Interpretations from Irving Fisher and Joseph Schumpeter 1. Introduction

The role of banks in crisis occurrence: interpretations from Irving Fisher and Joseph Schumpeter

Timothée Coulibaly1 and Matthieu Llorca2

Draft version

Paper to be presented at the 23rd ESHET Conference (2019) at Lille

Abstract: This paper investigates the relationship between money creation by banks and economic and financial crises occurrence with a particular focus on the works of Schumpeter and Fisher. What first stands out in the analyses of ideas of both authors is, their disagreement concerning the roles that banks play in crises occurrence in the financial sector. For Schumpeter (1911; 1939), money creation by banks allows for economic development whereas for Fisher (1935) it worsens economic fluctuations. Differences in research agenda of the two authors make it possible to reconcile these viewpoints and identify common causes as well as aggravating factors to crises. Subsequent sessions of this paper explore approaches that could offer options to reduce the likely occurrence of crises.

Keywords: Schumpeter; Fisher; Banks; Crises; Cycles

1. Introduction

Since the global financial crisis of 2008, it is observed that there is a renewed interest in scholarly literature in the analysis of economic and financial cycles; and the relationship between both concepts, also called macro-financial linkages (Claessens et al., 2012)3. Several authors showed evidence of negatives effects of financial crises on economic activity suggesting causality going from financial factors to real factors (Jordà et al., 2013). Financial crises are often followed by recessions with severe decline in economic activity and slow recovery than normal recessions. Causality also goes from real sector to financial sector. Real

1 [email protected]. Laboratoire d’Economie de Dijon (LEDi) | University of Bourgogne Franche-Comté 2 [email protected]. Laboratoire d’Economie de Dijon (LEDi) | University of Bourgogne Franche- Comté 3 Borio (2014) provide a review of empirical studies of macro-financial linkages. 1

business cycles theory explains economic fluctuations largely by real factors. Financial factors play little or even no role in these fluctuations. This bidirectional link makes a need for better understanding of macro-financial linkages. An important cause of financial crises recognized in literature is credit boom (Demirgüç-Kunt and Detragiache, 1998; Schularick and Taylor, 2012; Drehmann et al., 2012; Aikman et al., 2014). This suggests a role of banks in crises occurrence. Credit booms often end with financial crisis followed by negative effects on economic activity. Through financial accelerator, financial sector can amplify economic shocks (Bernanke et al., 1999). When agents in real sector have financial constraints, their financial leverage to financial sector become large, thereby increasing linkages between real and financial sectors.

Theoretical literature on the function of banks in the economy focuses the analysis on intermediation function. Banks are intermediaries whose business is to collect deposits and undertake maturity and liquidity transformation regarding their information provision4. Money creation has little place in these analyses despite the fact that banks create money (Werner, 2014). This function of banks is recognized by central bankers, heterodox economists following Keynes and several authors of twentieth century including Fisher and Schumpeter (Jakab and Kumhof, 2015; Werner, 2016)5. Money creation is done through credit creation. This suggest therefore a link between money creation by banks and credit boom.

An issue arises on the role of money creation by banks in occurrence of economic and financial crises and cycles. It is then important to take into account money creation by banks in analysing macro-financial linkages and cycles. This can be done through Fisher and Schumpeter’s works, considering that they describe the practice of money creation by banks; give an explanation of the role of banks in economic fluctuations; and provide solutions to alleviate fluctuations. Schumpeter shows an important role of banks in economic development through money creation. Banks are not simple intermediaries but their money creation function allows for economic development by extending means of payment of the economy. Banks create money to finance entrepreneurs carrying innovative plans. These new means of payment

4 See Diamond and Dybvig (1983); Diamond (1984); Bond (2004). Fama (1980) shows that when competitive, banks’ activity is compatible with general equilibrium and Modigliani-Miller theorem on the pure irrelevance of pure financing decisions. Bhattacharya and Thakor (1993) provide a review. 5 Schumpeter (1954) mentions that the idea that money is not irrelevant in the economy prevails among economists in twentieth century. 2

