Comments on the site of origin :Message 1 of 1 , Sep 6, 2008View SourceComments on the site of origin :http://www.rgemonitor.com/financemarkets-monitor/253222/fishers_debt-deflation_theory_of_great_depressions_and_a_possible_revisionCCommentsLB--nice post, informative and timely--ditto the thanks to Prof Roubini
Written by Anonymous on 2008-08-01 01:32:07Excellent post.
Reflatosis: a common condition in economies (societies, systems) that has a tendency to reinforce itself and to gradually increase the deviation from equilibrium.
Until kaboom, if no timely intervention.
Written by Little Saver on 2008-08-01 02:24:09Very well done LB. Thanks you. Not being an economist or in finance, The inflation or deflation debate intrigues me. I rely on the experts but the camps are clearly well drawn. Here we have the deflation gurus like Roubini, Mish, yourself etc and on the other hand we have John williams, Eric Janszen, Bob Chapman thinking of inflation and hyperinflation. Could you provide few dot points as to why you strongly feel that this will end in deflation and not inflation
Written by Ponder on 2008-08-01 03:54:06@ Ponder
I don't discount inflation as a phenomenon resulting from excess credit, but I see it as a prelude to deflation as the credit unwinds. Already we see heavy discounting as retailers come under pressure, and commodity prices are off their peaks as demand and speculation stumble under uncertainty. Inflation follows excess credit, but deflation follows unwinding, and deflation lasts much, much longer (e.g. Japan).
Written by London Banker on 2008-08-01 04:13:05Thanks again LB.
I see that you have the long term outlook. I have sort reached the same conclusion that deflation will prevail. Even John williams concludes that it will be a hyperinflationary depression. so, whether through inflation/ hyperinflation or deflation we seem to be headed for a depression (I think).
for all the gold bugs, would they not lose their investment in gold during deflation? Sorry if my questions are too basic or silly. I am out of my depth here.
Written by Ponder on 2008-08-01 05:01:11Im tempted to coin a new noun for reflation enthusiasm: refllatio?
Is refllatio the noun you wanted to coin?
Written by Detlef Guertler on 2008-08-01 09:09:39A fine essay with a refreshing admission of humanity and we all thank you for it. It's been quite a while since I have read Fisher and intend to remedy that in the near future.
The only disappointment is that your revision was not more extended, bringing your own analysis to bear on Fisher's thoughts, updating them in light of what of course is the most significant change between then and now. It is of course that the Fed has been loosed from external standards, at least nominally, and that creates some interesting twists possibilities that Fisher may have anticipated but did not expound upon.
Written by Jesse on 2008-08-01 11:37:37Thank you LB for exploring this hypothesis. Can you confirm the idea, or provide your thoughts that the fed is caught between a. the unthinkable - igniting more severe deflationary pressure if it raises rates (exacerbating distress selling of assets), and b. the unimaginable - a liquidity trap if it lowers rates without effect? Also, wouldn't stable v. unstable debt deflation at least clean the system but keep it relatively in tact, making it preferrable over hyperinflationary recession where our currency and credibility is possibly destroyed for generations. In other words, could we manage and survive a stable debt deflation?
Written by curious on 2008-08-01 12:49:16Thanks LB for that insightful perspective and how Fisher might today would be in awe of our reflation monster.
Your very scary figure was posted earlier (but I cannot find it now) with a link to analysis. One of the comments pointed out that even though the basic shape of graph is probably valid, it magnitude may be off because of the various definitions of debt and possible duplicated counting may have taken place (sorry, I cannot remember all of the details).
My personal very scary chart is http://research.stlouisfed.org/fred2/series/BORROW Here we see that the lending of the Fed from 1920 to date and the unprecedented jaw-dropping magnitude of $200 billion in loans to depository institutions compared to the last 90 years!
Written by ptm on 2008-08-01 13:47:05John Stuart Mill sentence catches the essence of the troubled times of the crisis, when it is far too late to remedy the pain, but it can still be decided who will bear the consequences of someone else follies. Great choice (BTW: I was almost shocked when I read today's post of Russ Winter starting with the exact same citation http://wallstreetexaminer.com/blogs/winter/?p=1818)
I can only imagine how it burns now to have been in the position to do something, but have failed to see the danger down the road. If it can be of any help, you and your passion are the only positive senses I feel in the word 'banker' anymore.
