"Panics do not destroy capital; they merely reveal the extent to which it has been previously destroyed by its betrayal into hopelessly unproductive works."
- John Stuart Mill

I have been both a central banker and a market regulator. I now find myself questioning whether my early career, largely devoted to liberalising and deregulating banking and financial markets, was misguided. In short, I wonder whether I contributed - along with a countless others in regulation, banking, academia and politics - to a great misallocation of capital, distortion of markets and the impairment of the real economy. We permitted the banks to betray capital into "hopelessly unproductive works", promoting their efforts with monetary laxity, regulatory forbearance and government tax incentives that marginalised investment in "productive works". We permitted markets to become so fragmented by off-exchange trading and derivatives that they no longer perform the economically critical functions of capital/resource allocation and price discovery efficiently or transparently. The results have been serial bubbles - debt-financed speculative frenzy in real estate, investments and commodities.

Since August of 2007 we have been seeing a steady constriction of credit markets, starting with subprime mortgage back securities, spreading to commercial paper and then to interbank credit and then to bond markets and then to securities generally. While the problem is usually expressed as one of confidence, a more honest conclusion is that credit extended in the past has been employed unproductively and so will not be repaid according to the original terms. In other words, capital has been betrayed into unproductive works.

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.

Like me, Professor Fisher lived to question his earlier convictions and pursuits, learning by dear experience the lessons of financial instability.

Professor Fisher was an early mathematical economist, specialising in monetary and financial economics. Fisher's contributions to the field of economics included the equation of exchange, the distinction between real and nominal interest rates, and an early analysis of intertemporal allocation. As his status grew, he became an icon for popularising 1920s fads for investment, healthy living and social engineering, including Prohibition and eugenics.

He is less famous for all of this today than for his one statement in September 1929 that "stock prices had reached a permanently high plateau". He subsequently lost a personal fortune of between $6 and $10 million in the crash. As J.K. Galbraith remarked, "This was a sizable sum, even for an economics professor." Fisher's investment bank failed in the bear market, losing the fortunes of investors and his public reputation.

Professor Fisher made his "permanently high plateau" remark in an environment very similar to that prevailing in the summer of 2007. Currencies had been competitively devalued in all the major nations as each sought to gain or defend export market share. The devaluation stoked asset bubbles as easy credit led to more and more speculative investments, including a boom in globalisation as investors bought bonds from abroad to gain higher yields. Then, as now, many speculators on Wall Street had unshakeable faith in the Federal Reserve's ability to keep the party going.

After the crash and financial ruin, Professor Fisher turned his considerable talents to determining the underlying mechanisms of the crash. His Debt-Deflation Theory of Great Depressions (1933) was powerful and resonant, although largely neglected by officialdom, Wall Street and academia alike. Fisher's theory raised too many uncomfortable questions about the roles played by the Federal Reserve, Wall Street and Washington in propagating the conditions for credit excess and the debt deflation that followed.

The whole paper is worth reading carefully, but I'll extract here some choice quotes which give a flavour of the whole. Prefacing his theory, Fisher first discusses instability around equilibrium and the influence of 'forced' cycles (like seasons) and 'free' cycles (self-generating like waves). Unlike the Chicago School, Fisher says bluntly that "exact equilibrium thus sought is seldom reached and never long maintained. New disturbances are, humanly speaking, sure to occur, so that, in actual fact, any variable is almost always above or below ideal equilibrium." He bluntly asserts:

"Theoretically there may be -- in fact, at most times there must be -- over- or under-production, over- or under-consumption, over- or under-spending, over- or under-saving, over- or under-investment, and over or under everything else. 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."

While disturbances will cause oscillations which lead to recessions, he suggests:

"[I]n the great booms and depressions, each of the above-named factors has played a subordinate role as compared with two dominant factors, namely over-indebtedness to start with and deflation following soon after; also that where any of the other factors do become conspicuous, they are often merely effects or symptions of these two."

This is the critical argument of the paper. Viewed from this perspective we may see USA and UK decades of under-production, over-consumption, over-spending and under-investment as all tending to a greater imbalance in debt which may, if combined with oscillations induced by disturbances, take the US and UK economies beyond the point where they could right themselves into a deflationary spiral.

