Debt-deflation and the future of the American Economy

The subject Financial Economics at the University of Western Sydney introduces students to the proposition that the money supply is endogenous?determined by interactions between the finance sector and the economy rather than being independently determined by the Federal Reserve. Irving Fisher?s analysis of the causes of the Great Depression figures prominently in this subject, and in this year?s essay students were asked to:

"Explain Fisher's Debt Deflation Theory of Great Depressions, and in the light of it provide an evaluation of the economic history of America for the past two decades, and predict the USA's economic performance till 2010."

Irving Fisher developed The Debt-Deflation Theory in 1933 in order to explain the economic mechanism that can lead to a Great Depression such as the one experienced by the US economy from 1929 to 1933. The main point of the theory is that over indebtedness acts in conjunction with deflation to produce a contracting economy causing bankruptcies, rising unemployment and falling profits. Over the last 20 years, one of the US economic policy makers? goals has been to lower the rate of inflation. However a recent downward trend in the already low inflation, together with an impressive growth in debt, has brought to light Fisher?s theory and triggered fears of a debt-deflation induced depression.

The Debt-Deflation Theory of Great Depressions is an explanation by Fisher of the apparent boom bust pattern prevailing in the economy. He divides the theory into four sections. In the first section, ?Cycle Theory in general?, Fisher defines different types of economic cycles and their possible causes. In the second section, ?The Roles of Debt and Deflation?, he provides a theory of how excess debt and the consequent deflation play a major role in the boom bust cycle. The third section provides an overview of the Great Depression in light of his new theory and introduces the concept of inflation as a cure to depression and deflation. The last section explores the possible ?Debt Starters? that initially triggers a boom economy.

In the first section on cycle theory, Fisher dismisses the idea of the business cycle being a single, simple, self-generating cycle as a myth. In its place he introduces the notion that there are many interacting cycles within the economy also interacting with non-cyclical forces such as growth and haphazard tendencies. He divides cyclical tendencies into two types, forced cycles and free cycles. Forced cycles are imposed onto the economy by outside forces, such as the yearly season cycle, day-night cycle, and monthly and weekly cycles imposed by religion and custom. The free cycle is self-generating and is commonly thought of when referring to the business cycle.

Fisher explains that equilibrium within the economy, though it is stable and the economy tends to gravitate towards, is never exactly reached and cannot be maintained because ?New disturbances are, humanly speaking, sure to occur, so that, in actual fact, any variable is almost always above or below the ideal equilibrium?[i] Some of these disturbance can be big enough to take the economy beyond a breaking point, from which the same equilibrium no longer applies and instability eventuates.

Fisher concludes that the dominant factors in affect during a great boom and depression are over-indebtedness and the consequent deflation. Although other factors such as over-investment and over-speculation may be important they have ?far less serious results were they not conducted with borrowed money?[ii]

Having determined the main factors in causing a great boom and bust cycle, debt and deflation, Fisher describes some secondary variables which contribute to the cycle, namely ?debts, circulating media, their velocity of circulation, price levels, net worths, profits, trade, business confidence, interest rates.?[iii]

The logical order of interrelations between those variables is derived by first assuming that ?the general economic equilibrium is disturbed by only one factor of over-indebtedness? and that over-indebtedness leads to debt-liquidation. Fisher divides the following occurrences into nine steps, 1. Debt Liquidation by the distress selling of assets. 2. Contraction of deposit currency, caused by a decrease in loans, also causing a slow down in the velocity of circulation, which causes 3. Deflation, caused by a swelling of the dollar and unless counteracted by inflation there is 4. A still greater fall in the net worth of business causing bankruptcies 5. A like fall in profits leading to 6. A reduction in output, in trade and in employment, the last three points leading to 7. Pessimism and loss of confidence, which in turn lead to 8. Hoarding, which further slows down the velocity of circulation. All changes above lead to 9. Complicated disturbances in the rate of interest in particular a fall in the nominal interest rates but a rise in the real interest rates caused by deflation.

Fisher emphasises the importance of over-indebtedness and deflation needing to occur together to ?work the greatest havoc.?[iv] The effects of over-indebtedness without causing deflation, and deflation not caused by over-indebtedness are much less significant then when the two occur together.

The Great Depression of 1929-1933 was the most extreme example of a boom bust cycle and was what inspired Fisher to develop the Debt-Deflation Theory. ?By March, 1933, liquidation had reduced the debts about 20%, but had increased the dollar about 75%, so that the real debt, that is the debt as measured in terms of commodities, was increased 40%?.[v]

Fisher points out two ways out of such a depression. One way is to let economic nature take its course until widespread bankruptcy causes the growing debt to eventually start diminishing. ?This is the so-called ?natural? way out of a depression, via needless and cruel bankruptcy, unemployment and starvation?.[vi]

Reflation, as affected by the government, according to Fisher is a much more effective and less painful cure to deflation. The reflation of prices causes a contraction in real debt, reversing the debt-deflation cycle and providing much needed relief for businesses.

