Thursday, July 31, 2008

Fisher's Debt-Deflation Theory of Great Depressions and a possible revision

“Panics do not destroy capital; they merely reveal the extent to which it has been destroyed by its betrayal into hopelessly unproductive works.”

- Mr John Mills, Article read before the Manchester Statistical Society, December 11, 1867, on Credit Cycles and the Origin of Commercial Panics as quoted in Financial crises and periods of industrial and commercial depression, Burton, T. E. (1931, first published 1902). New York and London: D. Appleton & Co

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.

Hattip: Steve Phillips for tracing the Mills quote back and demonstrating it wasn't JS Mill as I originally attributed it.

Quotable: To Infinity and Beyond!

"The difference between stupidity and genius is that genius has its limits."
-Albert Einstein

Hattip to P1AQL (the blogger formerly known as Print 1st Ask Questions Later)

Credit Cards Contracting

From Javelin Strategy and Research:

“The sharp decline in credit card spending challenges the popular belief that more Americans are charging basic goods in order to sustain their quality of life,” said Jim Van Dyke, president of Javelin Strategy & Research. “Consumers are making deliberate cutbacks like shopping at superstores, eating out less and watching what they charge. We believe this is because most people have already been impacted by the downturn or they’re anticipating that we haven’t seen the worst of it. It’s very cautious behavior.”

Javelin analysts also found significant cutbacks among credit card issuers. Seven out of ten issuers have reduced efforts to solicit new customers and 62% have cut back the lines of credit they make available to consumers.

“From declining consumer use, rising risk levels, and possible new merchant fee legislation, the credit card industry is taking several hits right now, which could have unintended consequences on Americans,” said Bruce Cundiff, director of payments research and consulting at Javelin Strategy & Research. “If the economy continues to decline, consumers will likely be forced to turn to credit, but find it unavailable when they need it most.”

Tomorrow I'll be writing about debt deflation and how contractions in credit intensify into a deflationary spiral. Hint: It starts when the middle class gets squeezed so hard by wage stagnation that it can't support any more debt.

Monday, July 28, 2008

Signs of Debt Deflation in Commercial Lending

A while back I said that one of the things to watch for was contraction of commercial and trade credit as that would signal the contagion of the financial crisis from the financial economy to the real economy. Here is more evidence that it is going to be ugly out there - and definitely deflationary in due course:

U.S. banks sharply reduce business loans
By Peter S. Goodman, International Herald Tribune

Banks struggling to recover from multibillion-dollar losses on real estate are curtailing loans to American businesses, depriving even healthy companies of money for expansion and hiring.

Two vital forms of credit used by companies — commercial and industrial loans from banks, and short-term "commercial paper" not backed by collateral — collectively dropped almost 3 percent over the last year, to $3.27 trillion from $3.36 trillion, according to Federal Reserve data. That is the largest annual decline since the credit tightening that began with the last recession, in 2001.

The scarcity of credit has intensified the strains on the economy by withholding capital from many companies, just as joblessness grows and consumers pull back from spending in the face of high gas prices, plummeting home values and mounting debt.

I'll be writing more about Irving Fisher's theory of debt deflation as causing the Great Depression in my Friday RGE blog, which I'll cross-post here. Fisher was marginalised and neglected by the Chicago School free marketers, but is well worth reappraising given the way history is repeating itself.

Saturday, July 26, 2008

Quotable: Bastiat, Jefferson and Gandhi

I love good quotes. Now with this blog I have a place to highlight them as I come across them. Some good ones are appearing today over on RGE Blog:

“The law perverted! And the police powers of the state perverted along with it! The law, I say, not only turned from its proper purpose but made to follow an entirely contrary purpose! The law become the weapon of every kind of greed! Instead of checking crime, the law itself guilty of the evils it is supposed to punish!

“If this is true, it is a serious fact, and moral duty requires me to call the attention of my fellow-citizens to it.”

-- Frederic Bastiat, The Law (1848)

Hattip: Guest on 2008-07-25 15:18:16 on RGE Blog

"I believe that banking institutions are more dangerous to our liberties than standing armies. If the American people ever allow private banks to control the issue of their currency, first by inflation, then by deflation, the banks and corporations that will grow up around [the banks] will deprive the people of all property until their children wake-up homeless on the continent their fathers conquered. The issuing power should be taken from the banks and restored to the people, to whom it properly belongs."

