Fisher's Debt-Deflation Theory

Posted by urbandigs

Thu Oct 23rd, 2008 09:26 AM

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A: Yale economist, and skull & bones member, Professor Irving Fisher is known for a lot of economic principles such as the Fisher Equation, the Price Index, the Phillips Curve, the Money Illusion, and the Debt-Deflation theory which I want to discuss today. For a bio on Professor Irving Fisher, click here. Although he did warn of the 'permanently high plateau' of stock prices only a few days before the great crash of 1929, he believed a recovery was just around the corned and as such, managed to lose most of his personal wealth and his reputation in the multi-year selloff during the great depression. Following the destruction, Fisher analyzed the Great Depression and came up with his debt-deflation theory. Try to take your time reading the below highlighted points, and then take a step back at the environment we are in today and decide for yourself if the theory holds water in todays complex intertwined system of finance.

The entire theory is provided in the link below. What you need to know is that this theory was formulated after an analysis of the Great Depression, and refers to the 'perfect storm' of events that must combine at the right time to have caused such an event. The entire paper is a worthwhile read. As in the paper, I will refer to certain points by the number they are referred to in the paper, so you can easily find them on the link below.

Professor Irving Fisher's Debt-Deflation Theory

19. I venture the opinion, subject to correction on submission of future evidence, that, in the great booms and depressions, each of the above named factors (over-production, under-consumption, over-capacity, price-dislocation, maladjustment between agricultural and industrial prices, over-confidence, over-investment, over-saving, over-spending, discrepancy between saving & investment) has played a subordinated role as compared with two dominant factors, namely over-indebtedness to start with and deflation following soon after; also that where any of the other factors do become conspicuous, they are often merely effects or symptoms of these two. In short, the big bad actors are debt disturbances and price level disturbances.

While quite ready to change my opinion, I have, at present, a strong conviction that these two economic maladies, the detb disease and the price-level disease (or dollar disease), are, in the great booms and depressions, more important causes than all others put together.

20. Some of the other and usually minor factors often derive some importance when combined with one or both of the two dominant factors.

Thus over-investment and over-speculation are often important; but they would have far less serious results were they not conducted with borrowed money. That is, over-indebtedness may lend importance to over-investment or to over-speculation.

The same is true as to over-confidence. I fancy that over-confidence seldom does any great harm except when, as, and if, it beguiles its victims into debt.

21. Disturbances in these two factors -- debt and the purchasing power of the monetary unit -- will set up serious disturbances in all, or nearly all, other economic variables.

22. No exhaustive list can be given of the secondary variables affected by the two primary ones, debt and deflation; but they include especially seven, making in all at least nine variables, as follows: debts, circulating media, their velocity of circulation, price levels, net worths, profits, trade, business confidence, interest rates.

24. 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 selling 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, precipated 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 to 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.

27. In actual chronology, the order of the nine events is somewhat different from the above 'logical' order, and there are reactions and repeated effects. The following table of our nine factors, occurring and recurring (together with distress selling), gives a fairly typical, though still in adequate, picture of the cross-currents of a depression in the approximate order in which is is believed they usually occur:



31. The two diseases act and react on each other. Pathologists are now discovering that a pair of diseases are sometimes worse than either or than the mere sum of both, so to speak. Just as a bad cold leads to pneumonia, so over-indebtedness leads to deflation.

32. And, vice versa, deflation caused by the debt reacts on the debt. Each dollar of debt still unpaid becomes a bigger dollar, and if the over-indebtedness with which we started was great enough, the liquidation of debts cannot keep up with the fall of prices which it causes. In that case, the liquidation defeats itself. While it diminishes the number of dollars owed, it may not do so as fast as it increases the value of each dollar owed. Then, the very efforts of individuals to lessen their burden of debts increases it, because of the mass effect of the stampede to liquidate in swelling each dollar owed. The more the debtors pay, the more they owe.

Noah here. So lets see, first off over-indebtedness and purchasing power of the monetary unit lead to deflation. We certainly had that over the 7-8 years or so as the dollar crashed against other major currencies and credit went parabolic with debt levels rising enormously. This lead to an imbalance of the 9 variables listed above, especially debt liquidations forcing a seizing up of the very marketplace where structured debt products traded. That led to a reduced velocity of circulation, or less lending. Which led to more debt liquidation. Which led to a fall in security prices, and then commodity prices. All at the same time, the dollar has strengthened, which is in-line with this debt-deflation theory!

Clearly, right now, we are in forced liquidation mode, commodities have collapsed, and the dollar has surged which would put us around Level V or VI of the above noted chain of events or consequences of debt-deflation. Keep in mind this paper was written some 70 years ago, yet fits fairly well with our complex system of finance in place today!

As you can see, I dig learning! Thoughts?