Home > Economics > Irving Fisher & debt-deflation

Irving Fisher & debt-deflation

September 11, 2010

Last week Joe Clark gave me a copy of Irving Fisher’s Econometrica article “The Debt-Deflation Theory of Great Depressions” and added a few less than friendly remarks about Fisher. Having just read the article, I can understand why. But instead of pointing out my disagreements, I think it is more valuable to point out what I think are the points of truth in the Fisher thesis.

Fisher suggests that the underlying cause of any large recession (he cites 1837, 1873, 1929) is the twin problems of (1) over-indebtedness; and (2) deflation. These then interact on net worth, profits and trade. Specifically, he points to the problem where de-leveraging (ie paying off debt) leads to deflation, which means the remaining debt is relatively larger… so that paying off debt puts people into more debt. And that makes people sad.

Fisher dramatises the issue (at one point even invoking starvation), but he is right to note the important role of money. As Friedman & Schwartz later showed, it was the sharp tightening of money supply by the Fed (along with the protectionist policies and increased political risk that came from congress) that turned a normal downturn into a “great” depression.

Money is important. Fisher is right to note that a monetary distortion can have devastating consequences on the real economy. This can be explained through Monetarist theory (where people struggle to distinguish between real growth and growth in the money supply) or through Austrian business cycle theory (where monetary distortions leads to mal-investment because different industries react differently to changed interest rates). Either way, a distortion in the money supply leads to a distortion in the real economy.

It is important to understand what “distortion” means here. To abstract from monetary considerations it is necessary to imagine a world with no monetary distortions, so that broad money supply (money base * credit multiplier * velocity) moves exactly in line with total production, so that there is no change in the general price level and all price changes reflect “real” (not “monetary”) changes. Of course, this is an impossible abstraction for many reasons — it is impossible to know exactly how much is being produced, exactly how much broad money exists at any point in time, or how to correctly measure a “general” price level. It is equally fanciful to expect any economic system to be free of monetary distortions. But the idealised abstract is helpful nonetheless.

In this hypothetical world, if the price of apples were to increase we would know that this represents a real change in the world somehow… perhaps there is a craze for apple-pies or maybe there was a storm that negatively affected an apple orchard. The possible cause of “monetary shock” is abstracted out of the equation.

But once we re-introduce monetary shocks into the system, there is forever a threat that a change in price is not a representation of reality, but simply a change in the value of the measuring tool (ie inflation or deflation). When this happens, the resulting change in behaviour can lead to real distortions in the economy. The most common example (provided both in Monetarist and Austrian theory) is when monetary expansion leads to short-term changes in behaviour (over-investment in Monetarist theory, mal-investment in Austrian theory), but these changes are unsustainable in the long-term once price have adjusted and then we have an inevitable correction (ie economic slowdown).

The common theme is that the short-term impact is powerful, but must then be “fixed”. The key difference is that Monetarist theory assumes the fix is a shift in the aggregate behaviour (lower or higher) while Austrian theory notices that the shift can be between sectors (mal-investment). On this point of difference, the Austrians are correct. This is important when we consider the consequence of monetary contractions.

In Monetarist theory, a monetary contraction will lead to under-investment which will eventually be “fixed” through an increase in investment. In Austrian theory, a monetary contraction will lead to under-investment and mal-investment, which will eventually be “fixed” both with some increased investment in the right areas and also some business failures where there was mal-investment. Both agree that monetary contraction can lead to an economic downturn, but the Austrian theory suggests a period of extended pain as the economy later redistributes resources to their “correct” place.

This is all to say why we do not want monetary distortions. Some Austrian economists have taken an aversion to monetary distortions to the extreme, arguing that there should be laws that try to restrict the credit multiplier (ie abolish fractional reserve banking). They argue that the monetary distortions created by changes in the credit multiplier are so severe that they undermine the strength of the economy and so we would be better off without them. They also tend to wrap their arguments up in faulty semantics of “fraud” and neglect the powerful benefit of credit-matching that is achieved through banks. But I think their key mistake is that they over-estimate the sensitivity of the real economy to changes in broad money.

