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.

Fisher

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. Consumers and businesses have to pay back debt with money that is worth less than the original credit, essentially increasing the debt( THE AMOUNT GOES UP IN REALITY AS THE CALLING RUN CONTINUES. ).

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( NOTICE THE PREFIX OVER- ). 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( BUT ONLY THAT ) 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( YES ) 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( NEGLIGENT ) promotions, taking advantage of the habituation of the public to great expectations; (d) the development of downright fraud( YES ), imposing on a public which had grown credulous and gullible”( FOR ME, A AND B ARE JUST NORMAL HUMAN DESIRES. THEY ONLY BECOME PROBLEMATIC WHEN CAUTION IS THROWN TO THE WIND. HOWEVER, GREED DOES NOT SUFFICE AS A CAUSE. PEOPLE NEED TO TELL THEMSELVES A STORY TO JUSTIFY THE RISK. IN THE CASE OF THE BANKS AND AIG AND THE BROKERS, ETC., IT WAS THE BELIEF THAT THE GOVERNMENT WOULD INTERVENE FORCEFULLY AND EFFECTIVELY IN A CRISIS. THIS IS CAUSE NUMBER 1. C AND D ARE MY CAUSE NUMBER 2 . WITHOUT C AND D, THIS CRISIS COULD NOT HAVE OCCURRED. IN OTHER WORDS, I'M SAYING THAT, AT THE VERY LEAST, THE INVESTMENT COMMUNITY ENGAGED IN NEGLIGENCE AND FIDUCIARY MISMANAGEMENT. )

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 the alarm either of debtors or creditors or both( A CALLING RUN ). Then we may deduce the following chain of consequences in nine links: (1) Debt liquidation leads to distress selling( A CALLING RUN ) 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( YES ), causes (3) A fall in the level of prices( AS PEOPLE WILL TAKE MORE AND MORE LOSSES TO GET SOME MONEY BACK ), 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( A PROACTIVITY RUN ). These losses, bankruptcies and unemployment, lead to (7) Pessimism and loss of confidence( FEAR AND AVERSION TO RISK ), which in turn lead to (8) Hoarding( IN CASE OF MORE CALLS ) 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.”( I BELIEVE THAT 7 IS THE MOST IMPORTANT, AND THAT IT PRECIPITATES 1, AND THEN JUST GETS WORSE AND WORSE. )

Sounds awfully familiar.

Summarizing his finding of the risks over too much debt and deflation, Irving writes: “(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( MY CHOICE) (reflation), and reflation might just as well have been applied in the first place( THAT'S BEEN MY POINT. OF COURSE, I ALSO RECOMMEND A TOTAL GOVERNMENT GUARANTEE AND BAGEHOT'S PRINCIPLES. )."