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What’s So Bad About Deflation? Remembering Irving Fisher - Real Time Economics - WSJ

November 20, 2008, 12:01 PM ET

What’s So Bad About Deflation? Remembering Irving Fisher

Falling prices sound good to consumers struggling to buy groceries or gas, but the work of Yale University economist Irving Fisher, whose theories were formed during the Great Depression, shows the negative effects of deflation. The drop in consumer prices reported yesterday raised concerns about whether the nation may eventually face a deflationary environment. The figures largely showed a retreat from the high inflation of the past year, making it hardly a concern right now. But broadly falling prices would be bad news for a country up to its ears in debt. Fisher Consumers and businesses have to pay back debt with money that is worth less than the original credit, essentially increasing the debt. Fisher was an economist who lost a fortune in the stock market collapse of October 1929, after famously declaring “stock prices had reached a permanently high plateau” just the month before. When the downturn hit he turned his talent to the underlying mechanisms of the crisis. In 1933, he wrote a paper titled the Debt-Deflation Theories of Great Depressions (reproduced by the St. Louis Fed) that feels as if it could have been written yesterday. He outlines the problems of over-consumption, over-spending and over-indebtedness, and what their effects can be. He might as well be talking about the recent housing bubble when he writes: “Easy money is the great cause of over-borrowing. When an investor thinks he can make over 100% per annum by borrowing at 6%, 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 realizing 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” Irving points to a chain of nine events that can be triggered by too much debt.
“Assuming, accordingly, that, at some point of time, a state of over-indebtedness exists, this will tend to lead to liquidation, through 1/2

com blogs. 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.wsj. as indicated by all nine factors.” that is. “The above eight changes cause (9) Complicated disturbances in the rates of interest. Irving writes: “(1) economic changes include steady trends and unsteady occasional disturbances which act as starters for cyclical oscillations of innumerable kinds. sometimes conspire to lead to a great volume of over-indebtedness. 2/2 . rates of interest. (6) the dollar may swell faster than the number of dollars owed shrinks. or money. are new opportunities to invest. Distribution and use of this material are governed by our Subscriber Agreement and by copyright law . Summarizing his finding of the risks over too much debt and deflation. which in turn lead to (8) Hoarding and slowing down still more the velocity of circulation.” Sounds awfully familiar. non-commercial use only. leads to attempts to liquidate. and the depression grows worse instead of better. in other words. bankruptcies and unemployment. and reflation might just as well have been applied in the first place. These losses.7/12/13 What’s So Bad About Deflation? Remembering Irving Fisher . (8) the ways out are either laissez faire (bankruptcy) or scientific medication (reflation). Inc. as above stated. causes (3) A fall in the level of prices. leads the concerns which are running at a loss to make (6) A reduction in output. This contraction of deposits and of their velocity. precipitating bankruptcies and (5) A like fall in profits. which in a “capitalistic. as bank loans are paid off. and to a slowing down of velocity of circulation. or commodity. lead (unless counteracted by reflation) to falling prices or a swelling dollar. lead to (7) Pessimism and loss of confidence. in turn. especially because of new inventions. a swelling of the dollar. in particular.” –Phil Izzo Copyright 2013 Dow Jones & Company. with other causes.WSJ the alarm either of debtors or creditors or both. a fall in the nominal. that this fall of prices is not interfered with by reflation or otherwise. For non-personal use or to order multiple copies. All Rights Reserved This copy is for your personal. there must be (4) A still greater fall in the net worths of business. rates and a rise in the real. (3) these. (7) in that case. in trade and in employment of labor. liquidation does not really liquidate but actually aggravates the debts.Real Time Economics . (5) these. (2) among the many occasional disturbances.djreprints. a private-profit society. please contact Dow Jones Reprints at 1800-843-0008 or visit w w w . precipitated by distress selling. (4) this in turn.