Written by Alessandro on 2008-08-01 16:03:27The cause of serial bubbles is no mystery to Congressman Ron Paul, Republican candidate for President or for any other Austrian economic thinker. It has not been free markets that have caused serial bubbles and the huge mis allocation of resources but rather the absence of free markets caused by fiat (or forced) used of government defined money rather than allowing markets to define and determine what is used as a medium of exchange.
Conventional wisdom (Keynesian and monetarist in origin) holds that whenever there is market turmoil (usually caused by prior excessive money creation out of thin air) is met with even more money created out of thin air. During Alan Greenspan's tenure at the Fed he pumped so much liquidity into the banking system that bankers were forced to seek more and more absurd ways to try to allocate that money to maximize profits. The result when money is created out of thin air rather than allowing commodity money to prevail is what the Austrians call "mal (bad) investment. The result of Alan Greenspan's monetary promiscuity during the 1990s was bad enough. He created the dot com and telecommunication bubbles which when bursting, resulted in trillions of lost wealth. Those enterprises which were funded with all that funny money, simply were not viable but because of the excess cash wealth was mis-allocated. But the 1990s was child's play compared to what was to come in the politically charged house funding scam that was to follow. And now the piper must be paid. Like it or not, we are heading back to real money -- to gold or silver or some form of money that cannot be created by lies, but must be won from the earth in a very difficult manner.
What has happened with the debasement of the dollar via fiat money has been one of the biggest wealth reallocating scams in history form those who produce wealth--the farmer, miners, manufacturers, inventors, etc. to the politicians and bankers in a fascist arrangement that is not only leading the U.S. into poverty but worse is likely to result in the total loss of our freedoms. And when that happens, a recovery may be many generations away. Such was the message of Ron Paul. But the establishment couldn't laugh at him hard and often enough to try to discredit the Austrian economic truths he was espousing. God help us all as we face what is looking more and more like a hyper inflationary future.
Written by Jay Taylor, Editor J Taylor's Gold & Technology Stocks newsletter on 2008-08-01 16:35:54LB:
First, this is excellent work. I really appreciate the effort and thought that went into it.
Next, it's important to temper the hysteria and fear we're currently experiencing with some recollection of who we are, and what we've accomplished so far as a society.
Let's start by acknowledging that over the past 30 years, we've committed a massive mis-allocation of capital. I see this realization coming to the fore much more frequently lately, and I feel it's the foundational concept for our society's next move. This is easy to see in hindsight, but it wasn't easy to see going forward, at least not until the late 1990's.
It's important to remember that we have tools in place today that can both generate and distribute capital at a pace never before achieved. What was speedily undone can be just as speedily re-done, and re-done much better.
I don't dispute that the devaluation cycle may take hold. But don't for a minute underestimate the alacrity with which the (now worldwide) modern economy can respond, once the direction's set and the need is commonly felt.
With this latest piece, you have clearly and in my opinion quite accurately identified what we, in the West, did wrong. Yes, there is benefit to repetition and amplification, but the others will soon be doing that.
Your calling is at the front lines. The front has now moved to "How to transition from awareness to decision to action". The battle is in a new phase, and there are new tools at the ready. It's time to re-fit the army, and point them at the next hill.
Please engage Dr. Roubini in this discussion. With the help of you and many others, he has succeeded in establishing a forum that has accurately identified "where we are now".
He could be equally successful in establishing an intellectual environment where innovation, R & D, and production could be happening, in addition to the great discussion.
We could be building the "what's next".
Written by OuterBeltway on 2008-08-01 17:40:39So, with reflatio, you're going to have inflation in prices and deflation in the productive economy until there is no productive economy and/or the currency collapses?