create an ad hoc situation that enables entrepreneurs to pursue new forms of production and realise “different combination of means of production” (Schumpeter, 1911, p. 65). According to Schumpeter (1911), determinants of cycles are related to real factors. Through, his creative destruction concept, he further shows that cycles and crises are normal phenomena in economic development process. In contrast, for Fisher money creation by banks amplifies cycles and explains large economic fluctuations and depressions. In The Purchasing Power of Money (Fisher, 1911), he shows that variations of money have only effects on price level in the long term. This suggests there are no effects of money on production in long term. In his 1930’s works, Fisher shows that price level fluctuations are caused by money creation by banks. Inflation and deflation are induced by money creation by banks thus, the root causes of inflation and deflation are the negative effects of economic decisions that is reflected through money creation by banks: This ability of banks to create money causes runs and panics on banks. According to Fisher, solution to economic fluctuations and crises, would come from banking reforms which should aim to confine banks to their intermediation function and return monetary creation prerogative to public authorities. Schumpeter’s proposals have not shared much on how to avoid crises as he sees crises as normal occurrences; however, he shared views to alleviate fluctuations and crises causing by factors that he called “abnormal process”. In this respect, similarities can be noted in both authors’ ideas about economic fluctuations. Schumpeter’ abnormal process can be related to Fisher’ over-indebtedness stated in the latter’s debt-deflation theory. Another difference between the authors is related to their difference in research agenda. The starting point of cycles corresponds with innovation according to Schumpeter and Fisher. But Schumpeter’s aim is to find “real” factors of economic development whereas Fisher identifies monetary factors of economic fluctuations.

We begin in section 2 by presenting the theoretical roles of bank in both authors’ ideas, specifically we examine the roles of money creation and the money creation practices by banks. In section 3, we present determinants of cycles and crises, and how both scholars analyse the role of money creation by banks as cause of economic fluctuations; correspondences are also showed. Section 4 provides proposals to deal with economic and financial crises.

2. Role of bank and money creation

2. 1. Bank according to Schumpeter

The role of banks according to Schumpeter is related to economic development. In his Theory of Economic Development, Schumpeter (1911), explains economic development with the concept of stationary equilibrium. In this regard, the economy is considered as a real economy of exchange. Property is private and the economy is characterized by labour division and free competition. Economic activity is as a circuit and is consistent with Say’s law. In this sense, he says that “… a demand is, so to say, ready awaiting every supply, and nowhere in the system are there commodities without complements” (Schumpeter, 1911, p. 8). Circuit is static because agents’ behaviours are not subject to significant changes. Production is made by following producer’s experience based on past quantities requested and prices. A need for money comes about when determining value of goods produced in relation to production factors; labour and land (Schumpeter, 1911, pp. 30-31). Circuit replicates itself or is extended through an increase of population or a renunciation of present consumption in favour of a rise in the production of goods to get more goods in the next period. Banks’ function in this circuit is to provide a better allocation of savings (Schumpeter, 2005, p. 157).

Banks’ activities would thus consist an optimal allocation of savings. Schumpeter offers an explanation of economic development in which innovation plays a key role. According to him, innovation is “the setting up of a new production function” (1939, p. 87). The term covers introduction of new products or production methods, opening of new markets and new forms of organization. Through innovation, the amount of goods and services produced increases when using the same proportion of factors of production6 as those used in a static economy. The increase in production through “new combinations” of factors of production is done by a special category of economic agents namely entrepreneurs. For Schumpeter, it is the entrepreneur who innovates and allows the circuit to extend or move. Entrepreneur in Schumpeter idea refers not only to an individual person but also to new companies created to make new combinations. The circuit is no longer static but becomes dynamic when innovative plans are achieved by entrepreneurs. The rate of profit expected by entrepreneurs with the

6 Factors of production are labour and land essentially. 4

implementation of the innovation is higher than the market rate of profit. In order to achieve the “new combination”, entrepreneurs need existing factors of production that is, as the economy is static, these factors are intended to be used by existing firms. In this sense he argues that “..., the carrying into effect of an innovation involves, not primarily an increase in existing factors of production, but the shifting of existing factors from old to new uses” (1939, p. 111). Under these conditions, it is therefore necessary to divert production factors from their existing use and to devote them to the realization of the “new combination”. To do this, Schumpeter indicates that a solution for entrepreneurs is to obtain means of payment, thus allowing them to use existing factors of production.

“Entrepreneurs borrow all the “funds” they need both for creating and for operating their plants- i.e., for acquiring both their fixed and their working capital. Nobody else borrows. Those “funds” consist in means of payment created ad hoc” (Schumpeter, 1939, pp. 110-1).

The role of banks in economic development appears at this level of analysis. Entrepreneurs borrow from banks to use factors of production. The role of banks, which was limited in the static circuit to that of financial intermediaries, collecting and allocating savings, will consist of creating new means of payment allowing entrepreneurs to produce. He presents it this way “… this creation of means of payment centres in the banks and constitutes their fundamental function, we find agrees with the prevailing conception.” (Schumpeter, 1911, p. 98).

Banks, by increasing the means of payment of the economy, enable a momentary reduction of the purchasing power of economic agents. In this way, entrepreneurs “divert” production factors available to old firms and realize innovative production plans.

“Only the entrepreneur then, in principle, needs credit; only for industrial development does it play a fundamental part …” (Schumpeter, 1911, p. 105). However, firms other than entrepreneurs will use bank credit. Economic development is characterized by alternating phases of prosperity and recession. In the prosperity phase, Schumpeter distinguishes a first phase during which entrepreneurs implement new combinations. The innovation initiated by them is followed by others firms. Schumpeter calls this phase “second wave”. During this phase, whether existing firms or new firms, these firms that replicate innovations implemented during the first phase can also use bank credit. Finally, it can be stated that entrepreneurs

implementing innovation allow economic development. But this evolution in capitalist economies occurs through monetary financing of banks.

