Fisher’s Debt Deflation Theory of Financial Crises

This post is the third part of lecture 8 of Advanced Macro L08C: Fisher’s Debt-Deflation Theory of the Great Depression. In previous segments of this lecture L08A: Micro-Foundations for Keynesian Economics, and L08B: Keynesian Explanation for Great Depression: Seriously Incomplete, we examined the Keynesian explanation for the Great Depression, and found serious deficiencies in it. L08A explains that many different kinds of outcomes, with and without unemployment, are possible depending on how we specify details of the micro-structure that Keynes failed to specify. L08B explains that a simple deficiency in aggregate demand created by savings does not suffice to create unemployment because savings of current period is income/wealth of the next. It is necessary to look at abnormal savings, together with fixed prices, to create surplus production which signals shortfall in aggregate demand to the producers. Thus, many elements – micro-structure, role of debt, and different sectors of the economy – must be added to the Keynesian model to achieve the outcome of unemployment due to shortfall in aggregate demand that is at the center of Keynesian analysis.

This post deals with the last segment of the lecture, which explains Fisher’s Debt-Deflation theory of inflation. The lecture goes through and explains the article: Fisher, Irving (1933), “The Debt-Deflation Theory of Great Depressions”, Econometrica – making only minor commentaries. The goal is to understand what Fisher was saying, before attempting analysis, critique, and extensions. Many elements of this explanation are crucial to understanding the Great Depression, but are not available in the standard Keynesian analysis. Recently, elements of this theory have been picked up and presented as “Fisher-Minsky-Koo approach: Debt, Deleveraging, And The Liquidity Trap: A Fisher-Minsky-Koo Approach”  Gauti B. Eggertsson and Paul Krugman: The Quarterly Journal of Economics,Vol. 127, No. 3 (August 2012), pp. 1469-1513. In this lecture, we only present Fisher’s original paper. Post covers portion of lecture from 37m to 1:15m.

Summary of Fisher’s Econometrica paper on Debt-Deflation.
Fisher starts with an insight which comes straight from the experience of living through the Great Depression. An economic system is complex, subject to numerous conflicting forces acting simultaneously and repeatedly through time. It is unlikely to ever be in equilibrium. It is unfortunate the modern economics rejects this fundamental insight.

Fisher starts by asking how we can study disequilibria? In theoretical terms, the answer is to look at the forces which are acting in a given economic situation. Instead of looking at the long run outcome of how these forces would be resolved to arrive at equilibrium, we should use historical experience to judge the relative speed and strength of these forces. This would be a radically different methodology from the one currently in use in economics today.

By using this methodology, Fisher comes to the conclusion that the Business Cycle is a myth. There are many different kinds of economic forces which create multiple cycles. The complex of of forces can acting in tandem or at cross purposes. There are three types of tendencies (forces) – both cyclical and non-cyclical: (1) Those which create growth; (2) Those which create random fluctuations; and (3) Those which create cycles – these cycles can be stable and unstable, and they can be due to  (or interact with) internal factors, or external shocks to the economy.

He compares the economic system to a boat, which can resist small waves, but will capsize in a major storm. The system can accommodate small cycles, but may fall into crisis in big ones. There are some economic variables which can systematically deviate from equilibrium values. He names Capital Stocks, Real Income, Prices. In particular, Say’s Law is regularly violated. The production of goods can be in excess, or deficient, both in stocks and in flows. Forces in temporary disequilibrium will determine what happens next. Overshooting or Undershooting targets for production is common. BUT – this is NOT the cause of BIG disequilibria. The CENTRAL diagnosis of Fisher is the following:

The biggest cause of economic crises is: Too little money (too high price) mistaken for excess of goods!!

NOTE: This resonates with Friedman’s insufficient money supply explanation. Also, the Keynesian explanation, both of which work with short run fixity of prices.

In arriving at this diagnosis, Fisher lists and considers many common factors which lead to disequilibrium, and rejects them as sources of major crises. He then focuses attention on the Big Bad Actors – Debts and Deflation – as the cause of crisis. H says that the Apparent Causes are Over-Investment & Over-Speculation – this was obvious to all in the aftermath of the Great Depression. But Fisher thinks that the real Harm is caused by UNDERLYING debt which is used to finance this activity.

The mechanism which Fisher outlines starts with excess debt taken in a booming economy. Since assets like land, stocks are booming, people are happy to take debt at low interest, planning repay from the gains they make due to rapidly rising prices of stocks and real estate. Banks are happy to lend because they have the valuable asset as collateral for the loan, so even if the lender cannot repay, they will be able to cover their costs by selling the asset. Since banks create the money they lend, there is no check on the process, and loans increase geometrically leading to a situation with excess debt.

At some point, the bubble bursts. This is generally caused by failure of nerve of some party – either the banks, or the lenders. As indebtedness increases, people take loans to repay interest on past loans, and eventually, a steady stream of failures to repay emerges to public notice. At this point some people panic and start selling their assets, which sets off a chain reaction. As people sell to pay off loans, money supply contracts, and loans become less available. Now people who were relying on borrowing to repay previous loans start defaulting, or start to sell assets to cover loans. As more and more people sell assets, asset prices collapse. The collapse of prices leads to DEFLATION. Deflation increases the value of money, so that the debt burden becomes heavier. Paradoxically, the attempt to pay off debt puts people deeper into debt.