As suggested earlier, the idealised abstract of no monetary distortions is an impossible counter-factual. The truth is that there will always be some monetary distortion in any system, including in the “no credit multiplier” existence. In a gold-currency situation, discovery of new gold will create a distortion. So will the non-discovery of gold if there is an increase in production. And even if those could match, there is no controlling the level of velocity (how often the same piece of money is spent in a time period). And the truth is that it is impossible (without an absurdly totalitarian government) to prevent a credit multiplier.

The truth is that while large monetary distortions cause significant problems in the real economy, small monetary distortions aren’t a big problem. Large distortions can come about through a single large mistake, but they can also come about through an accumulation of minor mistakes when there is an insufficient feedback mechanism.

The important point is that a good monetary system needs to have a good feedback mechanisms to ensure that broad money supply moves roughly in line with production so that there are minimal monetary distortions. This is generally true of gold (if there is “too little” gold then it’s value increases and so there is a greater incentive to find more), and of credit (more productive opportunities means an increased demand, which drives the credit multiplier). It is this sort of self-correcting money that is the goal of “inflation targeting”, and (I believe) would be in the interests of a profit-maximising private currency supplier.

One of the big arguments of monetary policy is which policy will best achieve monetary stability. I won’t comment on that debate now except to say that it certainly isn’t a policy of demand management (ie activist Keynesian policy).

This is all a long way of saying that Fisher is right to worry about how deflation can hurt the real economy, but he was wrong to focus only on deflation instead of looking more broadly at monetary distortions.

There is another point worth quickly noting. If there has been previous inflation, the best policy for the future is price stability at the higher price, not a deflation back to the previous price. The previous monetary distortion is a sunk cost and it is not possible to go back and un-inflate. That will simply be building a new monetary distortion on top of the old monetary distortion.

One example of this is with the 2008 world recession. One of the underlying causes was monetary expansion (mixed with bad regulation and poor risk-assessment) which led to asset inflation in the American housing market. The inevitable correction lead to the world recession. At that point we saw a significant monetary contraction, caused by a drop in the credit multiplier. If the money suppliers had allowed this to occur we would have effectively had two recessions — the first a correction from monetary expansion, and the second as a result of monetary contraction.

The correct response (and the one followed by most money suppliers) was to increase base money supply to offset the drop in the credit multiplier. In other words — cut interest rates. The reason was not (as suggested by Keynesians) to pump-prime the economy… but instead to prevent any further deflationary monetary distortions. This response was a major difference between the “great” depression and recent world recession.

  1. TerjeP
    September 12, 2010 at 11:18 am

    I agree with most of what you have said however there are occasions when reversing a monetary error is a good idea. This relates to the way inflation or deflation propagates through the universe of prices. An extreme example may illustrate the point. Let’s say that the OMO technicians at the RBA had a party one day, got drunk and flooded the markets with new cash. Let’s say this started to show up in nominal prices. The dollar falls by 25%, nominal gold and commodity prices spike sharply upwards. Obviously the price level has shifted. The next day they are sober again so what should they do? I would argue that they should reverse their mistake and bring the price level, in this case for gold and commodities, back down again. They would do this by recalling the cash. If they didn’t do this reversal then bad things would flow. The key issue in play is the fact that a monetary error does not cause an instantaneous shift in all prices but unleashes a process by which, over considerable time, the whole price level will be altered.

    Taking this further one could ask how many days must pass before the drunken mistake shouldn’t be reversed but merely accepted. I’d say the answer could be several hundred days, perhaps even years. The price shift following a monetary shock takes a long time to unravel and a reversal may be better than waiting for the unravelling. Certainly some prices, those constrained by long range contracts (eg office and factory leases) could take decades to unravel. And given wages are sticky the reversing a deflationary mistake would continue to be a good idea for a long time. Although obviously beyond some date a reversal is counter productive.