Monetary creation by banks to finance economic development requires banking institutions with selection capabilities. Indeed, “the banker’s function is essentially a critical, checking, admonitory one” (1939, p. 118). In this respect, the delegated monitoring function stated by Diamond (1984) is consistent with Schumpeter’s conception of the banking institution. Bankers must select borrowers and monitor borrowers’ activity until the completion of their project. Long-term relationships are necessary in this sense. To achieve this, Schumpeter stated that bankers must be independent of entrepreneurs and public authorities.

2. 2. Banking according to Fisher

Monetary creation through bank is also present in Fisher’s analysis. In 100% Money (1935), he describes the monetary creation activity of banks. Banks create money by extending credits beyond the initial amount of deposits available to them. This creation is limited by the possibilities of insolvency and illiquidity. Reserves requirements also help to curb monetary creation of banks. In bank institutional aspect, he perceived bank as “substantially a cooperative enterprise, run for the convenience and at the expense of its depositors” (1911, p. 41). With credit activity, the risk that depositors should bear is borne by shareholders in exchange for dividends.

Fisher, on the other hand, makes a distinction between the practice of banking and role banks should play in the economy. Practically, banks create money ex nihilo through bank credit in response to demand from agents. However, according to Fisher, banks should simply be an intermediary collecting deposits and granting credits at an amount not exceeding the deposits collected. Fisher (1911), indicates that banks can create money by discounting effects. This creation has a real base because it is done at the request of the economic agents. In this way, it makes it possible to extend the means of payment in the economy and facilities transactions among agents. He presents it in these terms: “Through banking, he who possesses wealth difficult to exchange can create a circulating medium” (Fisher, 1911, p. 41).

To grasp this role of banks Fisher (1911), posits the trade equation in The purchasing power of money as a fundamental point. The role of bank is closely linked to that of money. The 6

equation of exchange shows relationship among the means of payment (M and M’), the velocity of circulation (V and V’), level of prices (P) and the volume of transaction (T). Equality between the amount of money spent on the purchase of goods in the economy over a given period (MV + M’V’) and the volume of trade in goods (PT) translates as follows: MV + M’V’ = PT and it is a balance. Through the equation of exchange, Fisher analyses general level of prices that determines the purchasing power of money. There are five direct causes of variation in the level of price. These causal relationships are analysed by distinguishing between the effects of the variables on each other during the transition periods of the ultimate effects or equilibrium situation. During transition periods, prices fluctuate as variable change. Moreover, during this period, the variables have temporary effects between them.

From the explanation he gives of the equation of exchange, we note that Fisher separates deposits created by banks from “money”. This is important, as we will see later when presenting Fisher’s explanation of monetary causes of crises and his solution proposals. Money according to Fisher is currency. He’s focus on this means of payment is based on his conception of the economy: It is an exchange economy which holds the view that money is used for trade (1911, p. 9). He begins in The purchasing power of money by indicating his conception of money. Money is “any commodity … generally acceptable in exchange” (1911, p. 2).

Fisher (1911, p. 155) explains that production does not depend on money but on real factors such as technical conditions and natural resources. This independence is observed at equilibrium. In transition periods, which are observed between realisations of two equilibria, variations of the quantity of money can have a momentary effect on the production and the volume of exchanges. Therefore, at equilibrium, variations of the quantity of money have an effect of prices. As the quantity of money increases, this rise is followed by an expansion of demand for goods and services. For an unchanged quantity of goods and services available in the economy, the effect of increased demand will result in higher prices.

Monetary creation role by bank according to Fisher is different from that of Schumpeter. Role of banks in crises occurrence is differently perceived by both in relation to their conception of the role of banks in the economy. What Schumpeter highlights as the bank’s important role of financing entrepreneurs carrying innovative plans, Fisher identifies as source of monetary problems in economies. Bank, in extending credit beyond initial amount of deposits that it holds, inflates means of payment. Fisher’s analysis of bank focused on the role that bank should 7

play in the monetary stability of the economy, while Schumpeter gives an important function to bank in economic development process.

3. From banking practice to the causes of crises

A cyclical analysis is adopted by Fisher and Schumpeter when explaining the causes of economic and financial crises. Both share a distinction between economic and non-economic determinants of cycles (Fisher, 1933 ; Schumpeter, 1911); although Fisher is essentially interested in the causes of depressions rather than the full explanation of the cycle. As Schumpeter (1911) distinguishes crises from economic activity due to external factors such as climate shocks, wars or trade policies, etc., Fisher (1932; 1933) differentiates “forced” cycles from “free” cycles that are specifically due to economic factors. Despite the fact that several cycles can coexist (Fisher, 1933, p. 338 ; Schumpeter, 1939, p. 161), both seek to identify the root of crises by going beyond the symptoms. In doing this, the role of bank in occurrence of crises appears differently.