Fisher outlines how just 9 factors interacting with one another under conditions of debt and deflation create the mechanics of boom to bust for a Great Depression:

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 in nine links: (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. 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) 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.

Evidently debt and deflation go far toward explaining a great mass of phenomena in a very simple logical way.

Hyman Minsky and James Tobin credited Fisher's Debt-Deflation Theory as a crucial precursor of their theories of macroeconomic financial instability.

Fisher explicitly ties loose money to over-indebtedness, fuelling speculation and asset bubbles:

Easy money is the great cause of over-borrowing. When an investor thinks he can make over 100 per cent per annum by borrowing at 6 per cent, he will be tempted to borrow, and to invest or speculate with the borrowed money. This was a prime cause leading to the over-indebtedness of 1929. Inventions and technological improvements created wonderful investment opportunities, and so caused big debts.

* * *

The public psychology of going into debt for gain passes through several more or less distinct phases: (a) the lure of big prospective dividends or gains in income in the remote future; (b) the hope of selling at a profit, and realising a capital gain in the immediate future; (c) the vogue of reckless promotions, taking advantage of the habituation of the public to great expectations; (d) the development of downright fraud, imposing on a public which had grown credulous and gullible.

Fisher then sums up his theory of debt, deflation and instability in one paragraph:

In summary, we find that: (1) economic changes include steady trends and unsteady occasional disturbances which act as starters for cyclical oscillations of innumerable kinds; (2) among the many occasional disturbances, are new opportunities to invest, especially because of new inventions; (3) these, with other causes, sometimes conspire to lead to a great volume of over-indebtedness; (4) this in turn, leads to attempts to liquidate; (5) these, in turn, lead (unless counteracted by reflation) to falling prices or a swelling dollar; (6) the dollar may swell faster than the number of dollars owed shrinks; (7) in that case, liquidation does not really liquidate but actually aggravates the debts, and the depression grows worse instead of better, as indicated by all nine factors; (8) the ways out are either laissez faire (bankruptcy) or scientific medication (reflation), and reflation might just as well have been applied in the first place.

The lender of last resort function of central banks and government support of the financial system through GSEs and fiscal measures are the modern mechanisms of reflation. Like Keynes, I suspect that Fisher saw reflation as a limited and temporary intervention rather than a long term sustained policy of credit expansion a la Greenspan/Bernanke.

I'm seriously worried that reflationary practice by Washington and the Fed in response to every market hiccup in recent decades was storing up a bigger debt deflation problem for the future. This very scary chart (click through to view) gives a measure of the threat in comparing Depression era total debt to GDP to today's much higher debt to GDP.

Certainly Washington and the Fed have been very enthusiastic and innovative in "reflating" the debt-sensitive financial, real estate, automotive and consumer sectors for the past many years. I'm tempted to coin a new noun for reflation enthusiasm: refllatio?

Had Fisher observed the Greenspan/Bernanke Fed in action, he might have updated his theory with a revision. At some point, capital betrayed into unproductive works has to either be repaid or written off. If either is inhibited by reflation or regulatory forbearance, then a cost is imposed on productive works, whether through inflation, higher interest, diversion of consumption, or taxation to socialise losses. Over time that cost ultimately hollows out the real productive economy leaving only bubble assets standing. Without a productive foundation, as reflation and forbearance reach their limits, those bubble assets must deflate.

Fisher's debt deflation theory was little recognised in his lifetime, probably because he was right in drawing attention to the systemic failures that precipitated the crash. Speaking truth to power isn't a ticket to popularity today either.

Thank you, Professor Roubini, for being brave enough to challenge orthodoxy before the crash, and for being generous enough to share your forum so that we can collectively address the causes and consequences of financial excess today.

Hattip: Robert Dimand, Department of Economics Brock University St. Catharines Ontario Canada for all of his efforts to rehabilitate Fisher's debt deflation theory.

Hattip: The Federal Reserve Bank of St Louis for making Fisher's entire 1933 paper from Econometrica available online in PDF.

Hattip: Guest on 2008-07-29 21:10:21 for the debt/GDP chart.

Hattip: SWK/Kilgores for suggesting a post on Fisher.