Written by Anonymous on 2008-08-01 17:47:39A question I have about all of this is concerning the differences between capital and credit. I have always thought that capital was generated when assets were not immediately consumed, but rather consumption was deferred due to prudence and a longer time horizon. Credit does not appear the same at all. This would seem to be especially the case in a fractional reserve banking system, where one person might place their surplus capital into a savings account, and another borrow it for entrepreneurial uses. The fractional reserve based bank loans out far more capital than it really has on hand. Are we seeing the results of capital misallocation, or instead, a situation where we have a wave of credit desperately looking for a place to land? I am not an economist, nor do I play one on television. I am a perplexed political scientist who has done some reading and contemplation on economics.
Written by DocBerg on 2008-08-01 18:01:41Chapeau LB!
Fishers' theory seems to be reading the unclear thoughts in my head and exposing them in a much succinct and intelligible way and I find his choice of words very accurate: "...over-indebtedness to start with and deflation following soon after"
Although over-indebtedness is inflationary it does not lead to higher prices along the way (probably a partial explanation of why prices remained relatively stable during the previous years compared to the level of accompanying inflation). During a debt unwinding, if any inflation is produced, it will be short lived: Just like an unstable star exploding in a supernova before collapsing in on itself and absorbing everything around it.
OTOH, I find your willingness to question your own convictions and your profession's mission, that only few professionals are ready to undertake away from any unwarranted zeal, remarkable to say the least.
Written by AfA on 2008-08-01 19:33:03IS DEBT ALONE A THREAT?
Recently, Frank Shostak posted the following comment on Fisher's Debt-Deflation Theory on the website of the von Mises Institute:
Written by Flanders on 2008-08-02 07:00:02THE BUBBLE THAT BROKE THE WORLD
by Garet Garrett
Written by Flanders on 2008-08-02 07:29:06THE CAUSES OF THE ECONOMIC CRISIS
von Mises understood the consequences of monetary inflation way before Fisher.
Written by Flanders on 2008-08-02 08:10:32The question is how bad can it be?
I think Japan's case can provide some interesting parallels. The response from the authorities in US and EU has so far been going in the same direction, imho. Japan's bubbles were much greater on one hand in relative terms, but on the over they still had superior manufacturing industry and no deficits or public debt to speak of at the time of the crash. And still now, after almost 20 years they have the biggest public debt to GDP in G8 - a result of massive bailouts. So, US starts with less bubles, but less industry and much more debt.
What's your view on decoupling? Prof is against it 100%, but some people like Soros think overwise(or at lest write so in their books:)) Again, going back to Japan, at the time of the "lost decade" began it's share of global economy was not so different from that of US now or was it?
Kind of lost here, trying to make historical parallels and that does it means for global economy.
Written by flipper on 2008-08-02 10:17:31@ DocBerg on 2008-08-01 18:01:41 Are we seeing the results of capital misallocation, or instead, a situation where we have a wave of credit desperately looking for a place to land?
Both of course.
The benefits received from the outsourcing of production (globalization) and the savings which accrued, were invested in non-productive assets (via US Treasuries/GSEs, leveraged and then into things like real estate and corporate debt Im thinking about the part that went to buy back shares) rather than productive ones (plant & equipment, education, infrastructure, even health care). The failure is on the part of financial intermediaries to identify productive uses when confronted with that windfall.
That has happened again and again as investment follows the conventional wisdom of the time. In the 70s it went to Latin America. And in the 90s it was Asian real estate bubbles. But the place doesnt matter. The difference is between production and consumption.
The problem with the non-productive (consumptive) uses is that in the case of any disturbance you cant work your way out. Thats what non-productive means. You cant turn that investment into producing something better. Or even different.
Its simple for someone stuck in the conventional wisdom mindset of the moment to declare that the risk models were deficient and go back to his desk to rewrite them. That misses to point. As long as loans are made strictly on the basis of the ability to service debt the loan is at risk of those disturbances. The risk models always miss that. By definition the disturbances are unpredictable.
Yet for me to simply blame the failure on financial intermediaries is not satisfactory either. As OuterBeltway says, the front lines have moved. So, when we talk about restructuring the American economy we shouldnt limit ourselves to talking about the finances. Structural change. And present policy is all about propping up this failed system.