3. 1. Monetary creation of banks as aggravating factor of booms and depressions in Fisher’s analysis

In Fisher’s The Purchasing power of money (1911), fluctuations in nominal and real interest rates explain cyclical changes in economic activity. Changes in the level of prices are a major cause of these cyclical fluctuations. During transition phases between two equilibria, variations can appear on each variables of equation of exchange. In periods of inflation, corresponding to high level of prices, real interest rate falls with the value of debts. Economic activity also increases because agents have enough revenue to repay their debts. The expansion phase is reinforced by growth prospects which in turn rely upon profits generated. During this phase of inflation, real interest rate growth adjusts with a delay. Creditors, realising the decline in their purchasing power, increase (nominal) interest rates. But this gain does not suffice for creditors to gain from reducing purchasing power related to inflation. As a consequence, the increase of interest rates will go on gradually. It follows a gradually reduction of economic activity with the growing of interest rates; increasing costs of financing. Moreover, the rise of real rates reduces the value of collaterals and the leverage of borrowers. The existence of this gap between the two rates which favours the growth of profits continues until this gap is sharply reduced.

With rising of rates and due to reserves requirements, banks are forced to reduce credits at some moment. Once the growth of real rates reaches that point of inflation, the weight of agents’ debt increases significantly leading the economy to crisis. At this moment, bankruptcies occur because revenue streams become insufficient for debt repayment. A deflation follows with a reducing amount of means of payment available in the economy which is observed with the destruction of bank deposits. In addition, this deflation is also the result of a decline in the speed of the circulation of money. The expenses of agents are reduced because of the fall of economic activity. After the crisis occurrence, there is a gradual decline in real interest rate succeeding the rise in the purchasing power of the money. This occurs because creditors, observing a decline in demand for funds following the reduction in economic activity, lower interest rates proposed. This cyclical process starts again with the same manner as real interest rates become lower than nominal interest rates because of inflation. Fisher notes that the starting of inflation period could be a shock leading to an increase in the amount of money in the economy (1911, p. 58).

The role played by interest rate in The Purchasing power of money is similar to Wicksell’s monetary cycle. Wicksell (1898), through his distinction between the “natural” rate of interest and the interest rate required by banks, shows that bank-created money has an influence on economic activity but in short run. The natural interest rate is the equilibrium rate between the supply of funds (agents’ savings) and the demand for funds (investment) also define as the real rate. A dynamic exists between natural rate and money rate which is the bank interest rate. Banks have the ability to lend beyond deposits in their balance sheets. The interest rate to which they consent to lend may differ from the natural interest rate. When this rate is low, firms profit prospects increase. Indeed, the financing costs of firms are reduced inducing an increase of bank loans. Hence, this gap between the two rates drives the economy during inflation in a situation of full employment of the factors. Deflation process also occurs when the bank interest rate is higher than the natural interest rate. According to Wicksell, a rebalancing process occurs. In the case of a bank interest rate being lower than the natural rate, the growth of economic activity will increase the agents’ cash requirements for transactions and banks’ reserves will shrink. These actions will increase the bank rate leading to an equalization of the two rates. For Wicksell, the cause of these fluctuations is not due to banks. Banks do not intentionally lower the bank rate to increase the credits they grant. Rather, it is because they do not automatically adjust their rate to the natural interest rate that these fluctuations between the two rates and

economic fluctuations occur. Stability could be achieved by establishing a rule that allows the bank rate to be adjusted to the level of price.

This process, gives a role to real interest rate and inflation; this is analysed differently in Fisher’ latter writings, notably those of 1932 and 1933. Two main causal factors of crises are identified by Fisher, thus; over-indebtedness which he qualifies as “debt disease” and deflation or “dollar disease”. Other factors appear secondary or are simply symptoms. Whether overproduction, over-investment, under-consumption or euphoria, all of these factors, although not always chronological, result from the first two. The causality between these two factors is bidirectional. Expansion phase is characterized by the over-indebtedness of economic agents. When debtors realize the high level of indebtedness, efforts are made to bring balance sheets back to a sustainable level. This results in asset sales leading to a decrease in their price.

“When over-indebtedness, whether by sheer bulk or by rashness as to maturity dates, is discovered and attempts are made to correct it, distress selling is likely to arise. That is, in order to protect the creditors, some of the possessions of the debtor may have to be sold—his stocks, his bonds, his farmlands, or whatever his available assets may be” (Fisher, 1932, p. 13).

