The Debt-Deflation Theory of Great Depressions

by Irving Fisher

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

Genres: Economics

42 pages, Paperback

First published January 1, 1933

About the author

Irving Fisher was an American economist, inventor, and social campaigner. He was one of the earliest American neoclassical economists, though his later work on debt deflation has been embraced by the Post-Keynesian school.
Fisher made important contributions to utility theory and general equilibrium. He was also a pioneer in the rigurous study of intertemporal choice in markets, which led him to develop a theory of capital and interest rates.[4] His research on the quantity theory of money inaugurated the school of macroeconomic thought known as "monetarism." Both James Tobin and Milton Friedman called Fisher "the greatest economist the United States has ever produced."
Fisher was perhaps the first celebrity economist, but his reputation during his lifetime was irreparably harmed by his public statements, just prior to the Wall Street Crash of 1929, claiming that the stock market had reached "a permanently high plateau." His subsequent theory of debt deflation as an explanation of the Great Depression was largely ignored in favor of the work of John Maynard Keynes. His reputation has since recovered in neoclassical economics, particularly after his work was revived in the late 1950s and more widely due to an increased interest in debt deflation in the Late-2000s recession. Some concepts named after Fisher include the Fisher equation, the Fisher hypothesis, the international Fisher effect, and the Fisher separation theorem.

Reviews

[Rommel Harlequin Monet · Rating 4 out of 5]

THE DEBT-DEFLATION THEORY OF GREAT DEPRESSIONS

BY IRVING FISHER (1933)

INTRODUCTORY

In Booms and Depressions, I have developed, theoretically and sta-
tistically, what may be called a debt-deflation theory of great depres-
sions. In the preface, I stated that the results "seem largely new,"
I spoke thus cautiously because of my unfamiliarity with the vast
literature on the subject. Since the book was published its special con-
clusions have been widely accepted and, so far as I know, no one has
yet found them anticipated by previous writers, though several, in-
cluding myself, have zealously sought to find such anticipations. Two
of the best-read authorities in this field assure me that those conclu-
sions are, in the words of one of them, "both new and important."
Partly to specify what some of these special conclusions are which
are believed to be new and partly to fit them into the conclusions of
other students in this field, I am offering this paper as embodying, in
brief, my present "creed" on the whole subject of so-called "cycle
theory." My "creed" consists of 49 "articles" some of which are old
and some new. I say "creed" because, for brevity, it is purposely ex-
pressed dogmatically and without proof. But it is not a creed in the
sense that my faith in it does not rest on evidence and that I am not
ready to modify it on presentation of new evidence. On the contrary,
it is quite tentative. It may serve as a challenge to others and as raw
material to help them work out a better product.
...

...

I. (7) Mild Gloom and Shock to Confidence
(8) Slightly Reduced Velocity of Circulation
(1) Debt Liquidation
II. (9) Money Interest on Safe Loans Falls
(9) But Money Interest on Unsafe Loans Rises
III. (2) Distress Selling
(7) More Gloom
(3) Fall in Security Prices
(1) More Liquidation
(3) Fall in Commodity Prices
IV. (9) Real Interest Rises; REAL DEBTS INCREASE
(7) More Pessimism and Distrust
(1) More Liquidation
(2) More Distress Selling
(8) More Reduction in Velocity
V. (2) More Distress Selling
(2) Contraction of Deposit Currency
(3) Further Dollar Enlargement
VI. (4) Reduction in Net Worth
(4) Increase in Bankruptcies
(7) More Pessimism and Distrust
(8) More Slowing in Velocity
(1) More Liquidation
VII. (5) Decrease in Profits
(5) Increase in Losses
(7) Increase in Pessimism
(8) Slower Velocity
(1) More Liquidation
(6) Reduction in Volume of Stock Trading
VIII. (6) Decrease in Construction
(6) Reduction in Output
(6) Reduction in Trade
(6) Unemployment
(7) More Pessimism
IX. (8) Hoarding
X. (8) Runs on Banks
(8) Banks Curtailing Loans for Self-Protection
(8) Banks Selling Investments
(8) Bank Failures
(7) Distrust Grows
(8) More Hoarding
(1) More Liquidation
(2) More Distress Selling
(3) Further Dollar Enlargement

Digitized for FRASER

http://fraser.stlouisfed.org/
Federal Reserve Bank of St. Louis

[Michael Wald · Rating 5 out of 5]

If you lived in the 1920s-1930s, you knew Irving Fisher as one of the great living economists. He thought deeply about economics and practical issues affecting the U.S. economy. He had many faults, including a large ego, but his greatest fault was his inability to correctly read the financial markets in 1929 and into the Great Depression. That destroyed his popular reputation, but he was no charlatan. Not only did he believe what he preached, he backed it with his own money, most of which he lost when the Depression took hold.