The fact is that we just do not have the infrastructure to ascertain and make productive investments. Its costly to do the right analysis. Its much easier to look up someones credit score. The credit score can be automated. The process of separating good ideas from bad ones has yet to be automated. The Kerviels of the world are not going to help us. Trading shares is a zero sum game. Non-productive. The same goes for buying & selling companies. Which seems to be the favorite pastime of our CEOs (compensation package = Kerviel ^n) - non-productive. Pouring more money into already liquid markets non-productive.
Productive investment doesnt require magical technological breakthroughs. There are plenty of opportunities in TROTW for things we take for granted; pollution control equipment, modern health care, workplace safety, and thousands of conveniences of life that are luxuries elsewhere. AND TROTW CAN AFFORD IT! Where do you think that savings has been coming from?
Meanwhile, if you have any money (I dont) and dont want to play their game your money is eroded by inflation. (And perhaps even if you do play.) Dictatorial economics: you will because you must and it would be irresponsible to do otherwise. But there would seem to be an opportunity for someone who could identify better investment options. Think about it. What can you do?
Written by Free Tibet on 2008-08-02 12:25:04@Flanders
thanks for the Frank Shostak article, it's really a great read about today's problems (being written in 2006!).
I still think that forced savings is a big part of the capital mis-allocation, together with central banks looting.
I'll take Shostak on my side of our discussion about money creation ;)
Written by Alessandro on 2008-08-02 12:41:45Is this time different? What nobody can factor in to the whole mess that we appear to be in is technology. It is an unknown that cannot be applied to any model, chart etc. As an example we know for certain that tar sands/oil shale in the US can be harvested at a fraction of the current price for crude. Reserves in Utah alone are four times as large as those in Saudi. This would have the immediate effect of shifting the balance of power back to the US and reversing what Boone Pickens quite rightly refers to as "the largest shift of wealth in history". Imagine what this would do to the world markets, not just the currency markets per se. Overnight the dollar would strengthen beyond imagination, the balance of payments problem mostly eradicated etc. etc. My point is that I admit that the current situation seems like the end of the world as we know it but that assumes the status quo. It will not be the status quo, at least on the technical front. How do I know? Because I am involved in the industry.
Written by Guest on 2008-08-02 12:52:20@ Alessandro,
I am not really against anything Shostak said (if I have the intelligence to comprehend what he is saying) and I think it is an improvement of Fisher's debt-deflation theory: Not all debt is deflationary; it is the expansion of debt beyond what is warranted by real asset/real future output that is ultimately deflationary. Remark that I am not arguing the "end game" result, this is exactly my belief. I am not sure however about the motions that take place just before.
However, as good as Shostak's (or by that matter even Fisher's) explanation ia, I think it is undervaluing two factors: the status of dollar as reserve currency AND the possibility/ abilty for banks and other economic players to delay the unwinding/ liquidation of bad debt even after it became clear it is. My picture of this is a car that is travelling up at 200mph straight towards the edge of a cliff. The car will ultimately dive down, but before that it will continue to "fly" upward for a while and no brakes will stop that motion.
Although I agree with you that institutionalizing savings is a bad thing for the capital allocation decision, saving is a requirement to investment. As argued by Mish sometime the inflationary (and by extension the bad allocation of capital especially from ROTW to the US may be primarily driven by accumulation of reserves by China et al to keep stable currency against the dollar rather than a saving glut). So my usual suspects are:
1- Central banks' easy monetary policies
2- Dollar status as reserve currency
i - The inflationary effects of the first have been masked by the latter
ii - Currently the delayed effects of the extravagant credit expansion due to the first is starting to haunt us (inflation) due to the second one, up until either:
a - All unjustified credit and leverage are completely written down/ defaulted AND easy money by the Fed is no more followed or effective, AND/OR
b - The dollar peg (BWII) is broken
(a) will lead to deflation a la GD I. (b) will lead to devaluation of the dollar against US creditors, geopolitical and import/export des-unbalances (probably good for US future manufacturing) but entails a lot of pain to US in the medium term to buy back their somewhat cheaper debts (medium term enslavement? and foreigners will feel fooled?)
a+b: is that even possible? I am afraid yes if politicians and bankers are buying more time and enacting even more stupid interventions. But I cannot imagine what the result would be
Correct me if I am off and surely I am.