The framework of the equation of exchange remains in the 1933 article (The Debt-Deflation Theory of Great Depressions). Deflation takes place with a decline in the quantity of means of payment. Deleveraging of agents cancels credits and destroys deposits. The amount of deposit available in the economy is reduced as deleveraging progresses. In total, the amount of payment methods available in the economy will shrink. For an unchanged transaction volume, the relationship between the quantity of means of payment and the prices as described in the equation of exchange holds. Shifts in the quantity of means of payment have only effects on prices.

The combination of the two diseases amplifies their effects on each other leading to a severe crisis and very marked cyclical phases. Deflation also has an effect on the agents’ indebtedness. Lowering of prices burden the value of debts. Economic agents, in their effort to reduce their debt, will also make an emergency sale of assets or liquidate their debt contracts with banks thereby reducing the amount of means of payment. This in turn reinforces the decline in prices. The debt of agents becomes heavier with the new fall of the prices and lead to a deflationary spiral. This sequence is described by Fisher as “debt-deflation”.

Changes in the interest rate appear secondly relatively to debt disease and dollar disease. Through the equation of exchange, money supply shock affects the price levels and explains transition periods characterized by a change in the speed of circulation of money and output. In the sequence that he proposes of the cycle process in his debt-deflation theory, in times of depression, the rise of the real interest rate appears after a fall of production. Challe (2000) explains that the difference between the role of interest rate role in Fisher and Wicksell lies in the origin of the shock. In Wicksell idea, it is the difference between the two rates that explains the agents’ debt decisions. Fisher considers the level of indebtedness. Change in the interest rate occurs after the deleveraging efforts of agents. Nominal rate is reduced and the real rate increases with deflation. Fisher, who borrows from Wicksell an explanation of the transitional phase due to interest rate changes in The purchasing power of money, proposes debt-deflation theory, which can be perceived as radically different from that of 1911.

Fisher (1932) distinguishes two types of debt: an unproductive debt and a productive debt. This distinction helps to understand the dynamics of the debt. What he calls unproductive debt is debt that will not be repaid due to natural disaster or war. Activities related to unproductive debts are those for which income flows are halted as a result of natural disasters. Productive debt refers to productive activities but, because of funding availability, become unproductive as expected profits are overestimated and indebtedness increase. Fisher focuses is analysis on these types of debts or activities and how they are financed. There is a possibility of over- investment of agents due to funding availability which can lead to crisis. However, the real cause of the scale of cycles for him, is the interconnection between the means of payment and the debt.

The link between banking system, in particular the monetary creation of banks; indebtedness and crises are highlighted by Fisher. For him, the monetary system in which banks create money allows the interconnection between credit and money is a major cause of episodes of booms and depressions. From its equation of exchange (1911), which establishes a link between the quantity of money and prices, Fisher shows that banks increase the quantity of money in the economy and therefore the level of prices. Monetary creation by banks is an aggravating factor of cycles. He states it as follows:

“It is the banking system-the 10% system-which is at fault. Under this system, the bankers cannot help destroying money when it should be created, namely in a depression; while in a boom they create money when it should be destroyed”. (Fisher, 1935, p. 68)

Negative effects of money creation by banks can be seen both in economic activity and in the banks themselves. At the level economic activity, this monetary creation favours the succession of periods of inflation and deflation of the means of payment accentuating the fluctuations of the economic activity. Effects on banks are banking panics; bank failures and banking crises. When bank creates money beyond the amount of deposits it initially has, it becomes vulnerable to withdrawals by depositors.

Debt disease and dollar disease are the two main factors identified by Fisher to explain the cycles. Alleviating fluctuations of economic activity thus requires the resolution of these diseases. In this effort also appears the role of banks.

3. 2. Real factors as determinants of cycles in Schumpeterian analysis

Schumpeter’s explanation of factors preceding crises highlights the role of inflation and credit as Fisher. Inflation is partly induced by credit. Real factors also play a role. Inflation appears in the ascending phase of the cycle. This is due to the acquisition of capital goods by entrepreneurs. Inflation when it come about, affects old firms’ profit prospects. These old firms revise their profits prospects because of an increase in investment costs; increase favoured by the implementation of innovations. Crisis phase is characterized by deflation. It appears with the increase of supply of goods and services induced by innovation. The decline of old firms’ investment is combined with a fall of revenues with deflation.

Schumpeter recognises that, with monetary creation, there is an inflation of means of payment. According to him, this inflation is temporary and allows entrepreneurs to “divert” the means of production that are specifically reserved to production in the static circuit, to innovative production plans that induce economic evolution.

“... balances are, say, by discounting commercial bills, created against commodities which have just come into existence and about to start on their career through the system … they (newly created balances) may be said to be compensated in the sense that the effect on prices of the increase in the stream of money is compensated by a simultaneous increase in the stream of 12

goods, as it also may be whenever there are underemployed resources” (Schumpeter, 1939, p. 120).

