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Out of Keynes's Shadow Which a Dollar Circulates Through the Mar- Ket-Is Equal to Output Multiplied by the Price Level

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Out of Keynes's Shadow Which a Dollar Circulates Through the Mar- Ket-Is Equal to Output Multiplied by the Price Level Dimand, an economist at BrockUniversity in Canada, who has studied Fisher in depth. "The ideal thing is to avoid these sit- uations. Unfortunately, we are in one." Fisher was born in 1867 and earned his phn from Yale in 1891- In 1898 he nearly died of tuberculosis, an experience that turned him into a lifelong crusader for diet, fresh air,prohibition and public health. For a while he also promoted eugenics. His causes, both healthy and repugnant, com- bined with a lack of humour and high self- regard, did not make him popular. In 1894, on a trip to Switzerland, he saw, in water cascading into mountain pools, a way to "define precisely the relationships among wealth, capital, interest and in- come," Robert Loring Allen, a biographer of Fisher, wrote. "The flowing water, mov- ing into the pool at a certain volume per unit of time, was income. The pool, a given volume of water at a particular moment, became capital." Over the next 30 years he established many of the central concepts of financial economics. In 19l1, in "The Purchasing Power of Money", Fisher formalised the quantity theory of money, which holds that the sup- . ply of money times its velocity-the rate at Out of Keynes's shadow which a dollar circulates through the mar- ket-is equal to output multiplied by the price level. Perhaps more important, he ex- plained how changing velocity and prices could cause real interest rates to deviate WASHINGTON, OC from nominal ones. In this way, monetary Today's crisis has given new relevance to the ideas of another great economist of forces could produce booms and busts, al- the Depression era though they had no long-run effect on out- HORTLYafter he was elected president, forcing asset sales and driving prices down put. Furthermore, Fisher held that the dol- SBarack Obama sounded a warning: "We further. Fisher showed how such a spiral lar's value should be maintained relative are facing an economic crisis of historic could turn mere busts into depressions. In not to gold but to a basket of commodities, proportions ... We now risk falling into a 1933he wrote: making him the spiritual father of all mod- deflationary spiral that could increase our Over investment and over speculation are ern central banks that target price stability. massive debt even further." The address often important; but they would have far During the 1920S Fisher became rich evoked not just the horror of the Depres- less serious results were they not conducted from the invention and sale of a card-index sion, but one of the era's most important with borrowed money. The very effort of in- system. He used the money to buy stocks thinkers: Irving Fisher. dividuals to lessen their burden of debts in- on margin, and by 1929 was worth $lOm. I Though once America's most famous creases it, because of the mass effect of the He was also a prominent financial guru. economist, Fisher is now almost forgotten stampede to iiquidate ...the more debtors Alas, two weeks after he saw the "plateau" by the public. If he is remembered, it is usu- pay, the more they owe. The more the eco- the stockmarket crashed. ally for perhaps the worst stockmarket call nomic boat tips, the more it tends to tip. To his cost, Fisher remained optimistic in history. In October 1929 he declared that Though they seldom invoke Fisher, policy- as the Depression wore on. He lost his for- stocks had reached a "permanently high makers in America are applying his ideas. tune and his home and lived out his life on plateau". Today itis John Maynard Keynes, In academia Ben Bernanke, now the chair- the generosity of his sister-in-law and Yale. his British contemporary, who is cited, de- man of the Federal Reserve, sought to for- Buthis work continued. He was prominent bated and followed. Yet Fisher laid the malise Fisher's debt-deflation theory. His among the 1,028 economists who in vain foundation for much of modern monetary research has shaped his response to this petitioned Herbert Hoover to veto the infa- economics; Keynes called Fisher the crisis. He decided to bail out Bear Stearns mous Smoot-Hawley tariff of 1930. And he "great-grandparent" of his own theories in March 2008 partly so that a sudden liq- developed his debt-deflation theory. In on how monetary forces influenced the uidation of the investment bank's posi- 1933 in Econometrica, published by the real economy. (They first met in London in tions did not trigger a cycle of falling asset Econometric Society, which he co-found- 1912and reportedly got along well.) prices and default. Indeed, some say the ed, he described debt deflation as a se- As parallels to the 1930Smultiply, Fisher Fed has learnt Fisher too well: from 2001 to quence of distress-selling, falling asset is relevant again. As it was then, the United 2004, to contain the