Having said that, why should we pay attention to him now? Because having floundered in the markets, he continue to analyze what had happened. His Debt-Deflation Theory is worth reviewing, as is his views on how monetary policy is affected by not only amount of funds but also their velocity in the economy. His view that the dollar expands and contracts is a precise way of thinking about inflation and deflation, as is his thoughts on how debt and deflation interact.

When I was an undergraduate, I never heard of Dr. Fisher, mainly because economists had written him off, but if you recognize him as someone who was trying to constantly improve his understanding of markets and willing to update his theories as new information became available, he is worth a serious read.

[kz · Rating 4 out of 5]

Fisher having lost $10million in the stock market crash of 1929 began to think critically of his role in explaining economics and switched from advocating a decentralized, laissez-faire economic policies for the Federal Reserve to put into action to a more centralized version, making him unpopular with leading economists of the time. In this work he shares his Cycle-theory which proposes that the equilibrium that most economists talk about hardly exists and goes to show that any change in one area of the economy is going to affect everything else.

What I like about this reading is that Fisher concedes that Labor is the basis of the economy and that if the Federal Reserve just let the hand of the free market work itself out in 1933 then there would’ve been a political revolution as farmers in the Midwest were already “causing trouble”. Fisher as vaguely alludes to World War 2 being the reason the United States was able to pull out of the depression was by closing debts by selling war-related products and securities to our allies. I mostly think this because he doesn’t think world war 1 had much of anything to do with the depression. As it was caused, in fishers theory, by many entities trying liquidate their debts too quickly, deflating the dollar, increasing the debt.

Overall I liked this work, I’ll have to spend some time delving into some of Irving Fishers other works.

[Ricardo · Rating 4 out of 5]

It's a very short, but great book. It explains greatly how over-indebtedness is one of the main drivers of deflation for an economy. Even though it was written almost a century ago, it's a must-read for dealing with today's economy.

[Mohd Rahman · Rating 3 out of 5]

Some classic thoughts about debt-deflation theory of depressions. This may be extended to recessions as well.

[Dave · Rating 3 out of 5]

I read Principles by Ray Dalio earlier this year and there are similarities between Dalio and Irving Fisher. Both went on to decree changes in the market only to be proven wrong and shamed for years to come. The difference is Dalio is now heralded as one of the most successful hedge fund managers while Fisher was recognized for his genius after his death. I love that the author gives us a brief glimpse into the life of one of the first modern economists and his theories. Good short read.

[Gregg Wingo · Rating 5 out of 5]

Fisher's alternative theory to Keynes's "General Theory" this short work represents his academic rehabilitation and his critical contribution to the foundations of the "Post-Keynesian' school of economics. Being one of the first great neoclassical economists Fisher illustrates in this work that he could not be limited by past work but rather how a great thinker cannot stop but must continuously push for understanding of his field.

This edition is also updated by the reflections of an anonymous English banker and market regulator who speaks of how he like Fisher in the 20s failed to understand how dangerous debt could be when improperly managed for society's benefit. The banker's apologia admits to his role in the deregulation that led to the Great Recession and, again, like Fisher he was swept up in the irrational exuberance of his own Lost Generation.

A quick and informative read for our times and the Fed's current reflationary policies.

[Pedro Almeida Jorge · Rating 3 out of 5]

Make no mistake, this is an important book! Every economics student must read this article by professor Fisher. However, just like in "The Money Illusion", his policy suggestions have proven to be a disaster when applied.

I still give it 3 stars for the importance it has in the economic context of our times, as we are surely in a situation of 'over-indebtedness'. To promote this discussion was indeed worthy of merit. However, the idea that we just need to reflate prices in order to get back to the previous equillibrium is dangerous, to say the least, as our current monetary environment has been showing for almost 10 years.

As hard-hitting as it may seem, the only way to purge a credit expansion with the traits of a Ponzi scheme is through liquidation, the fastest possible liquidation. Every bubble must eventually pop. It wouldn't be a bubble otherwise...

[Toma · Rating 4 out of 5]

After losing a fortune and his reputation in the Great Depression (some $100mil in today's money), Fisher really wanted to understand what had happened. Figuring out the monetary system and its mechanics helped him construct this theory.

[SH C · Rating 4 out of 5]

Really accessible book for casual economists.
Fisher really simplifies down causes of recessions and depressions.
No jargon used.
Extremely relevant to post-GFC economy as central banks try reflate their way out of trouble.

[David · Rating 5 out of 5]

Insightful analysis on the deflationary forces of the 1930's - apropos for the problems facing the world today.