It is not detrimental to the functioning of the economy insofar as the production that is made by entrepreneurs is added to the goods and services produced by existing firms. The amount of means of payment in the economy does not increase without any real base but simply precedes that of goods and services. In this respect, by using the equation of exchange, the quantity of the means of payment (the deposits M’ in particular) increases in the same proportions as the quantity of goods and services (T) from one equilibrium to another, outside a shock affecting the amount of money M. Therefore, banking systems are not responsible for cycles and crises.

“…the credit system is no very active factor in the mechanism of cycles. It adapts itself to the demand which comes from entrepreneurs and submits to contraction by their repayment of loans. In both cases its role is rather a passive one” (Schumpeter, 1931, p. 17)7.

Banks adapt credit supply to entrepreneurs’ demand. Because of this adequacy, the causes of crises are to be sought on the demand side. Variation in the credit supply by banks is not in challenge. It does not focus on banks’ incentives to increase supply of credit during the upward phase of the cycle. The differences between bank interest rate and the rate of profit are also not used in his explanation of crises. He recognizes that bank credit rationing is a factor leading to crisis. However, this factor is not “primary”.

“Deflation also occurs in a depression which is already in being or is expected by the banking world, because the banks endeavour on their own initiative to restrict their credits. This factor is practically very important and frequently starts a real crisis; but it is accessory and not inherent in the process. Here we are not thinking of this factor either, though we deny neither its existence nor its importance, but only its primary causal role” (Schumpeter, 1911, p. 234).

Although he partly based on Juglar's work for his analysis of cycles, he does not focus on banks contribution to cycles and crises like Juglar (Legrand and Hagemann, 2007). As noted by Legrand and Hagemann (2007), Juglar’s cycles are mainly business cycles. Banks contribute to the expansion during the upward phase of the cycle by their supply of the credit which can be excessive; but they are not responsible for the crisis. This availability of credit leads to

7 Quoted by (Legrand and Hagemann, 2007). 13

speculative investments. What Juglar puts forward is not the excess of money favoured by banks but rather the excess of credit. According to him, the origin of cycles lies in the speculation of non-bank agents. In Schumpeter analysis, there is an endogenous variation of credit on demand. Schumpeter is more interested in the root causes of cycles, and so concentrates on the factors that can specifically explain fluctuations in economic activity.

It is in this sense that Schumpeter identifies the causes of cycles as the appearance of innovations, their implementation and the “destruction” of old firms or activities. The root of economic cycles is the irregular occurrence of innovations. Innovations appear by wave at the beginning of the cycle. They are implemented by entrepreneurs through bank credit. An increase in prices of goods and services follows with the introduction of new means of payment from bank credit. The achievement of production by entrepreneurs leads to a decline of old non- innovative firms’ profits. It follows bankruptcies of these old firms. These bankruptcies are limited at this stage to the business sector of innovative entrepreneurs. Realisation of production by innovative entrepreneurs is followed by imitations of other firms that can be newly created or by existing ones. Production of imitating firms increases the volume of goods and services and lowers prices. Profits of entrepreneurs and imitators are based on these new productions. Old firms that have not innovated or imitated, suffer losses with the fall of product prices following the increase in supply of goods and services and go bankrupt. This phase of bankruptcy of old firms corresponds to the crisis. In Schumpeter’s conception, the crisis reflects the adaptation of the economy to the introduction of innovations. It is unavoidable. The old inefficient firms are disappearing to make room for new firms that implement new combinations increasing the supply of goods and services of the economy and result to a new equilibrium. Economic development is thus characterized by the implementation of innovations. Economic cycles are justified by the irregular appearance of innovations over time. The duration of the expansion phase depends on the time of realisation of the new combinations (Schumpeter, 1939, pp. 166-167). Economic development is therefore punctuated by periods of crisis that are synonymous with adaptation to new modes of production.

Recession such as explained by Schumpeter is the phase of adaptation of the economy to the introduction of new combinations. This can result in the bankruptcy of old firms. In practice, Schumpeter indicates that entrepreneurs may experience bankruptcies living old firms on the market. Even so, the important fact of depression is the adaptation of the economy to the

introduction of innovations. Depression continues until an adaptation and until existing firms cover their expenses.

“But losses occur or are imminent … as long as all businesses, and hence the system as a whole, are not in stable equilibrium, which is as much as to say in practice until they again produce at prices approximately covering costs. Consequently there is, theoretically, depression as long as no such equilibrium is approximately attained. Nor will this process be interrupted by a new boom before it has done its work in this sense.” (Schumpeter, 1911, p. 243).

