The Great Economists Read online

  The assumption in the Quantity Theory of Money that the economy is in a long-run equilibrium is crucial. Most economists would argue that the economy is predominately in a state of transition. Furthermore, empirically the velocity of circulation tends not to look that stable. Therefore, if V and Q are changeable, there is not necessarily a direct and stable relationship between money and prices.

  However, this theory gave Fisher scope to see how money and prices might affect national output, and how these short-run fluctuations influenced the business cycle. He believed it was possible for the public to confuse rising prices as being driven by increased demand from a growing economy rather than an increase in the amount of money in circulation. In this instance, a rising price level might temporarily stimulate purchases if consumers believed the economy was doing well, a misconception he called ‘money illusion’. In order to test this proposition, he looked for short-term correlations between prices and output. He introduced the distributive lag model, where current output movements are modelled on seven monthly lags of price changes. He concluded that 90 per cent of short-term output movements were accounted for by recent changes in prices. His findings convinced him he had dealt a blow to all other business-cycle theories, as only around 10 per cent of cyclical movements were not explained by fluctuations in prices. However, Fisher himself had made strong assertions, in particular the assumed causality between prices and output rather than vice versa. Mainstream economists thought his work interesting, but were less than accepting of the conclusions.

  Fisher had a long-standing concern with how prices are set in the economy. In 1911 he published a book called The Purchasing Power of Money. He wanted to educate the general public about the consequences of money supply and inflation as he felt that people were unable to connect the two, and therefore could not protect themselves from the consequences of inflation. He later noted the European hyperinflation after the First World War, for which many causes were cited, but not the one Fisher believed to be paramount: an uncontrolled expansion in the money supply. He also wanted to make people understand the costs of inflation and why its control should matter. Inflation redistributes wealth from savers to borrowers since inflation reduces the quantity of goods those savings can buy while borrowers benefit from a reduction in the real value of what they owe. Also, workers on fixed incomes saw their real wages decline while companies tied to contracts agreed under the false premise of stable prices also suffered.

  Fisher’s Quantity Theory of Money argued that a stable money supply was the key to stable prices. By stable money he meant money that held a constant purchasing power over goods and services available in the economy. He used terms such as the ‘constant dollar’, ‘standardizing the dollar’, ‘unshrinkable dollar’ or the ‘commodity dollar’ to describe a dollar that could buy a constant amount of goods and services. His ‘commodity dollar’ would encourage the public to think about the purchasing power of a dollar when it came to setting prices and writing contracts.

  Fisher’s idea was in direct contrast to the gold standard, the de facto economic policy of the day. The gold standard required the dollar to be exchangeable for a fixed quantity of gold, but it had not always been successful at achieving price stability. His concept of the commodity dollar required a dollar to be fixed in value against a group of commodities (goods), and its gold content adjusted to maintain its purchasing power.

  He had observed that, between 1873 and 1896, the dollar’s value increased as American prices fell. Fisher argued that this led to a prolonged depression as the supply of money was determined by the amount of gold, so the money supply was growing at a slower pace than was needed for the number of transactions necessary to maintain growth in the economy. The obvious solution would have been to reduce the amount of gold in the US dollar to lower its value. If that resulted in too much inflation then the amount of gold backing the dollar could be increased. Practically speaking, Fisher’s idea required gold coins to be removed from circulation and replaced with ‘gold certificates’, which would circulate with gold bullion backing. This way, the amount of gold in a dollar being circulated can be disconnected from a fixed quantity of gold. The idea was to vary the amount of gold backing the dollar, in order to maintain its purchasing power. Or, as Fisher put it, the weight of gold behind the dollar would vary with prices.

  The book was very well received around the world. Keynes described it as a better exposition of monetary theory than was available elsewhere. However, in calling for the abandonment of the gold standard, Fisher had placed himself at odds with the consensus of political and business opinion. Those who opposed Fisher’s idea at least saw the logic, but did not believe it would be easy or practical to implement. They were also worried about undermining confidence in the operation of the gold standard, which already had been exposed as a fallible system of price stability. Tinkering with the gold standard was not a preferred option. Any admission that it was not perfect, or that the value of the dollar might require adjustment, was considered subversive and liable to undermine confidence in both the operation of the system and the value of the dollar.

