tiny ray of light in that regard. But much, much more is needed.

The slaves revolt

There is a growing meme at the moment on the failure of academic economics. Anatole Kaletsky has a piece in the Times which reminds of the responsibility economists bear using Keynes' famous quote:

Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back.

He points the finger at the rational expectations and efficient market hypotheses, arguing that the impact of these two ideas has been `dire', then says:

The prevailing academic orthodoxy has to be recognised as a blind alley. Economics will have to revert to a genuine competition between diverse intellectual approaches - such as behavioural psychology, sociology, control engineering and the mathematics of chaos theory.

So economics is on the brink of a paradigm shift. We are where astronomy was when Copernicus realised that the Earth revolves around the Sun. The academic economics of the past 20 years is comparable to pre-Copernican astronomy, with its mysterious heavenly cogs, epicycles and wheels within wheels or maybe even astrology, with its faith in star signs.

For my money, this is overly optimistic. Revolution is direly needed, but there will be massive resistance to change. (One is reminded of the similar useless and career-serving complexity in string theory.)

Meanwhile Willem Buiter uses a long and persuasive FT blog to flesh out the details of the failings of macroeconomics. Buiter questions the complete markets assumption, pointing out that the characteristic issue of the crunch -- illiquidity -- cannot even be addressed once that assumption is made.

He is also particularly good on how economists have simplified their theory so that they can work with it, abandoning any hope of realism for mathematical tractability. The simplest form of uncertainty (Gaussian random walks) was assumed; equations were linearised; equilibrium was assumed. (Buiter does not dwell on the last of these, but it is very important: one of the big issues in dynamic general equilibrium models is the `e' word, given that the frequency of shocks is large compared with the relaxation time of the model.)

Buiter is scathing about the use of these models to set policy:

The practice of removing all non-linearities and most of the interesting aspects of uncertainty from the models that were then let loose on actual numerical policy analysis, was a major step backwards.

The final nail is added by The Financial Crisis and the Systemic Failure of Academic Economics, a paper by David Colander et al. (Link via debtdeflation.com.) This goes over the same themes, stressing the need for someone, somewhere, to do some work on macro models which are useful for making policy. Perhaps academic economists are not actually the right people to do this - it may be that the Copernican revolution in economics comes from the theory of complex dynamical systems (the bastard son of chaos theory) or systems biology. Perhaps we will see a new experimentalism, with models being built which actually capture aspects of the economy, rather than aspects of economic theory. But certainly there is a huge problem waiting to be solved, and there should be kudos for anyone who can make a significant contribution to solving it.

Update. The New York Times has a piece on the lack of movement in academic economics so far. It isn't surprising. Change will require a reasonable number of young economists to say I am Spartacus, and that hasn't happened yet.

An embarrassing lack of ambition

Paul Krugman, who I normally have a lot of respect for, writes:

The figure above plots ... It’s not a perfect fit — this is economics, not physics,...

(Emphasis mine.) Honestly, what other academic discipline could dismiss the inaccuracy of a theory with an airy `this is not physics?' Economists wonder why many people think that they are little better than cultists. Krugman's piece displays a large part of the reason: economists can't predict much and they are not even embarrassed by that.

Recent refutations

John Quiggin has a nice series on economic doctrines that have been refuted by the Crunch. Part 1 is here. Go read: it's good.

About the best one slide summary I've seen

Jeff Frankels has a nice picture on his blog. I like it a lot, but I think it is slightly at error, so here's my version, a slight modification of Jeff's original:
(Click for a larger version.)

Keynesian economics in one sentence

From Paul Krugman, offered as a public service post:

The key to Keynes’s contribution was his realization that liquidity preference — the desire of individuals to hold liquid monetary assets — can lead to situations in which effective demand isn’t enough to employ all the economy’s resources.

Debt deflation

Gavin Davies has a nice summary in the Guardian of Irving Fisher's debt deflation theory. I'll edit slightly:

Deflation is defined as a pervasive decline in the general price level... When such a decline starts, three very dangerous things can happen.

First, real (inflation-adjusted) interest rates rise, and the central bank becomes powerless to prevent this, because it cannot reduce the level of nominal interest rates below zero. As the rate of deflation gets larger, the real rate of interest actually increases, and this perversely tightens the stance of monetary policy.

Second, the real level of debt in the economy also rises. Most debt is denominated in fixed nominal quantities (£100 for instance), so when the price of goods declines, more goods are needed to pay down the same quantity of debt.

Third, consumers - expecting price declines to continue - delay purchases because the real value of cash is likely to be higher in the future. This reduces demand, pushing the economy further into depression.

Monetary policy does not work in this regime: a fiscal stimulus is needed. Thus the central bank prints money (inflation not being a concern) and the government spends it on something, ideally something useful. Green Keynes anyone?

Update. Krugman has more on the same topic in the NYT here. As he says, to pull us out of this downward spiral, the federal government will have to provide economic stimulus in the form of higher spending and greater aid to those in distress.

What Pleasure It Is To Be A Real Keynesian Now

Finally the tide seems to be turning. Bernanke is talking about the need for central bankers to be mindful of asset price bubbles. Darling is reprioritising spending to produce a classic Keynesian stimulus. But isn't it bizarre that we now have nationalised banks and privatised railways? If ever there was one industry that the state should control - must control - it is transport. (The revelation on Saturday that the reason Virgin trains are so crowded is nothing more than revenue optimisation only makes the case even more clear.) Now Alistair has (reluctantly and a little tardily) got the nationalisation bug, perhaps he could finally undo the evils of his predecessors and renationalise the tube and the railways. Let's hear no more about internal markets in the health service or in education. Now is the time for the state to spend for the sake of us all.

Tim Congdon has completely lost it

On the news at 1, sounding mildly crazed, he said: There was nothing wrong with Northern Rock. No, Tim, nothing but a run that would have led to bankruptcy if the Bank of England had not intervened as Lender of Last Resort. Honestly, these monetarists are so dangerous giving them a media platform at the moment is roughly akin to shouting fire in a crowded theatre.

Update. He's at it again, saying to the BBC: "The way the government is going about it, they are effectively stealing from the shareholders. The long-run result will be to destroy the competitiveness of Britain's most important industries,". Again, no. Without government intervention, the shareholders would have nothing. There would be nothing to steal. The state is in fact being very generous letting shareholders keep any of the banks. It is probably politically expedient so to do, but it isn't necessary. Without the state, HBOS and RBS would have been toast today. You can't be competitive if you are insolvent.

Update. Did the BBC suddenly declare it discredited economist month? They had Madsen Pirie on the news this morning, decrying Keynesian stimulii. Of course he doesn't want us to try it; of course the whole nauseating troop of monetarists are trying to get publicity: if spending our way out of recession does work, any vestige of reputation they might have left will disappear.

A quick hat tip to the importance of debt deflation

Sadly I don't have time to address this properly, but I do want to make a quick connection between Ben Bernanke's favourite theory of the Great Depression - Irving Fisher's idea of debt deflation - and the current situation. Krugman is insightful here:

when highly indebted individuals and businesses get into financial trouble, they usually sell assets and use the proceeds to pay down their debt. What Fisher pointed out, however, was that such selloffs are self-defeating when everyone does it: if everyone tries to sell assets at the same time, the resulting plunge in market prices undermines debtors’ financial positions faster than debt can be paid off. So deflation in asset prices can turn into a vicious circle. And one consequence of what he called a “stampede to liquidate” is a severe economic slump.

That’s what’s happening now, with debt deflation made especially ugly by the fact that key financial players are highly leveraged — their assets were mainly bought with borrowed money.

For more historical context and comment, see The London Banker.