Written by AfA on 2008-08-02 16:21:18Lets review a little history, history that we are sure Fed Chairman Bernanke is familiar with. After the bursting of the U.S. asset price bubble in October 1929, the Federal Reserve engaged in some aggressive reductions in its then-main policy interest rate the New York Fed discount rate. Chart 1 shows that after raising its discount rate from 5% to 6% in August 1929, the New York Fed starting reducing its discount rate in November 1929, ultimately pushing it down to 1.50% by May 1931. The Bank of England basically shadowed the New York Fed in
terms of its policy interest rate actions until the summer of 1931.
In the summer of 1931, there began to be runs on the British pound. In an effort to combat these currency attacks, the Bank of England began raising its policy interest rate, the so-called base rate. In July 1931, the Bank of England raised its base rate by 200 basis points to a level of 4.50%. This did not stop the run on the pound. On September 21, 1931, the Bank of England abandoned the gold standard but, in an attempt to forestall further raids on the pound, raised its base rate another 150 basis points that month to a level of 6.00%. Market expectations began to develop that the Fed would follow the Bank of England in abandoning the gold standard. The United States began to experience a gold outflow. In an effort to stop this gold outflow, the New York Fed raised its discount rate a cumulative 200
basis points in two steps in October 1931 to a level of 3.50%.
In summary, the Fed dropped its rate drastically starting right after the stock market fall, didn't raise them until a currency crisis forced it to, and then limited its raise very carefully. These interest rate moves neither created nor prevented the credit contraction and economic Depression that became inevitable once the credit bubble of the 1920's had reached its peak.
Written by Michael on 2008-08-02 18:05:05I am surpised that nobody has mentioned the Yen carry trade and the unwinding of those positions. Lots of leveraged money went up in smoke in the last two or three years on this unproductive trade.
Written by Guest on 2008-08-02 18:47:39@Guest on 2008-08-02 12:52:20
Thanks for pointing this material (oil shale and tar sands in U.S. West) out to us. For other readers, here is a good place to start looking:
Shale has issues, primary among them is water, energy efficiency of extraction, and of course, carbon poisoning of the atmosphere.
But, it's data that will put "peak oil" people on the defensive. It also underscores Guest's assertion that "the status quo won't be". It'll be different than we expect.
Never a dull moment around here, right?
Written by OuterBeltway on 2008-08-02 20:18:36[oops, I posted this on the wrong forum! Repost]
"I think it is an improvement of Fisher's debt-deflation theory"
The main point in Shostak's article is the difference between money-equivalent debt (demand deposits at banks) and any debt with a maturity date. The expansion and liquidation of money-equivalent debt is respectively inflationary and deflationary, while the expansion or liquidation of any other kind of debt doesn't affect the money supply, independently of the "liquidity" of the debt instrument.
An unsustainable expansion of (non-money-equivalent) debt burned to non productive uses is bad because creditors will suffer enormous losses, but it is not deflationary by itself. Deflation comes from the fact that banks themselves have speculated into unproductive activities and the losses are eating into their reserves.
"Although I agree with you that institutionalizing savings is a bad thing for the capital allocation decision, saving is a requirement to investment. As argued by Mish sometime the inflationary (and by extension the bad allocation of capital especially from ROTW to the US may be primarily driven by accumulation of reserves by China et al to keep stable currency against the dollar rather than a saving glut)."
The whole dollar-peg/reserves mess is a different form of forced savings. The central banks effectively seize the savings of their people by printing and exchange the newly printed yuan for dollars and buy US IOUs. I agree it is no a savings glut, it is looting. And since people have no choice whether to save or not and how to allocate the savings, credit mis-allocation can happen on a massive scale.
"Never a dull moment around here, right?"
Written by Alessandro on 2008-08-03 09:13:19@ Alessandro,
I do agree except maybe on the fact that I think that inflation, and therefore deflation, can come from outside the banking system and that (probably this is the main point where we diverge) reliquification is important in the short/ medium term (especially when it comes to massive speculinvestment in non producing/ unproductive activities)
However, for the forced saving story, now that you explained it, I totally agree with you and can see it was mainly a problem of wording: two sides of the same story??