deflationary shock prices, rising'real interest rates, more dis- States is now awash in debt. No matter that waves of the tech-stock collapse, it kept in- tress-selling, falling velocity, declining net it is mostly "inside" or "internal" debt- terest rates low and thus helped to inflate a worth, rising bankruptcies, bank runs, cur- owed by Americans to other Americans. new bubble, in property. tailment of credit, dumping of assets by Asthe underlying collateral declines in val- Were Fisher alive today, "he would tell banks, growing distrust and hoarding. ue and incomes shrink, the real burden of us we have to avoid deflation, and to wor- Chart 1(see next page) is his: it shows how L_ ~btrise,. Debts go bod. w,"kemng bank<, ry about all that inside debt," says Robert deflation increased the burden of debt. ~ journal (see chart 2). There are important I Fisher's times differences between then and now. Debt I Modem times D America's: was lower at the start of the Depression, at American households' assets and debts, $trn $bn 164%of GDP. Mortgage debt was modest national wealth relative to home values, and prices were not notably bloated: they fell by 24% be- tween 1929and 1933,says Edward Pinto, a consultant, so were roughly flat in real terms. Debt burdens shot up because of deflation and shrinking output; nominal GDP fell by 46%between1929 and 1933. Debt burdens are high today mostly be- cause so much was borrowed in the recent past. This began as a logical response to de- clining real interest rates, low inflation, ris- Dee 2006 Sep 2008 Dee 2006 Sep 2008 ing asset prices and less frequent reces- Source: Federal Reserve sions, all of which made leverage less ~ Fisher was adamant that ending defla- dangerous. But rising leverage eventually ing nominal home prices to stabilise, and tion required abandoning the gold stan- bred easy credit and overvalued homes. reduce real debt burdens. But creating in- dard, and repeatedly implored Franklin Even without recession, falling home flation is easier said than done: it requires Roosevelt to do so. (Keynes was of similar prices would have impaired enough mort- boosting aggregate demand enough to mind.) Roosevelt devalued the dollar soon gage debt to destabilise the financial sys- consume existing economic slack, through after becoming president in 1933.The de- tem (see chart 3). Recession makes those either monetary or fiscalpolicy. valuation and a bank holiday marked the dynamics more virulent; deflation could Though the Fed does not expect defla- bottom of the Depression, though true re- do similar damage. Broad price indices fell tion, last month it did say that "inflation covery was still far off. But Fisher had at in late 2008. Granted, that was caused in could persist for a time below" optimal lev- best a slight influence on Roosevelt's deci- part by a one-off fall in petrol costs; but els. It is mulling a formal inflation target sion. His reputation had fallen so far that America's core inflation rate, which ex- which, by encouraging people to expect even fellow academics ignored him. cludes food and energy, has fallen from positive inflation, would make deflation Contemporary critics did poke a hole in 2.5%in September to 1.8%.Goldman Sachs less likely.Butits practical tools for prevent- his debt-deflation hypothesis: rising real sees it falling to 0.25%in the next two years. ing deflation are limited. In December its debt makes debtors worse off but creditors That is low enough to mean falling short-term interest-rate target in effect hit better off,so the net effectshould be nil. Mr wages for many households and falling zero. The Taylor rule, a popular rule of Bernanke plugged this in the 1980s. "Col- prices for many firms. More widespread thumb, suggests it should be six percentage lateral facilitates credit extension," he said and deeper deflation would mean that points below. The Fed is now trying to in June 2007,just before the crisis began in property prices would have to fall even push down long-term interest rates by earnest. "However, in the 1930S,declining further to restore equilibrium with house- buying mortgage-backed and perhaps output and falling prices (which increased hold incomes, creating another round of Treasury securities. With conventional real debt burdens) led to widespread finan- delinquencies, defaults and foreclosures. monetary ammunition spent, fiscal policy cial distress among borrowers, lessening What is the solution? Fisher wrote that has become more important. their capacity to pledge collateral.. .Bor- it was "always economically possible to In 2002 Mr Bernanke argued the gov- rowers' cash flows and liquidity were also stop or prevent such a depression simply ernment could ultimately always generate impaired, which likewise increased the by reflating the price level up to the average inflation by having the Fedfinance large in- risks to lenders." Mr Bernanke and Mark level at which outstanding debts were con- creases in government spending directly, Gertler of New York University dubbed tracted." Alas, reflation is not so simple.
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