“…in the great booms and depressions, each of the above named factors (over production, underconsumption, over capacity, price dislocation, over confidence, over investment, over saving etc.) has played a subordinate role as compared with two dominant factors, namely, over indebtedness to start with and deflation following soon after;… where any of the other factors do become conspicuous, they are often merely effects or symptoms of these two.” (Irving Fisher, 1933, p. 341)
Economists read the literature about the Great Depression with deep intellectual curiosity and savour in particular the still ongoing debate about its causes and remedies. Keynesians argue that price and wage rigidities and a failure of aggregate demand were the main culprits for the biggest economic catastrophe recorded in modern history. Monetarists posit that the main culprit was a terrible mistake on the part of the monetary authority, because it allowed the supply of money to contract. The new generation of Neoclassical economists argue that serious policy mistakes on the “real side” of the economy, such as the deployment of major trade barriers, turned a cyclical downturn into the Great Depression, and that issues of price rigidities, demand failures, credit, or monetary policy are at best of second-order importance.
In a seminal 1933 article, Mr. Irving Fisher offered a very different and innovative view. He focused on the meltdown of financial markets, the devastating effects of a downward spiral connecting the deflation of assets and goods prices, the process of deleveraging by households and firms, and contraction of economic activity.
Until about eighteen months ago, this was just one more of many unsettled economic questions that academic economists love to dwell on, largely because we don’t have a lot of data on Great Depressions to test our theories and because intellectual arrogance prevented us from taking seriously 1990s meltdowns in emerging markets and the Nordic countries as harbingers of what could happen to the US. Today, as we go through the catastrophic process of Fisher’s debt-deflation mechanism, there is no doubt that Fisher was right and the rest are just stories. If anything, we are left wishing prices were rigid!
But declaring a winner in the Great Depression debate is unimportant. The critical issue is to use the diagnosis that Fisher offered in his article – and what we have learned about debt deflations since then – to guide policy making. In this climate of hiring gurus for an ever-growing number of “top” economist posts in the US government, I would be very happy if we could just hire Irving Fisher!
Three lessons from Irving Fisher
Here are the lessons I learned after reading Fisher’s piece again and reflecting on our current dilemmas from its perspective.
Lesson 1: Fiscal stimulus is a band-aid. We need – now and for the next two years –massive government spending to support the unemployed and prevent the implosion of state and local governments. Beyond that, spending will not stimulate anything, and it has nothing to do with the causes of the crisis or with putting an end to it. It is the strong pain killer that the economy needs for the infection that afflicts it, but it is just a pain killer, not a cure. Well-crafted tax adjustments can be useful, but only if targeted to address the deflationary pressures and/or the fragility of the financial system (see Lesson 2). By the same token, trade protection and other similarly “brilliant” ideas floating around need to be opposed. They will do nothing to attack the causes of the crisis, and they could make the recession deeper and more protracted.
Lesson 2: Deflation must be halted and reversed, and the credit system restarted. Today, as in the early 1930s, these two parts of the puzzle are tightly interrelated, as Fisher explained. Deflation will not stop if the collapse of the credit system is not contained, and the collapse of the credit system will not stop until the deflation of asset and goods prices is controlled. A trillion dollars of fiscal stimulus today will not avoid catastrophe if the financial stabilisation fails. Conversely, the sooner a credible, comprehensive, and effective financial stabilisation plan is implemented, the lower the actual cost of “true” fiscal support needed for the social safety net.
Being realistic, however, even if we had this ideal situation in place tomorrow, a major recession – unlike anything most Americans alive today have ever seen – is unavoidable. Catastrophe is here and we will not escape it. But even the 18-to-24-months catastrophe we are in is not the worst outcome. The worst outcome would be a full repeat of the Great Depression. The worst of the Great Depression was not so much the initial economic collapse, as dramatic as that was, but its persistence for several years. This is what we still have time to avoid and where our energy should be invested. The political spin about pushing for reforms and bailouts to “avert disaster” needs to be corrected, so that everyone’s expectations are not biased towards thinking that a trillion dollars of fiscal stimulus means back to business as usual. The emergency is real and present, but not to escape catastrophe. All the numbers we have about employment, production, world trade, the financial system, etc. show that we are already in a catastrophe. The emergency is to avoid the persistence of the stagnation that occurred during the Depression. The emergency is to prevent most of the next decade from looking like 2008.
Lesson 3: Prevention. We got into this mess because financial development advanced way ahead of not only regulators and government officials, but the actors in financial markets themselves, including the geniuses who created the innovative financial products that we have now come to know (and fear) by their acronyms – CDOs, MBSs, CMOs, and the greatest villain of all, CDSs!
Preventing the next debacle, however, requires careful thinking. Imposing regulations and controls that would return the financial system to its 1960s structure would be a major mistake. The challenge is to identify where things went very wrong and plug the deep holes that exist while preserving the enormous potential that the securitisation of financial assets has for enhancing efficiency and standards of living worldwide. A starting point is to recognise that government made two huge mistakes in (a) directing regulators to ignore products like CDSs, by pretending that simply by an act of law they could be declared not to be standard securities or a form of gambling (both of which they were!), and (b) instituting and enlarging the implicit government guarantee backing the fast expansion of mortgage giants Fannie Mae and Freddie Mac. Had the wisdom of people like Mrs. Brooksley Born prevailed in the late 1990s, the CDS market would have been at least supervised, if not regulated. This alone would have saved us enormous pain today, because the jump from the mid-billions problem that sub-prime mortgages were to the mid-trillions debacle we are suffering occurred largely due to the casino-like setup in which AIG and other financial companies conducted the CDS business.
So I end with the lesson that the master himself gave to conclude his article:
“Finally, I would emphasise the important corollary, of the debt-deflation theory, that great depressions are curable and preventable through reflation and stabilisation.” (Fisher, 1933, p. 350)
Irving Fisher, “The Debt-Deflation Theory of Great Depressions,”, Econometrica 1933