“[I]n the great booms and depressions, each of the [most popular explanations] has played a subordinate role as compared with two dominant factors, namely over-indebtedness to start with and deflation following soon after…. In short, the big bad actors are debt disturbances and price-level disturbances.”
Irving Fisher, “The Debt-Deflation Theory of Great Depressions”, Econometrica (October 1933), 341.
While the current maelstrom probably has antecedents in Japan’s 1990s post-bubble malaise and America’s own Great Depression, it has uniquely struck the Internet age – or at least, the Internet blog age. My purpose here is first to clarify the term “debt deflation” much in use among the blogs, but more importantly to ask whether we are on the road to a debt deflation of the kind Irving Fisher described in his 1933 essay.
The first task is not purely semantic. People today have in mind a decline in asset prices when they use the term “debt deflation”. They are confusing a term coined by Irving Fisher’s 1933Econometrica essay with a very different phenomenon. “Debt deflation” as Fisher described it was present during the Great Depression, made a bad recession a true depression, and is not (yet) at play in the current upheaval.
Fisher should have inserted the conjunction “and” between the “D” words in his title, as in “The Debt-and-Deflation Theory of Great Depressions.” Because that’s precisely what Fisher describes: the destructive effect of nominally fixed debt contracts in the presence of a falling general price level. This is “debt-deflation” as Fisher meant it. Why is this destructive? Because if the price level is falling, then so are income streams. And it is from those falling income streams that a debtor must service and repay his obligations – the terms of which are not falling.
Bloggers today rightly worry about the falling price of financial assets. That is surely a problem for the institutions and investors that own them. This is an “asset deflation”; it is not a “debt deflation” insofar as borrowers normally do not enjoy any reduction in the terms of their debt obligations!
Returning to Fisher. Here’s how he posited the unwinding of unusually large debt bubbles, such as that which accumulated up to 1929:
“[A] state of over-indebtedness … 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 “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.”
Fisher goes on to explain that the process can be stopped at one critical link in the chain: the fall in the price level.
In the 1930s, there was indeed an effort to arrest the deflation, and so stop the corrosive debt-and-deflation dynamic. This was Roosevelt’s March 1933 dollar devaluation.
Is the United States today about to enter a period of “Debt (and) Deflation” as Fisher described it? The debt is there; what about the deflation?
There are several ways to think about this. One is deterministic: so long as you believe in the power of the central bank to influence the price level, then you can be sure that our policymaker-in-chief, Ben Bernanke, will ensure there will be no deflation. Bernanke’s work on the Great Depression reveals confidence that a monetary authority can indeed influence the price level even when the policy rate target hits the “zero bound”, i.e. the inconvenience of not being able to push the policy target interest rate below zero. In fact, Bernanke believes the central bank can fight deflation even without pushing the policy rate to zero:
“Perhaps the more important argument for engaging in alternative monetary policies before lowering the overnight rate all the way to zero is to ensure that the public does not interpret a zero reading for the overnight rate as evidence that the central bank has “run out of ammunition.” That is, low rates risk fostering the misimpression that monetary policy is ineffective.”
Bernanke, B. and Reinhart, V., “Conducting Monetary Policy at Very Low Short-Term Interest Rates”,AEA Papers and Proceedings 94:2 (May 2004), 89.
Another way to approach the price level would lead to a less sanguine outlook. The broad point of this approach, which follows Friedman’s dictum that inflation is “always and everywhere a monetary phenomenon”, is that the money supply – extremely broadly measured – is in free-fall. This, after all, is what we should mean by de-leveraging. Credit destruction is reducing leverage in the economy. Step back and think of it in terms of the “equation of exchange”. It holds that money times the frequency with which it’s spent equals the price level times total expenditures.
M * V = P * Q
We’re interested in the price level,
P = MV/Q
Where do you see M, V and Q headed in the next 24 months? Velocity is headed south, as money demand increases. In fact, money demand will be so strong as to counteract any increase in supply by the Fed. What matters most is the outlook for households. If they lose confidence in the banking system, then M really will collapse. That would most assuredly deliver a deflation. In which case, we’d be closer to Fisher’s nightmare than we might like to admit.
Are policy tools enough to counteract the deflationary tendencies associated with a sharp liquidation of financial assets? Japan’s central bank pushed the policy rate right to zero, and then engaged in “quantitative easing” – pushing more money into bank reserves than is required to keep the overnight rate at zero. That programme began in March 2001; prices did not rise with any regularity until October 2004.