    This issue has historical relevance. In the gold standard era it was not unusual for governments to go off the standard during wars so they could print cash. After the war they would go back on the standard at the pre war gold price. If the war was short this might be a good idea. Otherwise it may not be wise to go back at the same gold price. At the onset of WWI Britian left the gold standard. Had it returned at the pre war price a few years later things would have figured themselves out with modest pain. However they waited until 1925 before returning to the gold standard and rather than returning at a gold price consistent with the now mostly evolved price level they went back to the pre war gold price from a decade prior. This was one serious stuff up.

  2. Joseph Clark
    September 13, 2010 at 12:51 am

    Very nice. I see that you remain half pregnant on the issue of controlling the money supply. Fisher’s argument, and your partial agreement, boil down to one thing: a belief that the price of money is sometimes wrong and needs support at a particular level. The same logic might be used to defend fixing the price of bananas or hats.

  3. September 15, 2010 at 5:28 am

    I think there is a relevant distinction to be made between “price theory” and “monetary theory”, based on the role of money as a store of value and medium of exchange. Changes in the price of bananas or hats will not distort the price signals of anything… but changes in the value of money will distort price signals for everything. Perhaps we differ on whether we think price signals are important. I think they are.

    • Joseph Clark
      September 15, 2010 at 7:00 am

      I think it comes down to whether you like puppies and rainbows or not. I do.

    • TerjeP
      September 16, 2010 at 7:15 am

      The role money plays as a “store of wealth” and a “medium of exchange” is close to irrelevant because there are a squillion alternatives in use. The key role of money that we ought to be concerned with is it’s role as a “unit of account”.

      John is right then that price theory is important. However not so much because a change in the “unit of account” effects things like bananas buy more because an unstable unit of account makes long term contracts, relationships in other words, far more risky they they would otherwise be. Commerce is built on trust and trust is a hard ask in commerce when nobody knows how long a yard stick will be tomorrow and deliverables can’t be quantified over the long term. Those who operate purely in spot markets need not care about commercial relationships but most of commerce is not like that.

  4. Joseph Clark
    September 15, 2010 at 7:01 am

    “Changes in the price of bananas or hats will not distort the price signals of anything”

    Relative to the value of bananas and hats it will. You’re discriminating against people who choose to use hats as a medium of exchange. Why do you hate freedom so much?

    • TerjeP
      September 16, 2010 at 7:20 am

      Nobody uses bananas as a “medium of exchange” but that isn’t the point. The point is that nobody uses bananas as s “unit of account” when forming contracts.

  5. September 19, 2010 at 12:36 pm

    Touche & mea culpa. I should also have written “unit of account”. I think it’s fair to say that that any medium of exchange with sufficient market share will also be a medium of account… but it’s important to make the point explicit.

    And I agree with Terje that there are reasonable occasions when reversing a monetary distortion would be appropriate. As a rule of thumb, perhaps we could say that the longer it takes to unwind the mistake, then the less of the mistake should be unwound.

    Joe — I was talking about price *distortions*, not price changes. You are quite right that when prices change then prices change. But that is not a distortion. As explained in this post, monetary distortions are caused by changes in the value of money, which has the consequence of weakening price signals. You need to decide whether you think that’s a good or bad thing, puppy-boy.

  6. TerjeP
    September 19, 2010 at 5:04 pm

    I think it’s fair to say that that any medium of exchange with sufficient market share will also be a medium of account

    Not if you want to be accurate. One of the dominate mediums of exchange used these days is the transfer of demand deposit funds, usually by EFT but also possibly by cheque or in earlier eras by promissory notes. Demand deposit funds are not a unit of account but are measured by reference to a unit of account. Thus we will talk of paying dollars even whilst no physical dollars change hands. Dollars, the currency you put in your wallet and call cash, are a medium of exchange and a unit of account, but demand deposit funds are merely a medium of exchange (and store of value).

    Language makes these distinctions subtle but I don’t think you can deal accurately with the issues involved unless the distinctions are explicitly understood and dealt with.

    I like your rule of thumb regarding monetary mistakes.

  7. Joseph Clark
    September 19, 2010 at 10:39 pm

    “Nobody uses bananas as a “medium of exchange””

    Monkeys, Terje? Besides, I accepted bananas as a medium of exchange just the other day. Some idiot swapped one for some circular metal I had in my pocket.