Written by AfA on 2008-08-03 11:18:56@Alessandro:
This phrase, I think, is what captures the essence of why things went off the rails so badly:
"And since people have no choice whether to save or not and how to allocate the savings, credit mis-allocation can happen on a massive scale."
@LB: What I am gradually realizing is that the "market" isn't really being used to make allocation decisions - the profile of decision-making is acting very centralized, and I'm not seeing any economic or political forum where these massive allocation decisions are getting openly discussed.
If, indeed, these decisions are made by a small subset of the full market "intelligence", you perforce wouldn't get a normal distribution of investment successes and failures. You'd get what we're getting: distortions and excesses.
Let me propose a thought experiment, and I address myself to all thinkers on-deck at the moment. Suppose that:
a. The essence of banker's wisdom (what's a viable business, evaluation of current business conditions, character assessment, quality of mgmt team, etc.) were to be packaged and installed way, way down on the capital-distribution pyramid - right in the same marketplace proximity to the use-of-capital ("local", in every relevant meaning of the word)
b. Suppose this could be done without too much diminution in the quality of the "banker wisdom" - that the banking decision-making was good, it was ubiquitous, it was timely-applied - and the price/performance ratio of this applied knowledge was strongly positive
c. Suppose this "local banker" could tap local, regional, national and global sources of capital, and apply it locally under his/her aegis
Now, my question: what effect would that have on an economy? Would it really tend to move capital toward its greatest use? Would it really make any difference in the boom-bust cycles? If so, why? If not, why not?
I've got a bee in my bonnet about "allocation". I want to generate some alts, but I don't want to alt my way into a worse situation.
Feel free to respond here or, maybe better, at outerbeltway at yahoo dot com. Alessandro, you said something a while back that I want to focus on in a off-line conversation. Please drop me a line directly when you get a free moment. I want to pick your brain about some notion I'm developing.
Written by OuterBeltway on 2008-08-03 13:57:45@ All
I suppose I should have mentioned that moments after posting this I was on my way to a week at the beach to enjoy all the blustery winds, grey skies and wet weather that the British summer traditionally offers this time of year. I come back to find that the best discussion I have ever prompted is going on without me!
There are enough comments to keep me busy for weeks, but as I am committed to family and friends here, I am unlikely to do them justice in the half-hour daily of internet afforded me by the local library guest pass.
I will try to secure more flexible internet access to respond in full either here on the thread or in a follow up post for Friday.
Keep the discussion going regardless.
Written by London Banker on 2008-08-04 10:40:53Great discussion. As usual.
Written by Guest on 2008-08-09 23:55:23Truly impressive,
I read Mises extensively. Certainly missed Professor Fisher work.
Thank you for the great contributions. This one and the rest of them!
Written by François on 2008-08-10 11:20:33I'd like to coin a new phrase: "Cunts are still running the world".
Please weave into these theories the geopolitical dimension, namely petrodollar recycling, Iranian oil bourse challenging dollar hegemony, Plunge Protection Team attempting to manipulate the markets, Fed ceasing to publish M3 data to (blatantly) try and hide the PPT's activities.
The Dollar is living on borrowed time. The U.S. economy is living on borrowed time. And we are ALL living on borrowed time, as long as these CUNTS in Washington are pushing us ALL ever closer to WWIII (Georgia-Ossetia = Russian conflict, naval build-up in Gulf and planned economic blockade of Iran = God knows what).
Sorry for the use of bad language, but hey, "cunt" is a derivative of Latin, and so it is wholly appropriate to use it to describe the house of cards that is the Derivatives Market (aka Cunt's Trick).
