Irving Fisher on Debt, Deflation, and Depression 12 comments
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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.
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This article has 12 comments:
See Ludwig von Mises "The Causes of the Economic Crisis" 1931 if you want to understand the bigger picture as to what causes the problem.
From Page 179:
"The periodically returning crises of cyclical changes in business conditions are the effect of attempts, undertaken repeatedly, to underbid the interest rates ... through the intervention of banking policy—by credit expansion ... —in order to bring about a boom."
von Mises continues:
"All attempts to emerge from the crisis by new interventionist measures are completely misguided. There is only one way out of the crisis: Forgo every attempt to prevent the impact of market prices on production. Give up the pursuit of policies which seek to establish interest rates, wage rates and commodity prices different from those the market indicates."
See: mises.org/books/causes...
Current gub'mint policies to lend our way out of today's over-leveraged problems will only spawn the next crisis in the future.
Fisher had is right, and reflation can prevent an increase in the weight of debt caused merely by changes in the exchange value of money as velocity falls. But that alone does not redress the real misallocations that brought on the crisis in the first place, which are not caused merely by how the investments made in the boom where financed (a mere division of their nominal cash flows among those owning claims on them), but on those cash flows themselves proving insufficient to justify the expenditure first made on them, at the new prevailing rates of commodity interest.
The critical line in the quoted text is that the resulting movement of interest rates in the smash are not simply downward, but instead downward for contract interest and upward for commodity rates of interest. There is such a thing as a commodity rate of interest, and it doesn't restrict itself to "commodities" in the modern financial sense of that term. It means the rate of return on real capital invested in any line of business. This rate *rises* in the smash --- but this is barely noticed, because the rate on an existing claim rising corresponds to a capital loss to the holder of that claim the instant the rise takes place.
In other words, instead of loan offers at 5% chasing prospective returns at 5.5%, with tons of takers, one sees loan offers at 1-3% chasing prospective returns of 15-20%, with no takers to speak of.
The Mises-ean Austrian analysis has no room for this development. The error underlying that whole view is its accounting for capital as a uniform factor of production and its belief that the rate of return on capital will be arbed to equality across all possible uses of capital. It can be formally shown that this results in an overdetermined price system --- one with many more equations than unknowns. It is completely unsurprising that it fails to be seen in actual practice.
Where the Mises-ean, Austrian view is basically correct is in seeing the attempt to lower the rate of return on capital as being behind the cycle; where it is incorrect is in failing to see that this failing, the uniformity of the concept "capital" breaks up. At bottom, Mises too readily equates capital with a historical value (or book), and expects the rate of change in that value to be governed by savings out of income. This isn't what happens and it is plainly an error, a priori. The dominant factor in changes in the value of capital through time is the change in the value of existing capital resources, not net savings being added to a fund thought of as having some natural tendency to precisely preserve its invested value. There is no such tendency.
From a rational actor point of view, the queer thing about depressions is that men pass on loan offers at tiny demanded rates at the same moment the spreads available on riskier investments and their expected future value therefore, have soared. The reason is pavlovian training - men fear what has just hurt them.
The solution is also well known by now - counter-cyclical investment even if it means borrowing to do it. And that has been hardwired into the financing of modern welfare states. It was Minsky who pointed this out in detail.
By the middle of next year, tax receipts are going to plummet. Transfer payments will automatically rise. Stimulus packages and bailout packages and open market operations will add to this. And as a result, government will run massive short term deficits, borrowing from risk averse investors at near zero rates to do so. All of those funds will wind up in the hands of households and businesses.
Those households will desire some increase in their savings rate, and some reduction in their debts, respectively. There will therefore be some lag during which the normal deflationary forces described in the article will operate. But once those one-off adjustments have occurred, there will be massive additional cash flows into their hands at the expense of government (accounting) and risk averse savers (cash flows --- the acquirers of all the new government securities and new bank money created).