Schumpeter distinguishes this process that he calls “normal” process from an “abnormal” one. “Abnormal process” is characterised by speculative indebtedness and a similitude exists with Fisher’s over-indebtedness description. If Schumpeter does not emphasize this abnormal process, it is because the main cause of the crisis does not result from these phenomena. These phenomena appear after the implementation of the innovation. It is in the second phase of the expansion period that over-indebtedness and over-optimism emerge (Leathers and Raines, 2004). Like Fisher, he makes a distinction between productive debt and unproductive debt. Consumer loans and speculative activities during the second phase are classified as unproductive debts. Productive debts are those intended to finance innovation and expansion, which results in an increase in productivity. Factors related to euphoria and speculation are secondary (Schumpeter, 1939, pp. 145-146). These factors may be “quantitatively” more important than observed effects of innovation. Excess optimism and pessimism may be related to normal process or to other factors (Schumpeter, 1939, p. 146). These factors appear in the general prosperity phase after entrepreneurs implement innovations (Leathers and Raines, 2004).

“The depression as such we may call the “normal” process of resorption and liquidation; the course of events characterised by the outbreak of a crisis – panic, breakdown of the credit system, epidemics of bankruptcies, and its further consequences – we may call the “abnormal process of liquidation”.” (Schumpeter, 1911, p. 236).

The violence of the crisis is justified by the indebtedness of agents during the second wave. During the recession in which the economy adapts to the new combinations, destruction of old firms and production methods become more severe because of accumulation of unproductive debts during the second phase (Schumpeter, 1939, p. 148). Speculation and excessive risk during the second wave lead to a greater liquidation hence the severity of the crisis. There is an 15

“abnormal liquidation” with speculative indebtedness during the second wave of expansion. Price decline is stronger, leading the economy into depression. Depression may not appear depending on cycles. It results from psychological factors such as the mentality of the business community, greed, fraud and more generally the morality of actors including banks, monetary management, etc. (Schumpeter, 1939, p. 150).

3. 3. A possible synthesis beyond differences

Schumpeter shares several points in Fisher's debt-deflation theory. He recognizes that over- indebtedness and deflation contribute to crises. However, he does not share Fisher's view of that these are root causes of crises. According to Schumpeter, productivity growth is observed during the first phase of prosperity. It is rather in the second phase that the over-indebtedness of the agents is observed. Indeed, this over-indebtedness contains both productive and non- productive indebtedness that is not based on productivity. Households go into debt during the second phase with the prospect of increasing incomes. Firms also increase their debts with the assumption of an increase of demand. Resuming a conversation that he had with Fisher, he states that “If a man dies of consumption, I say he dies of consumption and not of the fever which is one of the concomitants of the process.” (Schumpeter, 1939, p. 146). The process described by Fisher is substantiate however, the root of crises remains innovation and the need for the economy to adapt itself to innovation.

Fisher shares with Schumpeter the factors behind the boom period (Boyer, 1988). In contrast to Schumpeter who theorises this process of prosperity, Fisher merely names it. For Fisher, profit prospects favour corporate indebtedness.

“... in 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 symptoms of these two. In short, the big bad actors are debt disturbances and price level disturbances.” (Fisher, 1933, p. 341).

Fisher recognises real origins of cycles but indicates that the magnitude of fluctuations is explained by monetary causes. For Fisher, the rising of prices is an important factor.

“Invention or discovery alone need not carry up the aggregate indebtedness very high, if the price level promptly refuses to follow up the lure of invention or discovery with the lure of profits not due to the invention or discovery but to credit inflation. The point is to quell the inflation as soon as the price level is even slightly affected by it.” (Fisher, 1932, p. 121).

For Fisher, the banking system that allow banks to create money is therefore responsible for the worsening of the crises since banks contribute to the variation of the quantity of the means of payment in the economy by allowing their increase at the moment when the economy does not really need them and by permitting their contraction in periods of deflation. According to Schumpeter, an unproductive debt financed by banks amplifies depression, but whether it is present or not, the depression produced by innovation will be realised. In this sense, banks can help magnify depression but are not responsible for it while for Fisher, banks contribute to the occurrence of crises in a banking system that allow them to create money. He acknowledges that the debt disorder will remain but, in the absence of “dollar disease”, over-indebtedness will cause less damage to the economy. These differences between the two authors are justified by the phenomena they study. Schumpeter studies cycles whereas Fisher is interested by the stability of the purchasing power of the money which is essential for trade and decision-taking of agents (Fisher, 1935, p. 178).

4. From causes to solutions

Various solutions are proposed by Fisher and Schumpeter to deal with crises. According to Schumpeter (1911, p.357) “No therapeutics can ... prevent the great economic and social process of decommissioning firms ... this process, in the private property and competition economy, is the effect necessary for any new economic and social upsurge, ...”. It indicates however that actions could be taken to reduce the magnitude of depression. For the “abnormal” phenomena of cycle expansion phase, measures could be implemented to mitigate their effects on businesses. Credit crunch that occurs during periods of depression, can affect firms which already implement new combinations. A credit policy should help curb these negative effects of depression on those firms (Schumpeter, 1911, pp. 254-255).

