Debt, Deleveraging, and the Liquidity Trap

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Debt, Deleveraging, and the Liquidity


A Fisher-Minsky-Koo approach

Gauti B. Eggertsson (NY Fed) Paul Krugman (Princeton)


In this paper we present a simple New Keynesian-style model of debt-driven slumps – that is, situations

in which an overhang of debt on the part of some agents, who are forced into rapid deleveraging, is

depressing aggregate demand. Making some agents debt-constrained is a surprisingly powerful

assumption: Fisherian debt deflation, the possibility of a liquidity trap, the paradox of thrift, a Keynesian type multiplier, and a rationale for expansionary fiscal policy all emerge naturally from the model. We

argue that this approach sheds considerable light both on current economic difficulties and on historical

episodes, including Japan’s lost decade (now in its 18th year) and the Great Depression itself.

This paper presents preliminary findings and is being distributed to economists

and other interested readers solely to stimulate discussion and elicit comments.

The views expressed in the paper are those of the authors and are not necessarily

reflective of views at the Federal Reserve Bank of New York or the Federal

Reserve System. Any errors or omissions are the responsibility of the authors.


If there is a single word that appears most frequently in discussions of the economic problems

now afflicting both the United States and Europe, that word is surely “debt.” As Table 1 shows,

there was a rapid increase in household debt in a number of countries in the years leading up to

the 2008 crisis; this debt, it’s widely argued, set the stage for the crisis, and the overhang of debt

continues to act as a drag on recovery. Debt is also invoked – wrongly, we’ll argue – as a reason

to dismiss calls for expansionary fiscal policy as a response to unemployment: you can’t solve a

problem created by debt by running up even more debt, say the critics.

The current preoccupation with debt harks back to...