In 1929, just before things went south in Wall Street, Irving Fisher made a public claim that stained his spotless academic reputation. Days after claiming that stock prices had reached a permanently high plateau, the stock market crashed, followed by the Great Recession. Although he developed pioneer work in areas such as quantity theory of money and theory of interest, both widely applied and developed throughout the last century, his unfortunate statement drove the spotlight away from him and towards economists like Keynes. While barely noticed by the public at the time, it has been in the light of the current recession that some of Fisher’s work has received a renewed wave of attention, particularly his Debt-Deflation Theory of Great Depressions that attempted to explain recessions.
This work by Fisher puts debt and deflation at the heart of recessions. For Fisher, debt is the problem, or more specifically, debt-fueled investments made during the booms. Why? Because the loans taken up by firms and households during booms – periods where access to credit is widespread – are usually stated in rigid debt contracts whose terms and nominal value don’t change in the face of fluctuations in prices. Then, when this debt-fueled bubble bursts, agents are over-indebted and will rush to sell their assets in the open market, in what’s called a fire sale. Since so many people are trying to sell a bunch of assets at the same time, these assets will be transitioned at much lower prices (relative to their underlying quality value) and inevitably end up in less productive hands – what Fisher called supply side changes. So after selling assets for, let’s say, half their price, there will be less money circulating in the economy, meaning, the money supply will contract. In this situation of mass bankruptcy, these supply side disruptions can last for a long time: in a world with animal spirits where people are reluctant to trust each other, companies and entrepreneurial agents can’t go out there and borrow readily, which constitutes a real barrier to restart the economy.
The question that follows is of course: how then can future recessions be avoided? For a man who favored very limited government intervention, Fisher’s answer for this question is, curiously enough, a monetarist one: in the wake of Benjamin Strong – the chairman of the Federal Reserve Bank of New York who first supported a leaning against the wind monetary policy – Fisher argued for the importance of controlling prices as the most relevant tool for avoiding debt-deflation crisis. Namely, he believed the monetary authorities should aim to produce reflation (getting the price level back to its pre-deflation level), leading one to speculate that Fisher would have been sympathetic to the idea of boosting money supply in the context of the recent financial crisis to try to keep the economy on track (what we call discretionary monetary policy).
This is not to say that Fisher’s theory is a perfect fit for the current situation. Skeptics might claim that the financial crisis that started at the end of 2007 did not result in a major deflation in consumer prices, which would be inconsistent with Fisher’s model. Yet, while the size of the fall in prices might be debatable, even if we consider it was not significant, we could always hypothesize that the Federal Reserve’s monetary and fiscal measures prevented hyper deflation. The fact is, Steve Keen, acclaimed for soundly predicting the financial crisis, drew many notions from Fisher’s Debt-Deflation theory. Like Fisher might have suggested, Keen claims that the current global economic crisis is the result of too much debt.
Decades after his death, debt-deflation theory has become one of the main works associated with Fisher’s name. Time and context have washed away some of the skepticism that Fisher’s unfortunate approach in 1929 generate and it is now fascinating to see a century-old theory from one of the most notable classicists managing to make its way into current economic discussions.
Filipa Canas & Margarida Anselmo