Friday, 10 October 2008

The most important article on financial crashes - by John Ross

Irving Fisher's 1933 paper 'The Debt-Deflation Theory of Great Depressions' is the most important article on the monetary mechanisms of financial crashes of an historic scale, and therefore of related economic depressions, ever written.[1] Unfortunately it is not possible to reproduce it in Socialist Economic Bulletin as it remains in copyright. Anyone who wishes to thoroughly understand the mechanisms of the current financial crisis should however understand it and if possible acquire it. [2]
Fisher's paper deals with the monetary mechanisms of financial crashes and economic depressions. It does not deal with their causes. The paper outlines the monetary consequences which follow from a state of affairs namely: 'assuming... that at some point in time, a state of over-indebtedness exists.' Fisher simply assumes that, without explaining why, such a state exists and what, therefore, follows from it. The explanation of why such a state exists in the current case is given below. But first the core of Fisher’s analysis of what then occurs will be set out.
Fisher notes, with two striking but precise metaphors, of the ‘rocking chair’ and of the ‘capsizing boat’, the consequences of disruption of economic equilibrium. He then explains the mechanisms by which the two differ.
First Fisher notes the naive assumption is frequently made that all economic oscillations tend to equilibrium. He believes that they do in fact do so in ‘normal’ economic cycles: ‘We may tentatively assume that, ordinarily and within wide limits, all, or almost all, economic variables tend, in a general way, toward a stable equilibrium. In our classroom expositions of supply and demand curves, we very properly assume that if the price, say, of sugar is above the point at which supply and demand are equal, it tends to fall; and if below, to rise.
‘Under such assumptions, and taking account of "economic friction," which is always present, it follows that, unless some outside force intervenes, any "free" oscillations about equilibrium must tend progressively to grow smaller and smaller, just as a rocking chair set in motion tends to stop.’ However he points out that under certain specific circumstances another type of deviation from equilibrium can take place: ‘There may be equilibrium which... is so delicately poised that, after departure from it beyond certain limits, instability ensues, just as, at first, a stick may bend under strain, ready all the time to bend back, until a certain point is reached, when it breaks. This simile probably applies when a debtor gets "broke," or when the breaking of many debtors constitutes a "crash," after which there is no coming back to the original equilibrium. To take another simile, such a disaster is somewhat like the "capsizing" of a ship which, under ordinary conditions, is always near stable equilibrium but which, after being tipped beyond a certain angle, has no longer this tendency to return to equilibrium, but, instead, a tendency to depart further from it.’
Fisher then outlines the vicious circle which occurs when the consequences of such ‘over indebtedness’ set in: ‘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... (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.... (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 labour. 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.’ We will not deal in this post with the adequacy of the measures proposed by Fisher, or current attempts by the monetary authorities to deal with this as the purpose is to outline clearly the mechanisms Fisher analyses.
To see the relation to the present crisis consider more carefully what is ‘over indebtedness’? It is not a quantitative issue of the simple arithmetic scale of debt. Debts, and assets, always exist in an economy.
Exxon, for example has vastly greater debts than any ordinary individual but that does not mean Exxon is necessarily in a state of ‘over indebtedness’ compared to an individual as Exxon also has vastly greater assets than any individual. If a company, individual, government or any institution has large debts but equally large, or larger, assets no problems exist, and if an individual has in comparison to Exxon tiny debts, but these are greater than their assets, then the individual is ‘over indebted’ but Exxon is not. In short, what is crucial is the balance between debt and assets – that is it is an issue of the balance sheet.
‘Over indebtedness’, the consequences of which Fisher analyses is, an issue of the relation of debts to assets, not of the absolute level of debt.
Once this is grasped then how the present state of ‘over indebtedness’ in the current financial crisis was ignited is clear and has been analysed in previous posts on this blog. The core of the present financial crisis is that the dollar is overvalued compared to the real competitive potential of the US economy, that is compared to any market equilibrium, and has been increasingly overvalued for approximately twenty years. Consequently all assets held in dollars are also overvalued. As those dollar denominated assets eventually begin to adjust downwards towards their real international values this means they no longer counterbalance the weight of debt which has been offset against them – this crisis, of course, logically breaking out in the weakest, that is most clearly overvalued, part of the asset chain, that is sub-prime mortgages. ‘Over indebtedness’ is then created as assets will no longer support the existing weight of debt. At this point all the mechanisms analysed by Fisher begin to set in.
As the balance sheet of the private sector institutions collapses, that is their assets are now worth less than their liabilities due to the decline in asset prices (that is they are ‘over indebted’) private sector lending dries up under the impact of two processes. First, due to potential or actual insolvency as regards their own balance sheets private institutions are no longer in a position to lend. Second, as they know others also face similar threats of insolvency, private institutions are no longer willing to lend to each other. The processes analysed by Fisher then produce violent contractions of private sector credit – precisely the processes seen today in the paralysis of the interbank lending market, the virtual halt of mortgage lending and all the other manifestations of the financial crisis.
As noted Fisher’s is an explanation of mechanism, not of cause. He explains what will occur if a certain state comes into existence not why it in fact comes into existence. But it is a magisterial exercise in monetary economics and should be required reading for anyone who wishes to thoroughly understand the mechanisms of the present financial crisis.


[1] Fisher's is an analysis of major financial crises of the scale of 1873, 1929 or the present one. It is not a theory of normal oscillations in the business cycle as he makes clear.
[2] Irving Fisher’s ‘The Debt-Deflation Theory of Great Depressions’ may be purchased online for £6 from the
British Library or for $10 from JStor.

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