“Let us begin at the beginning of the argument. There is a multitude of real assets in the world which constitute our capital wealth—buildings, stocks of commodities, goods in course of manufacture and of transport, and so forth. The nominal owners of these assets, however, have not infrequently borrowed money in order to become possessed of them. To a corresponding extent the actual owners of wealth have claims, not on real assets, but on money. A considerable part of this ‘financing’ takes place through the banking system, which interposes its guarantee between its depositors who lend it money, and its borrowing customers to whom it loans money wherewith to finance the purchase of real assets. The interposition of this veil of money between the real asset and the wealth owner is a specially marked characteristic of the modern world. Partly as a result of the increasing confidence felt in recent years in the leading banking systems, the practice has grown to formidable dimensions. The bank-deposits of all kinds in the United States, for example, stand in round figures at $50,000,000,000; those of Great Britain at £2,000,000,000. In addition to this there is the great mass of bonded and mortgage indebtedness held by individuals.So here Keynes is referring to the destabilising effects of price deflation via the process that Irving Fisher would call “debt deflation” a few years later in his classic article “The Debt-Deflation Theory of Great Depressions” (Fisher 1933), though, as Philip Pilkington points out here, it seems that “Keynes is not only aware of the debt deflation theory in 1931 but he also suggests that everyone is aware of it.”
All this is familiar enough in general terms. We are also familiar with the idea that a change in the value of money can gravely upset the relative positions of those who possess claims to money and those who owe money. For, of course, a fall in prices, which is the same thing as a rise in the value of claims on money, means that real wealth is transferred from the debtor in favour of the creditor, so that a larger proportion of the real asset is represented by the claims of the depositor, and a smaller proportion belongs to the nominal owner of the asset who has borrowed in order to buy it. This, we all know, is one of the reasons why changes in prices are upsetting.” (Keynes 1931: 169–170; reprinted in Keynes 1972: 150–158).
Keynes goes on to point out that the prices of many asset that function as the underlying collateral for bank loans had fallen disastrously during the early years of the depression, and that this induced a further crisis of insolvency in the banking system:
“To sum up, there is scarcely any class of property, except real estate, however useful and important to the welfare of the community, the current money value of which has not suffered an enormous and scarcely precedented decline. This has happened in a community which is so organised that a veil of money is, as I have said, interposed over a wide field between the actual asset and the wealth owner. The ostensible proprietor of the actual asset has financed it by borrowing money from the actual owner of wealth. Furthermore, it is largely through the banking system that all this has been arranged. That is to say, the banks have, for a consideration, interposed their guarantee. They stand between the real borrower and the real lender. They have given their guarantee to the real lender; and this guarantee is only good if the money value of the asset belonging to the real borrower is worth the money which has been advanced on it. It is for this reason that a decline in money values so severe as that which we are now experiencing threatens the solidity of the whole financial structure. ….Furthermore, there is another point that Keynes is making, as Philip Pilkington again also argues here: for Keynes, the fall in asset prices and the rush to physical cash or liquid forms of money is a rise in liquidity preference, which can also induce destabilising effects that are worse than debt deflation.
In many countries bankers are becoming unpleasantly aware of the fact that, when their customers' margins have run off, they are themselves ‘on margin.’ I believe that, if to-day a really conservative valuation were made of all doubtful assets, quite a significant proportion of the banks of the world would be found to be insolvent; and with the further progress of Deflation this proportion will grow rapidly. Fortunately our own domestic British Banks are probably at present—for various reasons—among the strongest. But there is a degree of Deflation which no bank can stand. And over a great part of the world, and not least in the United States, the position of the banks, though partly concealed from the public eye, may be in fact the weakest element in the whole situation. It is obvious that the present trend of events cannot go much further without something breaking. If nothing is done, it will be amongst the world's banks that the really critical breakages will occur.
Modern capitalism is faced, in my belief, with the choice between finding some way to increase money values towards their former figure, or seeing widespread insolvencies and defaults and the collapse of a large part of the financial structure;—after which we should all start again, not nearly so much poorer as we should expect, and much more cheerful perhaps, but having suffered a period of waste and disturbance and social injustice, and a general re-arrangement of private fortunes and the ownership of wealth.” (Keynes 1931: 175–177).
Philip Pilkington, “Keynes’ Liquidity Preference Trumps Debt Deflation in 1931 and 2008,” Fixing the Economists, February 24, 2014.
Fisher, Irving. 1933. “The Debt-Deflation Theory of Great Depressions,” Econometrica 1.4: 337–357.
Keynes, J. M. 1931. “The Consequences to the Banks of the Collapse of Money Values,” in J. M. Keynes, Essays in Persuasion. Macmillan, London.
Keynes, J. M. 1972 . “The Consequences to the Banks of the Collapse of Money Values,” in J. M. Keynes, The Collected Writings of John Maynard Keynes. Volume IX. Essays in Persuasion. Macmillan, London. 150–158.