-- Thomas Jefferson, Letter to the Secretary of the Treasury Albert Gallatin (1802)
3rd president of US (1743 - 1826)

Hattip: Mike C on 2008-07-25 17:40:32

"The Roots of Violence: Wealth without work, Pleasure without conscience, Knowledge without character, Commerce without morality, Science without humanity, Worship without sacrifice, Politics without principles"

-- Mahatma Gandhi: Indian leader, 1869-1948

Hattip: PeterJB on 2008-07-25 18:24:58

Friday, July 25, 2008

What's up with the covered bond push?

I've been particularly busy this week, nonetheless, I hope to convey enough background on the topic of covered bonds to start a discussion that I think may lead to interesting ideas.

Whenever Henry Paulson at Treasury, Ben Bernanke at the Fed and Shiela Bair at FDIC agree on anything, American taxpayers should check for their wallets to see if they are being mugged. As a result, my eyebrows rose a bit when these three started pressing in concert for covered bond issuance in US markets some weeks ago.

Covered bonds are a huge market of over $3 trillion in Europe, but have never been popular in the USA where securitisation was the preferred model for financing banks. They are perfectly legal and raise no issues, they just haven't been as profitable as securitisation so haven't been supported by the US markets. Covered bonds allow for extension of credit to a bank SIV or trust that will be serviced by income from hypothecated assets on the bank's balance sheet. The assets stay on the bank's balance sheet unless there is a default on the bonds, at which time the assets are forfeit as collateral to the trust vehicle servicing the covered bond.

Last week the FDIC released a policy statement on covered bonds that provides for "expedited release of collateral" if an issuing bank is taken into FDIC receivership or liquidation. The Treasury is expected to release a protocol on best practices for covered bond issuance in a high profile event next week. Hmmmm. What could be up?

If I had to guess, I suspect what we will soon see is something near to the following scenario:

Lists will circulate of troubled banks likely to go into FDIC receivership. Blogs have been full of such lists as of this week, quite suddenly, as it happens. The FDIC has to have a list because there are so many banks approaching insolvency that they are queued for FDIC receivership rather like planes circling Heathrow waiting for runway clearance to land.

Several of the central players in the recent market dramas - particularly those investment banks and hedge funds on close terms with Mr Paulson (naming no names, but initials GS comes to mind) - will go strong and aggressive for the covered bond market. They will go around to their list of troubled banks, which of course they will have compiled independently using Texas Ratio maybe, rather than having any foreknowledge of FDIC concerns. They will issue covered bonds to these trouble banks against any assets with real, proveable value left on the banks' balance sheets. They will be praised to the heavens by their friends in Washington as providing timely and necessary liquidity to a troubled banking system, proving the efficiency of the free market, bravely bearing the risk of new credit in exchange for troubled bank assets.
When the troubled bank nonetheless fails, our golden circle creditors get the good collateral in an expedited release from FDIC under its new policy statement. The FDIC is left with all the toxic waste assets and liability for depositor insurance claims, with no prospect of recovery of any value from the insolvent bank liquidation.

In the corporate sector, we could see the same kind of issuance. Covered bonds will be used to render profitable assets off soon-to-be-bankrupt corporates, leaving pensioners and other creditors with the stripped carcass in the liquidation.

When the FDIC itself becomes insolvent, which it surely must do as this game gets played to its obvious outcome, then the FDIC gets a GSE-style bailout via Treasury finance and the poor taxpayers get reamed again.

Am I too cynical? Is this a genuine attempt to realistically help improve liquidity and prosperity for America's banks? Or are the banks already destined to fail going to be looted and pillaged by the insiders before being burnt, leaving smouldering ruins for taxpayers to contemplate?

I'm not sure on this one, so I'm looking forward to views from those more expert here.

Thursday, July 24, 2008

RGE Refugees Welcome!

It seems that free access to Professor Nouriel Roubini's blog may soon be coming to an end as some regulars have received cryptic e-mails this week. I've set up this blogsite for refugees from the Professor's blog who want to carry on our dialogue over here. I'll be posting my weekly RGE blog here, and probably more informal content in the interim as I feel motivated.

Mostly I just want us to keep those in the sandbox playing happily together.

[UPDATE]: Professor Roubini commented over on my RGE blog as follows:

great you will have your own blog. I am not sure about the source of the rumor that my blog will soon be restricted to only paid users of RGE. That is utterly false; the blog is always free subject to free registration. But it is good you have your own forum. Many congrats. Nouriel
Written by Nouriel Roubini on 2008-07-25 15:39:46

So, no purge! Stop worrying! But come here to chat if you want anyway.