Written by Anonymous on 2008-08-21 12:05:02----- Original Message -----From: Michael HudsonSent: Tuesday, August 05, 2008 7:01 PMSubject: [gang8] Debt deflation articleFisher's Debt-Deflation Theory of Great Depressions and a possible revision
Roubini, London Banker | Aug 1, 2008
³Panics do not destroy capital; they merely reveal the extent to which it
has been previously destroyed by its betrayal into hopelessly unproductive
- John Stuart Mill
I have been both a central banker and a market regulator. I now find myself
questioning whether my early career, largely devoted to liberalising and
deregulating banking and financial markets, was misguided. In short, I
wonder whether I contributed - along with a countless others in regulation,
banking, academia and politics - to a great misallocation of capital,
distortion of markets and the impairment of the real economy. We permitted
the banks to betray capital into ³hopelessly unproductive works², promoting
their efforts with monetary laxity, regulatory forbearance and government
tax incentives that marginalised investment in ³productive works². We
permitted markets to become so fragmented by off-exchange trading and
derivatives that they no longer perform the economically critical functions
of capital/resource allocation and price discovery efficiently or
transparently. The results have been serial bubbles - debt-financed
speculative frenzy in real estate, investments and commodities.
Since August of 2007 we have been seeing a steady constriction of credit
markets, starting with subprime mortgage back securities, spreading to
commercial paper and then to interbank credit and then to bond markets and
then to securities generally. While the problem is usually expressed as one
of confidence, a more honest conclusion is that credit extended in the past
has been employed unproductively and so will not be repaid according to the
original terms. In other words, capital has been betrayed into unproductive
The credit crunch today is not destroying capital but recognising that
capital was destroyed by misallocation in the years of irrational
exuberance. If that is so, then we are entering a spiral of debt deflation
that will play out slowly for years to come. To understand how that works,
we turn to Professor Irving Fisher of Yale.
Like me, Professor Fisher lived to question his earlier convictions and
pursuits, learning by dear experience the lessons of financial instability.
Professor Fisher was an early mathematical economist, specialising in
monetary and financial economics. Fisher¹s contributions to the field of
economics included the equation of exchange, the distinction between real
and nominal interest rates, and an early analysis of intertemporal
allocation.. As his status grew, he became an icon for popularising 1920s
fads for investment, healthy living and social engineering, including
Prohibition and eugenics.
He is less famous for all of this today than for his one statement in
September 1929 that ³stock prices had reached a permanently high plateau².
He subsequently lost a personal fortune of between $6 and $10 million in the
crash. As J.K. Galbraith remarked, ³This was a sizable sum, even for an
economics professor.² Fisher¹s investment bank failed in the bear market,
losing the fortunes of investors and his public reputation.
Professor Fisher made his ³permanently high plateau² remark in an
environment very similar to that prevailing in the summer of 2007.
Currencies had been competitively devalued in all the major nations as each
sought to gain or defend export market share. The devaluation stoked asset
bubbles as easy credit led to more and more speculative investments,
including a boom in globalisation as investors bought bonds from abroad to
gain higher yields. Then, as now, many speculators on Wall Street had
unshakeable faith in the Federal Reserve¹s ability to keep the party going.
After the crash and financial ruin, Professor Fisher turned his considerable
talents to determining the underlying mechanisms of the crash. His
Debt-Deflation Theory of Great Depressions (1933) was powerful and resonant,
although largely neglected by officialdom, Wall Street and academia alike.
Fisher¹s theory raised too many uncomfortable questions about the roles
played by the Federal Reserve, Wall Street and Washington in propagating the
conditions for credit excess and the debt deflation that followed.
The whole paper is worth reading carefully, but I¹ll extract here some
choice quotes which give a flavour of the whole. Prefacing his theory,
Fisher first discusses instability around equilibrium and the influence of
'forced' cycles (like seasons) and 'free' cycles (self-generating like
waves). Unlike the Chicago School, Fisher says bluntly that "exact
equilibrium thus sought is seldom reached and never long maintained. New
disturbances are, humanly speaking, sure to occur, so that, in actual fact,
any variable is almost always above or below ideal equilibrium." He bluntly
"Theoretically there may be -- in fact, at most times there must be -- over-
or under-production, over- or under-consumption, over- or under-spending,
over- or under-saving, over- or under-investment, and over or under
everything else. It is as absurd to assume that, for any long period of
time, the variables in the economic organization, or any part of them, will
"stay put," in perfect equilibrium, as to assume that the Atlantic Ocean can
ever be without a wave."