Final demand in nominal terms therefore cannot stay down. Just as happened in the 1974 bear market period, it will surprise almost everyone with the speed of its recovery. There will be no great depression in reruns. Keynesian automatic stabilizers will see to it.
Monetarist ideologues and Austrians hate to admit this, because it violates their white-hat and black-hat view of things. But that is entirely in their own minds anyway, purely normative, and has nothing to do with practical economic reality.
Mark my words - in six to nine months, nominal GDP will be growing not sliding, and the whole thing reverses. And borrowing at 3 to lend at 10-15 is going to look in restrospect like a no-brainer trade. Men will wonder that anyone could have failed to see it and act on it, promptly.
Isn't this simply a repeat of what got us into this mess in the first place? Seems like a lot of borrowing at 1/2% (in Yen) and investing at 6% (overpriced mortgages) is what created the need for deflating.
It's easy to claim people should be borrowing at 3% to earn 10% when it only takes a click of the mouse to 'create' that capital to lend.
Under a non-fiat money economy, someone has to SAVE the money to loan out as capital by foregoing current consumtion. You can't just print it up. Capital is a tangible item. It can't be created or duplicated by decree. It represents natural resources and/or labor combined at a profit.
Those who own it either worked for it, or owned the means of production that generated it. They aren't going to lend it out at 3% under deflationary circumstances because it is scarce and many people will be bidding to use it via higher interest rates.
Printing fiat money and lending it out at low interest rates will only result in those funds being utilized in sub-optimal fashion and starting the boom-bust cycle over again.
The Mise-ian solution prohibits fiat creation of capital and requires that real capital be allocated based on willingness of borrowers to pay for its use. The most productive/profitable uses will be able to pay the highest rates of interest and will therefore get access to the limited capital. This directs the limited capital to the most 'useful' activities until such time that profits allow for additional savings.
If JasonC thinks today's capital environment is ripe for plucking he can borrow at 3% and buy some nice Zimbabwe 2 year notes paying 10,000,000%. He'll clean up.
"someone has to SAVE the money"
Suppose you say $10000 out of income, and invest it in some enterprise that fails and goes nowhere, earning a return of -100% in the first year. Does your having saved it first make it retain its book value as your savings? No.
Suppose you instead borrow $10000 at 3% and invest it at 10%, and the 10% investment actually pays the full 10%, and does so for 10 years as you fully repay the debt. Does the fact that you didn't first save it out of income mean its book value and true value and any other magic rabbit's foot value is "really" zero? No.
The value of an investment does not depend on where it came from, but on the success or failure of the investment to deliver the returns the investor envisioned when he made it.
Even if the investment returns exactly the same cash flows as the investor envisioned when he first made it, the value of the investment may be twice what he expected or half what he expected, depending on the level of interest rates used to discount a long stream of future cash flows back to the present.
Capital seeking better returns can go to worthwhile investments or to mistakes regardless of where it came from or how it was funded, likewise. Does an offer to lend to you at 3-5% - currently going begging, clearly - ensure you will invest only in projects earning 6%? Does it make projects earning 10-15% go away? No.
The earnings rate on the capital depends on the capital value of the capital. Leave the future cash flows unchanged but change the price, and the rate earned changes. A 10% investment is not one that ought to be engaged in while some other at 6 isn't, it is merely the same project with a lower price tag.
Price tags on bags of future cash flows are set by investor confidence and behaviors, not by a single interest rate on savings. There is no such interest rate. All the Austrians pretend there is, but this merely shows how busted their whole equilibrium model is and how far from reality. One can in fact prove that there must be a distinct rate of interest in every type of future claim and that the price system is overdetermined otherwise.
Another way of stating this is that no one can arb to equality all rates of return on capital. They are all changing, and the real capital is not fungible enough to switch from use to use faster than capital values fluctuate.
