Irving Fisher on Debt, Deflation, and Depression

by: Brian Griffin

In 1933, Irving Fisher, possibly the first celebrity economist, published his paper titled “The Debt-Deflation Theory of Great Depressions,” a thorough reading of which should be required by anyone who wants to talk intelligently about our current crisis. I believe that not only does it address the causes and effects of depressions but also discusses possible solutions.

As for causes, Fisher believes there are two major factors that lead to a major depression as opposed to a run-of-the-mill slowdown in the business cycle: over-indebtedness and deflation. He believes that other factors can play a role in business cycles but they are basically secondary factors when it comes to real economic upheaval. Over-indebtedness and deflation are the main players in any extended economic downtown. He cites 1837, 1873, and 1929-1933. (I encourage you to read about these periods in history on Wikipedia.) He then lays out the effects, which an astute reader will see are quite applicable to today.

Assuming, accordingly, that, at some point of time, a state of over-indebtedness exists, this will tend to lead to liquidation, through the alarm either of debtors or creditors or both. Then we may deduce the following chain of consequences in nine links: (1) Debt liquidation leads to distress setting and to (2) Contraction of deposit currency, as bank loans are paid off, and to a slowing down of velocity of circulation. This contraction of deposits and of their velocity, precipitated by distress selling, causes (3) A fall in the level of prices, in other words, a swelling of the dollar. Assuming, as above stated, that this fall of prices is not interfered with by reflation or otherwise, there must be (4) A still greater fall in the net worths of business, precipitating bankruptcies and (5) A like fall in profits, which in a ” capitalistic,” that is, a private-profit society, leads the concerns which are running at a loss to make (6) A reduction in output, in trade and in employment of labor. These losses, bankruptcies, and unemployment, lead to (7) Pessimism and loss of confidence, which in turn lead to (8) Hoarding and slowing down still more the velocity of circulation.

The above eight changes cause (9) Complicated disturbances in the rates of interest, in particular, a fall in the nominal, or money, rates and a rise in the real, or commodity, rates of interest.
Evidently debt and deflation go far toward explaining a great mass of phenomena in a very simple logical way.

Now, it shouldn’t take very much to see that our over-indebtedness during this past cycle arose from expectations of large increases in the price in real estate. A broader statement would be that over the past ten years investors of all types (individual, corporate, government) have been willing to leverage their balance sheets in expectations of a better return on their investment. However, these same investors were not being adequately compensated for the risks they were taking. And now, we find ourselves in the midst of a massive deleveraging. And of his list of nine items, we can pretty confidently say that most, if not all, are playing out.

So, are we screwed? Is The Great Depression II about to begin? Well, let’s look at what Fisher views as the solution.

Unless some counteracting cause comes along to prevent the fall in the price level, such a depression as that of 1929-33 (namely when the more the debtors pay the more they owe) tends to continue, going deeper, in a vicious spiral, for many years. There is then no tendency of the boat to stop tipping until it has capsized. Ultimately, of course, but only after almost universal bankruptcy, the indebted-ness must cease to grow greater and begin to grow less. Then comes recovery and a tendency for a new boom-depression sequence. This is the so-called “natural” way out of a depression, via needless and cruel bankruptcy, unemployment, and starvation.

On the other hand, if the foregoing analysis is correct, it is always economically possible to stop or prevent such a depression simply by reflating the price level up to the average level at which outstanding debts were contracted by existing debtors and assumed by existing creditors, and then maintaining that level unchanged.

Fisher’s solution is simply reflation. If this sounds a lot like the playbook that Bernanke and the Fed are using, that’s because it is. It’s no secret that Bernanke has a profound understanding of the Great Depression. He has already lowered interest rates to 1% and provided liquidity to the markets in creative ways. He and Hank Paulson are trying to incentivize banks to lend again so that we can rebuild confidence in the system. With all that being said, it remains to be seen if any of this will work. Fisher wrote his paper in 1933 and thought we were emerging from the Depression then but it took a few more years. There is still a lot of pain to come for this economy in the near term. There are many years of excesses to be wrung out but we can take some solace in the fact that policy makers are studying their history books.