Fisher is more prolific in proposals. He offers a series of solutions to crises throughout his writings. Thus he recommends: the establishment of an information system allowing agents to integrate changes in purchasing power into their decisions (Fisher, 1911); the introduction of a

system of full coverage of deposits (Fisher, 1935); considering a “compensated dollar” (Fisher, 1913), and a controlling of the money supply by the central bank (Fisher, 1932). In his book published in 1932 (Booms and Depressions), Fisher’s advocates are in line with the reduction of the indebtedness of agents. The link between prices and credit through debt also makes it desirable to advocate credit control as a solution to dollar disease (Fisher, 1932, pp. 126-131). This control involves a central bank rate policy (variation of the discount rate or variation of reserve requirement ratio depending on banks’ pace of deposit creation) or open market operations.

Fisher’s ultimate solution is monetary and banking reform. It is about separating debt and money by imposing a full coverage of credits by the “real” bank deposits also called 100% money (Fisher, 1935)8. Banking regulation is insufficient to prevent inflation and deflation. Changes in practices by banks are observed in the face of introduction of new rules. In this respect, Fisher's writings predict the inefficiency of regulatory policies aimed at increasing bank capital. According to Fisher, the reform of the monetary system is the ultimate solution other than the approach of “more regulation” as many others would suggest.

“Thus the whole history of banking seems to have been a see-saw in reserve requirements. There has been a cycle of abuse, remedy, evasion. The individual banker is tempted by the lure of profits to reduce his “idle” reserves; the law then applies, as, remedy, higher reserves or consolidation of reserves; the banker responds by finding a way to evade these safeguards, which brings us back to the original abuses in some new form” (Fisher, 1935, p. 45).

Fisher’s proposal presents benefits for banks and the economy. It solves illiquidity problem facing by a bank (Diamond and Dybvig, 1983). With 100% money, banking panics would no longer occur as deposits are covered. It proposes a separation between deposit and credit activities of banks. Banks would manage deposits and charge for their management. Credit department would collect savings of the agents (term deposits) and, because of the prohibition to create money, lending will only be according to the amount of savings. Credit supply would not exceed savings. For the economy, 100% money system leads to price stability. Savings

8 The solution proposed by Fisher also echoes that of authors aiming at separating management activity of means of payment from that of credit (Pollin, 2009; Chamley et al., 2012; Pennacchi, 2012). See Lainà (2015) for a review of the evolution of full-reserve banking among academic and regulation environment in the United States and Great-Britain.

would be redirected towards the financing of economic activity. Financing of speculative activities based on money creation would disappear. This price stability will therefore allow healthy growth, thereby reducing fluctuations in economic activity and crises. With 100% money system implementation, monopoly privilege of money creation is “withdrawn” from bank and is confined to public authority generally central bank or Monetary commission in Fisher’s plan. As Fisher proposes, evolution of the quantity of money would be done by the central bank (or monetary commission). Central bank would inject money into the economy according to economic needs and reduce it according to the same needs. Fisher militated for the establishment of this system until death (Allen, 1993).

5. Conclusion

Schumpeter and Fisher have a different analysis of the role of banks in crises occurrence. Schumpeter seeks to identify the determinants of economic cycles. Through its concept of creative destruction, it shows that it is the emergence of innovation by wave that explains the economic fluctuations. The destruction of the old firms is distinctive of a crisis. The role of banks appears minor. In its scheme, banks are not responsible for the occurrence of crises. Fisher does not specifically attribute to banks a responsibility in the occurrence of crises, but rather puts into question the banking system in which banks create money. Banks create and destroy payment methods at the request of non-bank agents. Causes appear both from banking sector and real sector. But this monetary creation of banks is source of inflation and deflation and accentuates cycles that one of the main causes is over-indebtedness, alongside inflation and deflation of the means of payment.

Beyond the differences, a possible synthesis between ideas of two authors can be made. Differences in viewpoints are related to the nature of the problem analysed by both them. Schumpeter analyses causes of the cycles of economic activity while Fisher analyses monetary causes of economic fluctuations. Both share a common origin of the cycles. Innovation is at the beginning of cycles. Over-indebtedness in Fisher's debt-deflation theory begins with innovation; source of new profits. Expansion phase is characterized by the over-indebtedness. This over-indebtedness of agents is also possible in Schumpeter analysis, who calls it an abnormal process distinct from the normal process of creative destruction. Growth prospects increase the debt of agents through bank financing.

Destruction is inevitable for Schumpeter and his proposals are simply aimed at alleviating its magnitude or avoiding the abnormal process. Only Fisher offers a real plan to solve the crises. The resolution goes through the establishment of a banking reform conferring on a public authority the prerogatives of monetary creation of the economy.

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