Financial crisis: Different this time?
By Matthew McClearn
Irving Fisher couldn’t have been more wrong. Even as other observers fretted that a market bubble was about to burst, he confidently predicted that stocks had reached “a permanently high plateau.” Fisher was one of the leading economists of his generation, a professor at Yale University and one of the most quotable prognosticators on Wall Street. He wasn’t just selling this Kool-Aid — he drank deeply, investing heavily in the stock market, and had assembled a fortune of $10 million from virtually nothing.
Too bad it was October 1929. The subsequent crash not only exposed his folly; it wiped out his net worth and left him in hock $1 million to his sister-in-law. As the economy collapsed around him, Fisher continued to insist for the next two years that an imminent recovery of stock prices was just around the corner.
Caught flat-footed by the Depression, Fisher eventually concluded that existing economic theory couldn’t explain the pervasive misery he was witnessing. He began scrutinizing the Depression’s macabre mechanics, and those of major crises from the 19th century. In 1933, he published a groundbreaking new theory. Entitled The Debt-Deflation Theory of Great Depressions, it sought to isolate and explain which factors determine whether an economy enters a destructive tailspin. Don’t peruse Fisher’s work before going to bed: it presents uncomfortable parallels to the modern era, and thus might provoke insomnia.
In the 1930s, as now, it was fashionable to talk of the “business cycle.” Ask that great oracle of our times, Google, to define the concept, and you’ll get plenty of competing explanations but no consensus; the term, it seems, is virtually meaningless. To Fisher, it suggested that the overall economy oscillates in a reasonably predictable manner, entering phases of growth and contraction with regularity. (The Guardian, a British newspaper, claims fluctuations occur at five-year intervals.) Fisher rejected this view as bunkum. He saw multiple cycles working concurrently. “There are always innumerable cycles, long and short, big and little,” he wrote, “any historical event being the resultant of all the tendencies then at work.”
But just when it seemed Fisher had a gift for stating the obvious, he isolated a mere two ingredients in all this noise — burgeoning debt and falling prices — as being prerequisites for economic disaster. In his view, excessive investment and speculation just weren’t dangerous enough — unless, that is, they were done using borrowed money. And swaggering overconfidence wouldn’t do either, unless it drove people to take on too much debt. “Disturbances in these two factors — debt and the purchasing power of the monetary unit — will set up serious disturbances in all, or nearly all, other economic variables,” he wrote. “In short, the big bad actors are debt disturbances and price-level disturbances.”
His own brushes with insolvency notwithstanding, Fisher was no debt-dreading fearmonger. He understood that debt need not be the result of frothing-at-the-mouth irrationality, nor the wanton surrender to depraved human appetites. In fact, it can be a sensible response to low interest rates. “Easy money is the great cause of over-borrowing,” Fisher wrote. “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 borrowed money.” Fisher also understood that debt must always be considered in relation to wealth, income and the gold supply (the latter being particularly important in Fisher’s day, because exchange rates were locked to the gold standard).
The problem with debt, Fisher believed, is that once there’s too much of it, it leaves both borrowers and lenders in precarious situations. In a heavily indebted system, even a minor shock (such as falling share prices) can undermine confidence, provoking borrowers to begin selling assets to pay down debt to a more manageable level. A first wave of distress selling ensues. Deposit currency contracts as loans are paid off, slowing the circulation of money through the system. And that, in turn, causes deflation.
Deflation means that prices are in general decline. Note the emphasis on “general” — falling prices in one sector of the economy, such as personal computers or automobiles, might cause difficulties for those sectors, but that’s different from falling prices across the board. The current chairman of the U.S. Federal Reserve, Ben Bernanke, has explained that “deflation is in almost all cases a side effect of a collapse of aggregate demand — a drop in spending so severe that producers must cut prices on an ongoing basis in order to find buyers.”
Deflation is often feared more than its destructive sibling, inflation. It sends bankers into a tizzy; if the value of a loan’s collateral implodes, the principal is no longer safe. They become averse to providing financing, and credit dries up. Meanwhile, potential buyers have little incentive to make purchases when they anticipate falling prices.
