Friday, October 26, 2012

Fisher on Debt Deflation

This paper of Irving Fisher (1867–1947) is now a classic:
Fisher, Irving. 1933. “The Debt-Deflation Theory of Great Depressions,” Econometrica 1.4: 337–357.
This is where Fisher expounded his theory of debt deflation, or at least the paper people generally cite.

Yet it was not in fact Fisher’s first statement of the idea. Fisher’s theory was first stated in his Yale lectures in 1931, and then in a talk before the American Association for the Advancement of Science on 1 January 1932 (Fisher 1933: 350, n.). It was then published in his book Booms and Depressions: Some First Principles (London, 1933).

Even Fisher admitted that Thorstein Veblen’s book The Theory of Business Enterprise (in chapter 7) came close to a prior debt deflation theory (Fisher 1933: 350, n.).

Fisher also mentions Ralph Hawtrey and Frederic L. Paxson (University of Wisconsin) as other forerunners of the debt deflation idea, though their theories were far from complete, and Fisher still claimed a degree of originality and sophistication not seen in earlier theories (Fisher 1933: 350, n.).

Fisher described his 1933 paper as “embodying … my present ‘creed’ on the whole subject” (Fisher 1933: 337).

Fisher viewed business cycles as caused by many factors or forces, both exogenous and endogenous (Fisher 1933: 338). It is noticeable that Fisher had still not completely freed himself from general equilibrium theory, even in his 1933 paper, for he could write the following:
“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.” (Fisher 1933: 339).
Nevertheless, it “is as absurd to assume that, for any long period of time, the variables in the economic organization, or any part of them, will ‘stay put,’ in perfect equilibrium, as to assume that the Atlantic Ocean can ever be without a wave” (Fisher 1933: 339).

Fisher rejects Say’s law and accepts that general overproduction at certain times is a reality (Fisher 1933: 340).

Fisher saw two factors as playing a major role in the business cycle: (1) over-indebtedness and (2) deflation “following soon afterwards,” and regarded the economic crises of 1837, 1873 and 1929–1933 as important examples of debt deflationary episodes (Fisher 1933: 341). The excessive debt may cause over-investment and over-speculation in the boom (Fisher 1933: 341).

According to Fisher we have the following steps in a debt deflationary crisis:
“(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 [that is, price deflation – LK]. 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 1933: 342).
This description is of course a model, and in real life the order, intensity, effects and interrelations of the factors above may be different in any actual recession or depression (Fisher 1933: 342 and 344).

Fisher was also quite clear that deflation alone in an environment without great private debt does not necessarily cause economic disaster:
“Likewise, when a deflation occurs from other than debt causes and without any great volume of debt, the resulting evils are much less. It is the combination of both-the debt disease coming first, then precipitating the dollar disease-which works the greatest havoc.” (Fisher 1933: 344).
By the end of the paper, Fisher turns to solutions to debt deflation, and his cure is “reflation” or price stabilisation (Fisher 1933: 346–348), a cure he appears to think can be achieved mainly by monetary policy. We see here how Fisher wrote before the Keynesian revolution and the turn to the importance of fiscal policy.

Fisher, Irving. 1933. Booms and Depressions: Some First Principles. George Allen and Unwin, London.

Fisher, Irving. 1933. “The Debt-Deflation Theory of Great Depressions,” Econometrica 1.4: 337–357.

Raines, J. Patrick and Charles G. Leathers. 2008. Debt, Innovations, and Deflation: The Theories of Veblen, Fisher, Schumpeter and Minsky. Edward Elgar, Cheltenham and Northampton, MA.

Veblen, Thorstein. 1904. The Theory of Business Enterprise. Charles Scribner’s Sons, New York.


  1. "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."

    An interesting and much undiscussed aspect of the theory. Very relevant to today.

  2. What is the modern manifestation of Fisher's theory. Is it the balance sheet recession guys?

    1. I suppose there are 3 modern developments of the theory:

      (1) Minsky's financial instability hypothesis

      (2) Steve Keen's work

      (3) Richard Koo's balance sheet recession approach

      This does not include neoclassical work, however.

  3. Did Fisher miss the government intervention in the market part?
    Velocity is a meaningless economic concept. What's important is the value that comes from a trade not the number of trades in any given period of time.
    The "level of prices" is also meaningless. Prices change in a heterogeneous fashion and never in a uniform direction but an average of all those heterogeneous changes is just as meaningless.
    Fisher describes the obvious the seen but completely ignores the unseen.

  4. "Did Fisher miss the government intervention in the market part?"

    Red herring.

    "Velocity is a meaningless economic concept."

    On the contrary, if it were meaningless it could not be defined in a coherent/clear way. It can. And it is also a real concept.

    "The "level of prices" is also meaningless"

    I see! So you have no way to know whether the average level of prices is going up or down: and therefore no basis whatsoever to complain about the *alleged theft* from price inflation.

    In fact, it follows that nobody has ever suffered from loss of purchasing power of their money from price inflation as measured by a CPI because "an average of all those heterogeneous changes is just ... meaningless"?