In the final section Fisher identifies the most common cause of over indebtedness to be ?new opportunities to invest at a big prospective profit, as compared with ordinary profits and interest, such as through new inventions, new industries, development of new resources, opening of new lands and markets?.[vii] Such new opportunities provide great incentive for speculation especially with the help of leverage.

The last twenty years have seen a dramatic increase from 11 trillion to 34 trillion dollars of US total debt, an increase of about 310%. Total debt includes government, corporate and private sector debt. However during the same period US GDP has risen from $2.8 trillion to $10.45 trillion, an increase of about 370%. It seems that the total US debt is increasing on par with GDP. The ratio of US Debt to GDP levels is slightly higher than the record 264% in the period of the Great Depression. However $10 trillion of the current debt is that of the financial sector- ?banks, savings institutions, finance companies, issuers of asset-backed securities and government sponsored enterprises such as Fannie Mae and Freddie Mac.?[viii] These borrowings are mainly used to fund other loans in the corporate and private sector, causing the majority of the $10 trillion dollars to be double counted. This was not the case during the great depression as the finance sector at the time was far less developed.

Since 1980 the US inflation rate has dropped from about 11% to the current low level of 1.59%. Most of this drop occurred between 1980 and 1983, when it decreased 8% to about 3%. Since 1983 inflation has been fairly steady hovering between 5.5% and 2%. However, following a 2-year downward trend, inflation has hit a low of 0.6% over the last three months. A continuing of this trend could see something the US economy has not been tested with for a long time, deflation.

The low inflation is a result of the recent decline in durable goods prices, which has been offset by increasing prices on services. Although inflation is still positive a ?little less than half the US economy is now in the throes of outright deflation?.[ix]]

In the Great Depression, as hypothesised by Fisher in the Debt-Deflation theory, deflation was a direct cause of asset liquidation caused by a market crash, which was a consequence of over indebtedness. The downward trend in inflation since the 2000 Internet bubble crash provides some evidence of this occurrence in the current US economy. However in today?s global economy there are many more factor?s involved in causing a change in price level. For example a significant influence on the US goods market has been the emergence of China as source of relatively cheap goods.

In the last two decades there have been two major stock market crashes, the 1987 crash and the Internet bubble crash of 2000. The 87 crash was preceded by 2 years of growth in the stock market at an average of 40% per annum. Just like the boom preceding the Great Depression, leverage and margin lending over-inflated the market until it crashed on the 22^nd of October by over 20%, the largest daily drop in history.

Fuelled by a frenzy over the potential value of internet companies, the internet bubble was the largest and most widespread speculative bubble in the history of the stock market. When it burst, the market crashed by over 40% within a few weeks, taking with it over 4 trillion dollars in shareholder capital.

Although both crashes were induced by over indebtedness, neither of them was immediately followed by depression causing deflation. The reserve bank had learnt its lesson from the Great Depression and in both cases acted as a lender of last resort providing much needed liquidity to a desperate financial system.

Interest rates are the Federal Reserve?s key tool in trying to control the US economy. During times of slow growth or even recession, interest rates can be lowered to stimulate the economy. Lower interest rates ?make it cheaper for businesses to invest and consumers to buy big ticket items?.[x] Lowering interest rates also raises the prices of assets by lowering the discount factor of future income streams.

In 1980 interest rates were well above 10%, from 1984 to 1987 they dropped from just above 10% down to almost 6%. These relatively low interest rates may have contributed to the creation of the 1987 stock market bubble. They did increase after the crash to about 8% by 1990. In the 90?s interest rates fluctuated between 6% and 3%. However, since the beginning of 2001 the Federal Reserve has been lowering rates from 6% down to a current low of 1.25%.

Over the last twenty years, the US economy has absorbed stock market crashes without going into a depression as predicted by Fisher?s theory. However Fisher did acknowledge that a depression could be avoided by positive action by the Federal Reserve. However with interest rates at 1.25%, the Federal Reserve does not have any room left to counter a possible deflation by lowering interest rates. A possible deflation in the US economy would not be an immediate result of asset liquidation caused by a crash in the stock market, the Federal Reserve can claim some success from the part it played in avoiding that. That does not make deflation any less dangerous in the current state of the US economy. The debt burden across all sectors is significantly high. The real interest rate is the nominal interest rate minus inflation, hence deflation, or in other words negative inflation causes an increase on real interest rates, making it more difficult for debtors to service their interest repayments. Interest rates cant be lowered much further to counteract the affect of deflation on real interest rates.