  After failing to convince President Woodrow Wilson of the merits of his plan, Fisher believed that he had to garner public opinion. He attempted to do so in 1914 by publishing a non-technical and popularized version of his 1911 work, which he called Why is the Dollar Shrinking? Fisher also gave the Hitchcock Lectures in 1917 on ‘Stabilizing the Dollar’, which later became a book of the same title. In 1927 he gave the Geneva Lectures focusing on the problem of money illusion. The lectures were turned into a short book written in large text and with the general public in mind. The first part of the book focused on how money illusion created economic cycles. The second part was the policy prescription, outlining what a monetary authority should do and how individuals could avoid money illusion to protect their real living standards. His effort was to be fruitless. Despite a succession of publications and numerous speeches between 1912 and 1934, he was unable to persuade policymakers to adopt the principle of the commodity dollar.

  Although the commodity dollar idea never took off, similar schemes such as index-linked wages and pensions have become widely adopted. The development of price and quantity indices in economics was largely due to Fisher, who argued that wartime inflation had called for the indexation of wages to protect real take-home pay. He had already applied the concept to his own staff.

  In 1922 he published one of his most technical works, The Making of Index Numbers. He described how indices of price and output movements could be constructed. A year later he established the Index Number Institute. This was a business to prepare and issue economic index numbers for publications. In 1926 he added an economic analysis section to the INI, and by 1929 some of his statistics were reaching over 5 million newspaper readers.

  The idea of indexation can also be applied to debt so investors’ returns are protected from inflation. While a director of Remington Rand, Fisher pioneered the first inflation-indexed bond, where investors earned a set real return regardless of what the inflation rate was. It didn’t catch on, simply because most investors at the time did not understand what they were being sold. Today most debt issuance is still in nominal terms that do not take inflation into account, but inflation-protected bonds have become part of the debt issued by governments around the world.

  Although indexation schemes are now fairly widespread, perhaps the country which has come closest to embracing Fisher is Chile. The UF, or Unidad de Fomento (Development Unit), was introduced in 1967. The UF is nominally the Chilean currency, but corrected for inflation. It remains in use today for wage contracts, for instance, so pay rises are awarded in real terms. The UF made indexing to inflation transparent, and Chile is the most inflation-indexed country in the world.

  The Nobel Prize-winning economist Robert Shiller, in the spirit of Irving Fisher, has proposed that contracts in the US be expressed in terms of baskets reflecting the real value of a consumer’s nee
d, or in Fisher’s terminology, a set of commodities they buy. He also suggested that governments could issue debt, so sell government bonds, denominated in terms of shares of nominal GDP and proposed calling these shares Trills. Each would pay a quarterly dividend equal to one trillionth of a country’s national output, in which case the dividend would automatically correct for movements in inflation.

  The intellectual pursuit that dominated Fisher’s work stemmed from his experience in losing his fortune in the Great Depression. As events overwhelmed him, he sought out explanations. He did not like to be proven wrong, and needed to understand what was happening. He remained convinced the market and the economy would recover, but first he felt a strong need to explain the drama of the Great Crash.

  In his 1930 book The Stock Market Crash – and After, Fisher identified why the market had been pumped up excessively in the years preceding the crash. First, overeager shoestring investors had driven the market up beyond its fundamental worth and were overextending themselves using credit. There was also the influence of margin buying in certain stocks. (This was, of course, exactly what Fisher himself had been doing.)

  By 1932 the US economy was far from being in recovery mode and the quick rebound to the 1929 crash predicted by Fisher looked increasingly unlikely. Unemployment had hit 25 per cent compared to around 4 per cent in 1929. GDP had fallen by over 40 per cent. Nearly 6,000 banks had failed since the crash. Despite the terrible news, Fisher still believed the depression was bottoming out, and that the economy would quickly move away from depression in 1933. It didn’t.

  After his experience of the 1930s, Fisher produced a theory of business cycles different from the monetarist version of his earlier work. This was the debt-deflation theory of depression, which he laid out in his 1932 book Booms and Depressions, and summarized a year later in his famous 1933 article in Econometrica entitled ‘The Debt-Deflation Theory of Great Depressions’. Fisher identified all great depressions as starting from a point of overindebtedness:

  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.15

  In the case of the Great Depression, the overindebtedness originated in reckless borrowing by corporations who had been encouraged by high-pressure salesmanship of investment bankers. The collapse of the debt bubble then led to a self-perpetuating vicious circle of falling asset prices, which, as Fisher knew from experience, made it hard to repay one’s debt. It led to further distressed selling, rising bankruptcies and even bank runs as loans went bad on banks’ balance sheets.

