Debt Deflation

By James H. Nolt

My blog on “The Great Crash” two weeks ago mentioned Irving Fisher, the Yale economist who days before the great stock market crash of 1929 proclaimed that “stock prices have reached what looks like a permanently high plateau.” Fisher is still widely taught today for his not very prescient pre-crash theory of the “Fisher Effect,” but largely ignored in modern textbooks for the work he did on debt deflation after his eyes were opened by the Great Crash.

The “Fisher Effect,” argues, roughly, that real (inflation adjusted) interest rates should be roughly constant overt time, but the nominal interest rate we see is the real rate plus the effect of inflation. Thus, for example, if the real interest rate (yield) “should” be, let’s say, 3 percent for safe government bonds, and the actual (nominal) yield is 5 percent, then that is because creditors expect the inflation rate will be about 2 percent, so that their real return will be 3 percent after accounting for the 2 percent fall in the value of money because of inflation. (I am dubious about the implication of a “natural” real interest rate, but more on that in future blogs.)

So what does the Fisher Effect imply when nominal rates are zero or even negative, as some European government bonds were during recent weeks? It implies that creditors expect deflation. In other words, they expect average prices to fall rather than rise, and therefore money in the future will buy more than it does now. Continuing the example of a real interest rate that should be 3 percent, then a zero percent nominal yield on European bonds means creditors expect an average 3 percent per year decline in prices, something we have not seen much since the Great Depression of the 1930s.

Now this gets us to Fisher’s post-crash work, including a 1933 book, The Debt Deflation Theory of Great Depressions. In that work, Fisher explains why falling prices are such a nightmare. Ordinary people, especially older people, often wistfully remember when a movie cost a dime and a nickel bought you a candy bar. What’s so bad about falling prices?

Of course, falling prices mean falling incomes for the businesses selling all those goods and services. Businesses facing falling income generally cut wages to maintain profits, but so far that seems ok. I remember economics teachers saying, “So what if all prices and incomes were half or all were double? Nothing would really change.”

Fisher says that common idea is wrong. One thing does not change. Nearly all debts from home mortgages to business loans to bonds have a contract value specified as a fixed money quantity. If prices and incomes fall in money terms but all debts stay fixed, many debtors are in trouble. They have to pay the same debt with less income. The most bullish investors with the most debt are in the most trouble. Shrinking incomes must continue to pay the cost of debts that have maintained their value, or face bankruptcy.

Thus changing price levels are hugely important, but by far the main reason is not the reason given prominence in most economics textbooks. The main reason is that changes in price level change the relative value of debts and incomes. When prices decline, the relative burden or debts increases as the value of those debts for creditors increases. That is, deflation engineers a vast transfer of wealth from debtors to creditors. Bulls are punished; bears are rewarded.

Price inflation, of course, has the opposite effect. It transfers wealth from creditors to debtors. That is why creditors, led typically by bankers, fight inflation vigorously. Creditors own loans that lose their value as inflation increases. Debtors, on the other hand, benefit from having the burden of their debts inflated away. Inflation increases the value of incomes and real estate, while decreasing the relative value of debts.

I first realized how important this is politically when I read journalist William Greider’s book, Secrets of the Temple, about the dramatic reversal of U.S. inflation from the highs of the 1970s to the lows of the 1980s. Greider explains why this was so bad for the home-owning mortgage-owing middle class. During the 1980s, I also met and learned much from one of Greider’s informants, economist Robert Johnson, currently president of the Institute for New Economic Thinking, which is sponsoring some of the most innovative research in economics today.

I disagree, however, with the main thrust of Greider’s book in pointing his finger principally at the Federal Reserve, America’s government-sanctioned central bank. The Fed is indeed a powerful institution with some influence over things like the level of money prices, and therefore the balance of power between debtors and creditors, between bulls and bears. But what Greider and many other critics of the Fed ignore is that the power to fight inflation does not reside only in governmental central banks. The price level is influenced, but not controlled, by Fed policy.

During the last third of the nineteenth century, long before the Fed was founded in 1913, at a time when government-sponsored central banking existed nowhere, the longest deflation in world history occurred. This was during the heyday of laissez faire liberalism. Governments did little to regulate economic affairs, and yet even without action by government, inflation and deflation both occurred, including this one very long period of deflation, punctuated by several sharp depressions with worldwide impact. Economists will tell you it all has to do with the gold standard and the relative supply of gold, but that is only part of the story.

Although the value of money can be pegged to a certain quality of gold or silver, as it was then, this does not fix the prices of everything else. Inflation or deflation can still occur, largely influenced by the availability of credit. If credit is cheap and widely available, investment and other forms of private spending boom, tending eventually to drive prices up. When credit becomes expensive (high interest rates) and loans hard to get, (or when credit is “tight”), then demand contracts and prices fall.

Economists teach that the price level is all about the “money supply,” but it is not. Much of demand depends on the availability of credit. Credit can expand or contract independent of the supply of money, however measured. In fact, paper money is just one form of circulating credit. Other forms include bills and bonds, which we have discussed in previous blogs. There are also non-circulating forms of credit, which is simply allowing customers to defer payment, creating what accountants call “accounts payable.”

When credit expands faster than real output, a bullish boom is stimulated. The prices of some things must increase, but which prices increase depends on the specific character of the boom. If you are a wise bull, you own or produce whatever assets are increasing in price. When credit contracts, prices fall. Bears who know what prices to short will make a killing. As average prices fall, the value of debts increases. Creditors gain wealth. Some debtors fail. Their assets are expropriated in bankruptcy proceedings or “fire sales.”

We are taught to believe that economic downturns are bad for everyone, but they are not. Next week we will revisit the question of how private creditors, such as banks, can influence price levels bearishly in their own interest.



James H. Nolt is a senior fellow at World Policy Institute and an adjunct associate professor at New York University.

[Photo courtesy of Alexander Stein]

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