In trying to forecast the economic future of the world?s biggest economy, it is necessary to recognise the existence of true uncertainty. The economy is influenced by a complex interaction of different factors, a large proportion of which are not endogenous. In today?s world there are many uncertainties, terrorism, new disease, the possibility of new and revolutionary inventions, development of alternative energy sources, the price of oil etc. Forecasting is hence limited to factors which are endogenous, factors which can be measured and its future behaviour predicted with the aid of economic theory, specific to this essay, Fishers Debt Deflation theory.

The next ten years for the US economy largely depend on whether it can sustain current debt levels especially when tested with deflation. The relative size of the debt and whether the US is over indebted is really a matter of perspective. A relevant measure of over indebtedness is total bankruptcy filings. Bankruptcies have increased dramatically over the last two years, following a steep upward trend since 1995. Total bankruptcy figures are dominated by personal bankruptcy filing, it is worth noting that there is no upward trend in business bankruptcies. ?Research by the Federal Reserve indicates that household debt is at a record high relative to disposable income. Some analysts are concerned that this unprecedented level of debt might pose a risk to the financial health of American households. A high level of indebtedness among households could lead to increased household delinquencies and bankruptcies, which could threaten the health of lenders if loan losses are greater than anticipated?.[xi]

The bankruptcy figures bring to focus the major problem in the current US economy, that is the real estate bubble. Real estate values have risen nearly 50% nationwide over the past six years, shooting up by an annual rate of 10-40% in recent years. Home loans account for $5.8 trillion, of the $8.2 trillion in household debt. ?The Americans? equity in their homes, net of debt, has dwindled to 57% compared with 85% a half-century ago, even with the recent powerful surge in home prices?.[xii]

The loss of confidence in the stock market contributed in speculative capital flowing to the real estate market, however the housing bubble would not have been possible if not for the Federal National Mortgage Association (Fannie Mae) and the Federal Home Mortgage Loan Corporation (Freddie Mac).

Fannie Mae and Freddie Mac are known as secondary market corporations, they can buy the mortgages from the primary mortgage lending institution. The primary institution can use the funds from the sale to generate a new mortgage, thus Fannie Mae and Freddie Mac provide a mechanism for real estate loan creation without the constraint of the reserve requirement. In fact, since 1995, Banks have created $2.25 trillion in loans to prospective homebuyers, but during the same interval have lent a total of $1.29 trillion to the entire economy. This is because Fannie Mae and Freddie Mac have acquired 75% of the $2.25 trillion in new mortgage loans. According to Richard Freeman, ?The City of London-Wall Street financiers' objective, and also that of Fannie Mae, is to inflate housing prices through increases of ?fictitious value,? thereby increasing the size of mortgages needed to buy the houses at inflated prices, and thus, increasing the principal and interest-rate cash that can be gouged from households. It is an unadulterated looting operation.?[xiii]

Applying Fisher?s theory to the housing bubble places the US economy at the point of over-indebtedness, with personal bankruptcies providing an early sign of step one of the theory, the distress selling of assets. A collapse in the real estate market could have two immediate consequences. Firstly ?academic studies show that changes in home prices have nearly double the impact on consumer spending than does the ?wealth effect? from rising or falling stock prices.?[xiv] This would trigger a further slowdown in the economy. Secondly as pointed out by Herring and Wachter ?real estate booms often end in banking busts?[xv] Banks which have large holdings of non-performing real estate loans, as a result of a crash in the real estate market, ?will be unable to generate sufficient retained earning to restore their capital in a timely manner. Instead they will shed assets, scaling back new lending to all sectors of the economy and declining to roll over outstanding loans when they mature.?[xvi] At that stage the US economy would be at step two of Fisher?s theory, contraction of deposit currency, caused by a decrease in loans.

The US Federal Reserve does identify the threat and potential dangers of deflation, however it remains confident that it is ready and able to fight off a possible deflation and Federal Reserve officials maintain that the chance of a long-term deflation is very small. The Federal Reserve is committed to stopping deflation and as Allan Greenspan stated, ?If deflation were to develop, options for an aggressive monetary policy response are available?[xvii] These options include further driving down short term interest rates to a minimum level of zero, purchasing long term treasury bonds with the purpose of injecting money into the economy and lowering long term interest rates. Federal Reserve officials have even mentioned such drastic measures as enforcing a ceiling on long term interest rates effectively reducing the cost of mortgages, this would provide short term relief to the housing bubble, however it will also act to make it more resilient allowing it to blow up even further, making a potential crash even more disastrous. Another option that has been mentioned by the Federal Reserve is flooding the economy with currency by printing money. ?The fact is, though, that real deflation is so rare that central bankers have little experience fighting it. No one really knows whether a central bank's anti-deflation policies would work.?[xviii]

A debt-deflation induced depression would have a dominating influence on the US economy over the next ten years. A crucial factor in the future performance of the US economy is the housing market. A crash in the over-inflated housing market has the potential to drive the US economy into a depression. A depression in the world?s largest economy has the potential to plunge the world into a similar situation, especially in light of the struggling Japanese and German economies. In this, the worst-case scenario for the US, ten years might not be enough for the economy to see a recovery.