Borrowing at low rates to invest at high rates is capitalism. Saving out of income and expecting a guaranteed return from doing so, and assailing any force that interfers with collecting it, without running any risk, is instead an illusory fantasy. All it does it supply the credit at low rates wanted by the first sort.
No one is harmed in the slightest by such finance, because it is your free choice which side of it you stand on. If you think the rates on safer assets are so low one is a fool to accept them, then you can exploit that by borrowing at those rates instead of lending at them. If on the other hand you think leveraged investments are so insanely risky you'd never engage in them, then you cannot simultaneously castigate others for earning high returns running those risks for you.
The risks are there simply as a function of the real capital itself being entirely at hazard. Its value can all disappear tomorrow, even if every dime was supplied twice over out of real savings --- it is perfectly sufficient for demand to shift to some other commodity. No, you are not ensured by any economic law that you will still receive without fail some magical average rate of interest.
There are no safe investments, full stop. There are none even somewhat safe is calm times without others made less safe through leverage, standing ahead of them in claims and in losses. All investments derive their value from real services they perform for fickle consumers, and depend on their own unstable incomes and wealth. And no arrangement conceivable can change that, in the slightest.
1) Confidence broken, so private equity will be slower then normal to reinvest especially in finance. Also, as it does, it will retool itself towards innovation in upward mobility. This has been lacking for nearly a decade so it will not be an immediate effect.
2) Government did not police the majority of the allocation of liquidity which initially was dumped into commodities, creating further destruction of the consumer, small business which is the driving force of spending and job creation. The accelerating job losses is the effect.
I do believe Washington has finally woken up out of it's denial stage.
Government will sit down and conduct studies as to how to appropriate liquidity, reenact legislation, most likely overdo regulations some and regulatory bodies to boot (although this will add some confidence). This takes time. So I agree with your theory that we will see short term depressionary effects but it will not be a repeat of lengthy depression as we saw in the 1930's. I have stated my forecast often, that the next Bull market is 2013. But there is some incredible bargains right now and in-between. If one was responsible and held cash, one will see once in a lifetime returns. But for now, back to front :)
Solutions to our economic problems require that economists are able to distinguish between:
A. the difference between the supply of money and the supply of loan funds.
B. the difference between means-of-payment money and liquid assets.
C. the difference between financial intermediaries and money creating institutions.
D. recognize aggregate monetary demand is measured by the monetary flows (MVt) not nominal GDP.
E. recognize that interest rates are the price of loan-funds, not the price of money
F. recognize that the price of money is represented by the price (CPI) level.
G. realize that inflation is the most important factor determining interest rates, operating as it does through both the demand for and the supply of loan-funds.
Even so, our problems cannot be totally solved. They can only be ameliorated.
Deflation makes wage declines look worse which is depressing to everyone.
But the basic problem is income and wealth inequality because modern Americans live far better than any human beings have ever lived before and they have no reason to complain about that. They will be jealous, however because it is human nature to be jealous.
The problem for the future will be one of perceptions and ideologies (which are supposed to be dead but aren't.)
The big question will be: Can the working class get enough money to feed themselves, heat and cool their apartments and will their children be provided with schools that give the talented an opportunity to contribute to society?
If not, America will either have a revolution or have the kind of society we see in countries like Brazil.
(However, inflation would finally produce the same result because we Americans are at the end of our tether.)
Economics will not save us, only intelligent action.
God save us from utopian leaders like Hitler and Stalin.
Back to the basic virtues! (God, now I sound like William Bennett who was busted for gambling. Maybe there is a lesson in that :)
Well, have you all ever thought of the counterparty to US?
It's China or Asia.
Where did the inflows come from? From them.
Where did the outflows go? To them.
Now, if the world is as liberal as Friedman envisioned, then everything would have been solved by the invisible hand.
However, in the real world, we've got all sorts of barriers to capital, labor, and goods movements besides the natural geographical and cultural barriers.
Only a TRUE global free market can save this!