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Irving Fisher, a remarkable mathematician and among the American Neoclassicals, made several significant contributions to the Marginalist Revolution. His major contributions are towards; theory of capital and investment; popular revisiting of ‘Quantity Theory of Money’; index numbers theory; the Phillips Curve; and theory of debt-deflation. A Yale economist, Fisher was colorful and eccentric figure. He was an enthusiastic supporter of health food and eugenics.
However, a week before the famous crash of stock market in 1929, he was convinced and continuously assured the investors that the stock prices had achieved a permanent and new plateau and were not overinflated. This prediction proved to be incorrect and became a cause of reputation and fortune loss. Four years later, he asserted that the Great Depression resulted due to over-debt combined with falling prices. He launched a new phenomenon famously known as debt-deflation. (Fisher 1933)
The primary element of reasoning presented by Fisher was that, even though economists painted the economy as if it were in equilibrium on permanent basis, he concluded that the real economy is always in the state of disequilibrium. Fisher strongly argued that the forces that support the rise of Depression, in fact, were disequilibrium in nature. Depression is due to the occurrence of two primary factors; falling prices and excessive debt. (Fisher 1933)
Although, there are different other factors that could also lead to a major disaster, such as excessive speculation and over-confidence, deflation and debt were the two major forces that transformed a blooming economy into a Depression. The sequence of events presented by Fisher that tends to follow a major financial crunch results in the context of low inflation and excessive debt. (Fisher 1933)
Fisher argued that, in an endeavor to reduce debt-burden, the borrowers are involved in distress selling for repayment of debt through raising money. But such repayment results in a price level deflation and a reduction in money supply. Fisher believes that price level deflation is the primary cause of all sins in the economy. He narrates it as the ultimate result of attempts by agents to reduce indebtedness. (Fisher 1933)
The reduction in indebtedness is done by distress selling for the purpose of raising money for the payment of loans and, as explained above, results in the reduction of deposit currency which ultimately causes deflation.
After the 1929 crash, when business debt was overriding, most of the firms discovered that their commitment of debt repayment could not be met from their regular cash flows. Consequently, they embarked on distress selling. The reason was to raise the required money- and since everyone was reducing price level, the general level of price fell comprehensively. Even such organizations who were able to mange their debts effectively also found that their general profit level fell more than they owe. Fisher observed and concluded based on this scenario that the payment of debt results in increasing debts. (Fisher 1933)
When the assets prices are reduced by distress selling, the loss resulted from it aggravate indebtedness and could lead to increased distress selling. Fisher firmly believes that distress selling can be termed as self-defeating. Fisher in his model emphasized the outcomes of financial crisis for macroeconomic variables; the price level; aggregate spending; and asset prices. The theory of debt deflation has raised concerns about the role played by Washington and Federal Reserve in aggravating the circumstances for debt deflation and credit excess. (Fisher 1933)
Point of Views in other Models
Fisher is of the view that borrowers are involved in distress selling when they endeavor to reduce their debt or in other words ‘indebtedness’. (Fisher 1933) But the cumulative payments made by the borrowers results in a price level deflation and reduction in money supply. Minsky narrated the theme to incorporate the role of asset market. He highlighted that distress selling results in decreasing prices of assets. This decrease cause significant loss to agents having debts already matured. As such distress selling is reinforced and results in reduction of investment spending and consumption, which further deepens deflation. (Crotty 1993)
Bernanke, however, believed that debt deflation involves extensive bankruptcy, weakening the credit intermediation process. Ultimately the credit contraction decreases aggregate demand. Keynes asserts in his model that the level of production particularly of capital assets is reliant upon the interconnection between costs of production and the level of expectation of prices to be realized in the market. (Crotty 1993)
Keynes is of the view that the reduction in price level could result in increasing the real value of wealth in private sector. It signifies that the assets of creditors and liabilities of debtors will increase. Debtors, as per Keynes, have a much high level of marginal propensity to spend as compared with creditors and as such the total marginal propensity to spend declines. Keynes states that the modern world is portrayed by financial intermediation, as the entire banking system lends money on shares, bonds, goods and real estate. He emphasized that huge volume of bank and borrower default, if occur simultaneously, reduces the success and efficiency of financial intermediation, by increasing the cost of data-gathering as well as services related to market-making. (Crotty 1993)
Fisher, I,1933. The Debt-Deflation Theory of Great Depressions. Web.
Crotty, JR 1993 ‘Rethinking Marxian Investment Theory: Keynes-Minsky Instability, Competitive Regime Shifts and Coerced Investment’, Sage Journals, Vol, 25, no. 1, pp, 1-26.