  He then described the process of debt-deflation, where attempts to liquidate assets in order to reduce debts become self-defeating, as the ensuing fall in prices raises the real value of debts even more. In other words, the real cost of borrowing is the nominal interest rate minus inflation, so deflation increases the cost of debt while inflation would reduce it. Fisher observed:

  Each dollar of debt still unpaid becomes a bigger dollar, and if the over-indebtedness with which we started was great enough, the liquidation of debts cannot keep up with the fall of prices which it causes. In that case, liquidation defeats itself. While it diminishes the number of dollars owed, it may not do so as fast as it increases the value of each dollar owed. Then, the very effort of individuals to lessen their burden of debts increases it, because of the mass effect of the stampede to liquidate is swelling each dollar owed.16

  For Fisher, the simple way out of the crisis was reflation of the price level, which would reduce the real value of debt. Although Fisher’s work was to come back into vogue later, his prognosis was generally ignored in favour of John Maynard Keynes, who in 1936 published The General Theory of Employment, Interest and Money. Keynes identified excessive saving and a lack of aggregate demand as the cause of the ongoing depression, and urged the government to restore full employment through deficit-financed government spending.

  Ben Bernanke and financial accelerators

  One of the criticisms of Fisher’s debt-deflation explanation is that price changes simply have a redistributive effect between debtors and creditors. Falling prices result in an increase in the real value of debts, and a transfer of wealth from debtors to creditors. Therefore, creditors gain while debtors lose, but the overall impact on society should be closer to zero.

  Ben Bernanke, who served two terms as the chairman of the Federal Reserve between 2006 and 2014, and oversaw the US central bank’s response to the 2008 global financial crisis, was previously an academic economist and scholar of the Great Depression. In an article published in 1983 he claimed to have rescued the Fisher debt-deflation hypothesis by adding the idea of the credit crunch.17 This would be the missing link between deflation and dramatic declines in nominal incomes.

  As prices fall, the real debt burden of debtors rises; but, far from benefiting, it actually hurts creditors because falling asset prices, rising loan impairments and bankruptcies lead to a fall in the value of assets on bank balance sheets. These collateral effects lessen the incentive for creditors to lend, resulting in a credit crunch, which then hits aggregate demand in the economy through a fall in consumption and investment.

  This idea goes to the heart of the ‘financial accelerator’ concept, which describes how financial conditions tend to propagate business cycles. It is predominately based on the idea of asymmetric information. Those wishing to borrow to invest have a much better understanding of the projects than the creditor. Therefore, debt contracts often require the posting of collateral, which is an asset that is pledged by the borrower to the project. For instance, a borrower may pledge his home as collateral for a loan. So, the collateral comes down to the net worth of the debtor. Falling asset prices reduce this net worth. Therefore, an economic downturn can lead to a tightening of financial conditions and less credit availability.

  The Great Depression and ensuing debt-deflation led to wide-scale distress among borrowers, lowering their ability to pledge collateral. But this also increased the risk to lenders as the average financial health of borrowers deteriorated, which impeded the flow of credit to the economy. The banking panics of the 1930s caused banks to shut their doors to avoid facing the risk of a run on their deposits. This, however, shut them off from their customers and increased the asymmetric information problems between borrowers and lenders, which further dampened normal lending activities to households and businesses.

  Fast forward seventy years and it is clear that financial accelerator effects played a key role in the run-up to, and the aftermath of, the 2008 global financial crisis. As mortgage lending is secured on the value of houses, rising house prices tend to improve the financial conditions of lenders as default risks fall. This encourages further mortgage lending, which has the effect of raising prices further. This lending may also be directed at riskier parts of the mortgage market, that is sub-prime, or less than prime creditworthiness, lending. As homes are worth more, the loan-to-value ratios increase, which also gives homeowners the opportunity to refinance their mortgages at lower rates of interest.

  It is possible that the way banks finance themselves today has increased the impact of the financial accelerator on lending activity. Historically, banks have been viewed as institutions that intermediate between savers (their depositors) and borrowers (those who take out loans). Banks today, though, are less dependent on deposits for money creation. Global money markets are substantial and provide a large source of wholesale funding to financial institutions.

  What this means is that banks themselves may not be dissimilar to other borrowers. Banks that are well capitalized
are likely to be able to raise wholesale funds at lower interest rates than those that are poorly capitalized. For banks, it is typically expensive to raise new capital on the open market, so their balance sheets are primarily determined by earnings and asset values. In turn, the level of bank capital relative to regulatory levels can be an important determinant of a bank’s cost of financing. But banks’ capital positions also tend to be strongly pro-cyclical since assets tend to increase in value in a boom and fall in a recession. This further enhances the potential potency of the financial accelerator, observed in the large build-up of mortgage debt and high leverage of the financial sector in the run-up to the financial crisis.

  It also means that in the aftermath of a financial crisis, where the banking system finds itself overleveraged, burdened with non-performing loans and insufficient capital, there can be a sharp drop in the flow of credit to the economy. This was seen in Japan when the financial problems of its banks and corporations contributed to lost decades of growth.