While disturbances will cause oscillations which lead to recessions, he
"[I]n the great booms and depressions, each of the above-named factors has
played a subordinate 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 symptions of these two."
This is the critical argument of the paper. Viewed from this perspective we
may see USA and UK decades of under-production, over-consumption,
over-spending and under-investment as all tending to a greater imbalance in
debt which may, if combined with oscillations induced by disturbances, take
the US and UK economies beyond the point where they could right themselves
into a deflationary spiral.
Fisher outlines how just 9 factors interacting with one another under
conditions of debt and deflation create the mechanics of boom to bust for a
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, 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 ³capitalistic,² 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) 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.
Hyman Minsky and James Tobin credited Fisher¹s Debt-Deflation Theory as a
crucial precursor of their theories of macroeconomic financial instability.
Fisher explicitly ties loose money to over-indebtedness, fuelling
speculation and asset bubbles:
Easy money is the great cause of over-borrowing. When an investor thinks he
can make over 100 per cent per annum by borrowing at 6 per cent, he will be
tempted to borrow, and to invest or speculate with the borrowed money. This
was a prime cause leading to the over-indebtedness of 1929. Inventions and
technological improvements created wonderful investment opportunities, and
so caused big debts.
* * *
The public psychology of going into debt for gain passes through several
more or less distinct phases: (a) the lure of big prospective dividends or
gains in income in the remote future; (b) the hope of selling at a profit,
and realising a capital gain in the immediate future; (c) the vogue of
reckless promotions, taking advantage of the habituation of the public to
great expectations; (d) the development of downright fraud, imposing on a
public which had grown credulous and gullible.
Fisher then sums up his theory of debt, deflation and instability in one
In summary, we find that: (1) economic changes include steady trends and
unsteady occasional disturbances which act as starters for cyclical
oscillations of innumerable kinds; (2) among the many occasional
disturbances, are new opportunities to invest, especially because of new
inventions; (3) these, with other causes, sometimes conspire to lead to a
great volume of over-indebtedness; (4) this in turn, leads to attempts to
liquidate; (5) these, in turn, lead (unless counteracted by reflation) to
falling prices or a swelling dollar; (6) the dollar may swell faster than
the number of dollars owed shrinks; (7) in that case, liquidation does not
really liquidate but actually aggravates the debts, and the depression grows
worse instead of better, as indicated by all nine factors; (8) the ways out
are either laissez faire (bankruptcy) or scientific medication (reflation),
and reflation might just as well have been applied in the first place.
The lender of last resort function of central banks and government support
of the financial system through GSEs and fiscal measures are the modern
mechanisms of reflation. Like Keynes, I suspect that Fisher saw reflation as
a limited and temporary intervention rather than a long term sustained
policy of credit expansion a la Greenspan/Bernanke.
I¹m seriously worried that reflationary practice by Washington and the Fed
in response to every market hiccup in recent decades was storing up a bigger
debt deflation problem for the future. This very scary chart (click through
to view) gives a measure of the threat in comparing Depression era total
debt to GDP to today¹s much higher debt to GDP.
Certainly Washington and the Fed have been very enthusiastic and innovative
in ³reflating² the debt-sensitive financial, real estate, automotive and
consumer sectors for the past many years. I¹m tempted to coin a new noun for
reflation enthusiasm: refllatio?
Had Fisher observed the Greenspan/Bernanke Fed in action, he might have
updated his theory with a revision. At some point, capital betrayed into
unproductive works has to either be repaid or written off. If either is
inhibited by reflation or regulatory forbearance, then a cost is imposed on
productive works, whether through inflation, higher interest, diversion of
consumption, or taxation to socialise losses. Over time that cost ultimately
hollows out the real productive economy leaving only bubble assets standing.
Without a productive foundation, as reflation and forbearance reach their
limits, those bubble assets must deflate.
Fisher¹s debt deflation theory was little recognised in his lifetime,
probably because he was right in drawing attention to the systemic failures
that precipitated the crash. Speaking truth to power isn¹t a ticket to
popularity today either.
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