    “I was talking about price *distortions*, not price changes.”

    I know you were, dearest, and nobody is saying they like distortions. What you are saying is you think it’s not too difficult to identify and counteract monetary distortions. I don’t think that.

  8. TerjeP
    September 20, 2010 at 4:28 am

    Just because something is traded that does not mean it is a medium of exchange. Did you receive the banana with an expectation that you would use it in subsequent trade? Or did you just eat it like a monkey would?

  9. Joseph Clark
    September 20, 2010 at 4:35 am

    I did. I exchanged it with my tummy for deliciousness and fulfillment.

  10. TerjeP
    September 20, 2010 at 7:56 am

    Well sure if we get silly bananas are a medium of exchange, a sex aid, a paper weight, a form of nuclear physics, a way to lubricate a bike chain and possibly a telescope. However I thought we were having a sensible discussion not a stupid one.

  11. September 20, 2010 at 1:13 pm

    Terje — I disagree that the distinction between base money and credit matters in this context.

    Joe — You are quite right that many things can be used as money. However you are wrong to imply that all potential forms of money are equal in terms of their impact on the economy. The reality is that certain types of money tend to dominate in an area, and significant changes in the dominant money will cause signficiant distortions in price signals.

    You also wrongly characterise my position. In my post I say that it’s impossible to perfectly keep the value of money stable; you characterise my position as saying it’s “easy” to prevent distortions (John 1, Joe 0). I go on to say that the important thing is to not *create* significant distortions; you characterise this as me saying we should try to *counteract* distortions (John 2, Joe 0).

    My position is simple. A monetary system that creates fewer distortions is preferable to a monetary system that creates more distortions. Your position seems to be (1) denying there are distortions; (2) saying that everything in the world is a distortion; (3) saying that distortions are good; and then (4) denying there are any distortions again.

  12. Joseph Clark
    September 21, 2010 at 5:47 am

    Not saying everything is equal in terms of impact, or that you are ambivalent to the problems of price stabilisation, or that you like drowning puppies and then making puppy stew afterwards. Creating a distortion to counteract another distortion is still creating a distortion, but I’m happy if you want to call it something else because you think it does a good thing.

    As to your position, that’s also my position! What a happy double coincidence!

    I do have a specific example which you might like to ponder: A positive productivity shock will cause deflation, which will mean more real money for people who hold money. If a money supplier inflates to keep prices flat it will transfer wealth from the holders of money (at least, they would have had the wealth) to the holders of assets and the supplier. This will not provide good incentives for people to hold money in future. More generally I don’t think the price level change in this instance should be called a ‘distortion’ at all; I think it’s a perfectly useful market process.

  13. September 21, 2010 at 6:40 am

    You are once again mis-characterising my position. I’m not suggesting “creating a distortion to counteract another distortion”, I’m suggesting “have a system that produces fewer distortions”.

    You example is clearly a distortion, as explained in great detail in the body of this post. You seem to be once again reverting to “denying the existence of monetary distortions”. If you are true to form, your next comment will likely insist that “all price changes are distortions”, and then we can continue this merry dance.

    You are right that adding base money will provide an income to money suppliers. That is effectively the “price” that people pay the money supplier for their service. Though you should also remember that broad money may adjust without actions from the money supplier if the credit multiplier (or velocity) changes. In that instance, the benefit will go to the credit supplier instead of the money supplier.

  14. Joseph Clark
    September 21, 2010 at 6:46 am

    How does that puppy stew taste?

  15. Joseph Clark
    September 21, 2010 at 6:50 am

    As we often say these differences will be settled when we’re both private currency providers. I’ll promise to keep a fixed supply of base money and you promise to cleverly manipulate your supply to keep prices ‘stable’.

  16. TerjeP (say taya)
    September 21, 2010 at 6:53 am

    Terje — I disagree that the distinction between base money and credit matters in this context.

    Your allowed to disagree. It would be nice if you gave reasons.

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