Balance sheets of banks, and firms, contain assets which are priced according to their market prices (This is called Mark-to-Market in accounting terminology). When stock and real estate prices collapse, the net worth of banks and businesses can become negative. Similarly, mortgage loans go under-water; they have negative equity. In simpler terms, this means that the value of house you own is less than the amount of loan you must pay to the bank to get ownership of the house. In this situation, it pays for the homeowner to declare bankruptcy and walk away from the loan and the house. Similarly, businesses whose net worth has become negative can collapse. This leads to panic and loss of confidence about the future in the general public. As expectations about the future become negative, people stop investing, business stop producing and lay-off employees. Heavily indebted people lose incomes and ability to pay off loans. Negative expectations about the future become self-fulfilling prophecies.

In the “Fisher” Sequence of events which leads to major crisis, Fisher says that two diseases – excessive debt, and price deflation – act together to create crisis.The effort to pay off debt leads to falling asset prices, which leads to further increase in real debt, and decrease in ability to pay. This is a vicious cycle which leads to collapse. Either one of the two forces acting individually would tend to return the system to equilibrium. The system can take small shocks and return to equilibrium, but large shocks, acting in tandem, lead to collapse.

Some Comments on Fisher’s Debt-Deflation paper

Fisher attempts to define “over-indebtness” which would lead to crisis, but failed to do so satisfactorily. Here Hyman Minsky made a major contribution. Minsky identifies three stages of debt in the business cycle. In the first stage, people & firms borrow to invest, and their stream of earnings is enough to pay off the interest and the principal. In the second stage, earnings are not sufficient to pay the principal, but enough to pay interest. Now loans are re-financed when the principal is due. In the third stage, earnings streams are not even sufficient to repay interest, and borrowing is done to pay interest on the loan. This last stage is what Fisher wanted to define as “over-indebtedness”, but failed to do.

He attempts to quantify the size of loans relative to assets/income available to repay. He writes that debts in 1929 were at historically highest known levels. By 1933, debts reduced by 20%, Prices decreased by 55%. Value of dollar increased by 75% — real debt increase 40%. This provides support for his key hypothesis: As you pay off debt, you go deeper into debt

Fisher offers the solution as price reflation, breaking one of the two components of the vicious cycle. He thought that if we could take policy actions to prevent prices from falling, or to put them back up to pre-crisis levels, then the economic system would find its way back to equilibrium. However, subsequent authors have cast doubts on this, suggesting that the levels of debt are so high that they cannot be repaid, even if assets do not lose their value. Thus the only solution would be to require debt-forgiveness.

The Wikipedia entry on Debt-Deflation provides a good summary of key points of Fisher’s thesis, and also its influence on subsequent work, and later developments. In fact, Fisher’s theories were ignored and neglected in favor of Keynes for a long time, prior to revival of interest in the 1980s. One of the reasons for this neglect was the idea that debt did not matter. What is a debt of one person is an asset of the other, so debts cancel. This mirage – that debts do not matter – continues to mislead economists. It is the large-scale inability to repay debts which is ignored in this picture.

As debts mounted up, Fisher’s Debt-Deflation theory has enjoyed a resurgence in popularity. It seems clear from a lot of research that levels of debt play a very important role in leading to financial and economic crises. For example, Atif Mian and Amir Sufi in House of Debt, highlight the role of leveraged debt as a key factor in the Global Financial Crisis. “Deflation”, or a dramatic fall in inflated asset prices, also plays a major role, and when combined with leveraged debt, this creates the catastrophic combination that Fisher identified. In retrospect, it seems that the widely accepted Keynesian explanation for the Great Depression was seriously incomplete, and Fisher identified some key elements missing from Keynes. For an update on Fisher, see:   DEBT, DELEVERAGING, AND THE LIQUIDITY TRAP: A FISHER-MINSKY-KOO APPROACH  by Gauti B. Eggertsson and Paul Krugman, in The Quarterly Journal of Economics,Vol. 127, No. 3 (August 2012), pp. 1469-1513

Last Portion of Lecture 8 – from 1hr 15m onwards

The last portion of the lecture  L08D Friedman-Schwartz   discusses the Friedman-Schwartz book on the Monetary History of the United States, which puts forth yet another diagnosis for the reasons of the Great Depression. They argued that it was the sharp contraction in the money supply that was responsible. This diagnosis was the one that was actually followed by Bernanke during the Global Financial Crisis, who massively increased money supply via Quantitative Easing programs. This did prevent financial collapse, but could not prevent the Great Recession, invalidating the Friedman-Schwartz hypothesis about the causes of the Great Depression. Furthermore, as a result of Quantitative Easing, reflation of asset prices has also occurred, which was Fisher’s proposed remedy. This has not proven very satisfactory, in many different ways. Of the two problems, Fisher thought that taking care of Deflation would suffice, but it seems to be only half of the remedy. The other half is the “Debt”, which can be removed by various methods, such as debt-forgiveness.

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