The scenario above is likely, but it is not the only possibility. The Federal Reserve is well aware of the potential dangers. Although avoiding disaster may be beyond the Federal Reserve?s capabilities and economic realities, avoiding a depression would prove the resilience of the US economy to economic shocks.Speculative bubbles and the consequent crashes are an economic reality, perhaps the awareness of Fisher?s model has helped economic policy makers and intelligent businessmen to create an economy and companies which are not immune to the effects of economic shocks, but are more resilient to them.

[i] Irving Fisher ?The Debt-Deflation Theory of Great Depressions? Financial Economics readings

Vol II, 2003

[ii] Irving Fisher ?The Debt-Deflation Theory of Great Depressions? Financial Economics readings

Vol II, 2003

[iii] Irving Fisher ?The Debt-Deflation Theory of Great Depressions? Financial Economics readings

Vol II, 2003

[iv] Irving Fisher ?The Debt-Deflation Theory of Great Depressions? Financial Economics readings

Vol II, 2003

[v] Irving Fisher ?The Debt-Deflation Theory of Great Depressions? Financial Economics readings

Vol II, 2003

[vi] Irving Fisher ?The Debt-Deflation Theory of Great Depressions? Financial Economics readings

Vol II, 2003

[vii] Irving Fisher ?The Debt-Deflation Theory of Great Depressions? Financial Economics readings Vol II, 2003

[viii]] Jonathan Laing ?The Debt Bomb? Barron?s (Jan 20, 2003)

[xiii] Richard Freeman ?'Fannie and Freddie Were Lenders': U.S. Real Estate Bubble Nears Its End? Executive Intelligence Review (Jun 21, 2002)

[xviii] Sam Zuckerman ?Fearing deflation, Federal Reserve changes policy? The Beacon Journal (Jan 12,2003)

A super article. Thanks for this. A couple of points:

1. Fisher did not anticipate the credit card debt impact (they did not exist in the 1930's) which accelerates the personal debt overload (perma-debt at 27% - 29% APR charged on the AVERAGE balance outstanding and amortizing at a 120 to 180 month schedule).

2. Corporate bankruptcies set a record in 2002 contrary to the articles assertion that there is no upward trend in corporate bankruptcies.

Over time there will be downward pressure on both durable and non-durable goods costs, with a resultant downward pressure on costs of production e.g., salaries and benefits to reduce prices.

There will have to be a re-think of savings/investment issues; a return to the immediate post war era of higher savings, lower debt loads and lower yields on investments. Residential real estate will go back to being a non-investment type of vehicle with the sales multiples seen in recent years disappearing.

Regards,

Wow, that blows away any essay I ever wrote in college.

According to this, GDP has increased faster than debt, implying a declining debt load as a percent of GDP and a level 20 years ago that was significantly higher than the record level sited. That doesn't seem consistent with the notion that we are drowning in debt, although perhaps these statistics need to be interpreted relative to real interest rates at the respective time periods.

Excellent writing and analyis. Would that all collegians were so astute.

It seems that the total US debt is increasing on par with GDP.

Our GDP numbers are distorted with 'imputed productivity' such as improved features and functions in a product, without which unadjusted GDP would be lower.

Since 1980 the US inflation rate has dropped from about 11% to the current low level of 1.59%.

Again US statistics are distorted. Core inflation (without food, energy, insurance, taxes, health care, etc) may be down. Actual every day living costs are up, as are the 'inflated prices' of homes & stocks - asset inflation. Yes, cars, computers, and furniture, etc are cheaper, largely due to lower cost of off-shore labor and components.

A possible deflation in the US economy would not be an immediate result of asset liquidation caused by a crash in the stock market, the Federal Reserve can claim some success from the part it played in avoiding that.

Actually, credit for any success goes solely to whomever keeps buying S&P 500 futures contracts when the cash market is falling.

This bears repeating:

According to Richard Freeman, "The City of London-Wall Street financiers' objective, and also that of Fannie Mae, is to inflate housing prices through increases of 'fictitious value', thereby increasing the size of mortgages needed to buy the houses at inflated prices, and thus, increasing the principal and interest-rate cash that can be gouged from households. It is an unadulterated looting operation."

Disclaimer: Opinions posted on Free Republic are those of the individual posters and do not necessarily represent the opinion of Free Republic or its management. All materials posted herein are protected by copyright law and the exemption for fair use of copyrighted works.