A Forgotten Economist's Theory Comes Back to Life

Happened upon this chart which illustrates the theory of one of America's greatest economists, Irving Fisher, who is now practically forgotten. However, after the crash of 2008, his ideas gained fresh attention, and this chart that illustrates his “Debt- Deflation Theory” should strike a familiar chord with those who understand today's economics. In his book, “Econometrica,” written in 1933, he wrote of nine steps to a deflationary death spiral.

(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, 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.

In 1933, he wrote:

Over investment and over speculation are often important; but they would have far less serious results were they not conducted with borrowed money. The very effort of individuals to lessen their burden of debts increases it, because of the mass effect of the stampede to liquidate…the more debtors pay, the more they owe. The more the economic boat tips, the more it tends to tip.

Continuing in Econometrica:

"Debts of 1929 were the greatest known, both nominally and really, up to that time. They were great enough not only to "rock the boat" but to start it capsizing. By March, 1933, liquidation had reduced the debts about 20 per cent, but had increased the dollar about 75 per cent, so that the real debt, that is the debt as measured in terms of commodities, was increased about 40 per cent[(100% - 20%) X (100%+75%) =140%]."

Those who have followed my earlier pieces on deleveraging, spending, and interest rate policy should find the application of this theory instantly recognizable. Unfortunately for Fisher, perhaps the nation's first "celebrity economist," in 1929 he famously uttered the words that would ruin him professionally and personally: "Stock prices have reached what looks like a permanently high plateau." That was in September of 1929, about a month before "Black Thursday." After that, no one held him in regard, and following his own advice, he was ruined financially. A reminder that even genius fails.

Fisher's theory, although formulated even before the Great Depression began, sounds contemporary, and explains why the recovery is stubbornly slow. With massive amounts of personal capital being used to extinguish debt as quickly as possible, deflationary forces remain in command of the economy, ("the more they pay, the more they owe") which even zero interest rates are hard pressed to overcome. This explains why the Federal Reserve is committed to a policy that will yield an inflationary result. In theory, an outcome that would finally break Fisher's Debt-Deflation Cycle. Hopefully, we're almost there.

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