Once deflation takes hold, Fisher posited, a nasty cycle ensues. As prices fall, the dollar gains purchasing power — meaning that each dollar of outstanding debt becomes a greater burden. “The liquidation of debts cannot keep up with the fall of prices which it causes,” Fisher explained. “The liquidation defeats itself….The very effort of individuals to lessen their burden of debts increases it, because of the mass effect of the stampede to liquidate in swelling each dollar owed.” Businesses watch their net worth and profits plummet. Some go bankrupt. Survivors cut output and fire workers. People begin hoarding currency, which further slows the flow of money.
Fisher posited that a sufficiently over-indebted economy acts much like a capsizing ship. Under normal conditions, a ship is designed to right itself following a disturbance. Once tipped beyond a certain point, however, it has a tendency to depart further from equilibrium. In the economy’s case, capsizing stops only after nearly everyone is bankrupt. “This is the so-called ‘natural’ way out of a depression, via needless and cruel bankruptcy, unemployment and starvation,” he wrote.
All this, Fisher believed, neatly explained the Depression. He claimed that the low interest rates of the 1920s spurred investors to borrow, and to invest or speculate with the proceeds. By 1929, debts had risen to unprecedented levels — so great that they capsized the boat. In the weeks following Oct. 29, 1929 — or Black Tuesday, as it came immediately to be known — waves of margin calls provoked distress-selling of investments. So began the debt-deflation. By 1933, Fisher observed, liquidation had succeeded in reducing outstanding debt by 20%, but it had also increased the value of a dollar by 75%. In real terms, debt had actually increased 40%. The more debtors paid, the more they owed.
Such was the greatest economic disaster in memory. J. Bradford DeLong, a professor at the University of California at Berkeley, wrote: “At its nadir, the Depression was collective insanity. Workers were idle because firms would not hire them to work their machines; firms would not hire workers to work machines because they saw no market for goods; and there was no market for goods because workers had no incomes to spend.”
Confronted by the Depression, the first instinct of governments and central banks was to do nothing. Fisher deemed this a terrible mistake; he believed it was always possible to reflate price levels back to equilibrium — by lowering interest rates, for example. Fisher argued that once President Franklin Roosevelt embarked on reflation in 1933, the Depression reversed itself: “Had no artificial respiration been applied, we would soon have seen general bankruptcies of the mortgage guarantee companies, savings banks, life insurance companies, railways, municipalities, and states.” The Depression, in other words, could have been far worse.
Fisher was noted for giving unsolicited advice, but his new theory was widely ignored. “If he’d been hit by a bus in the middle of 1929, he would have had a reputation as an academic who nonetheless managed to make a great fortune from nothing,” says Robert Dimand, a professor of economics at Brock University who co-edited a book about Fisher’s legacy. “By 1933, Irving Fisher was a figure of fun. At the time, the response was: ‘That’s the guy who said stocks had reached a permanently high plateau. He’s just trying to come up with an alibi for why he was wrong.’”
Fisher died in 1947. A decade later, famed economist John Kenneth Galbraith was still ridiculing him. But after a half-century of abuse, he was somewhat rehabilitated in the 1970s as theorists such as noted American economists Hyman Minsky and James Tobin began fretting about the stability of the financial system. Debt-deflation theory was trundled out once again, and some of its proponents have since gained considerable influence. Mervyn King, governor of the Bank of England, wrote about it as an academic. And a sharp young Stanford economics professor updated Fisher’s theory in 1983. His name was Ben Bernanke.
Though still widely ignored in times of growth and stability, Fisher’s theory has attracted new devotees during virtually every credit disturbance of the past 30 years. “We’ve seen a recent resurgence in interest in debt-deflation in recent months,” says Dimand. “I suspect it will resurface every time there’s a financial crisis.”
Ben Bernanke couldn’t have been more wrong. The veteran economist and newly minted Federal Reserve chairman predicted that troubles in America’s sub-prime market would not prove contagious. “We believe the effect of the troubles in the sub-prime sector on the broader housing market will likely be limited,” he proclaimed during a speech, “and we do not expect significant spillovers…to the rest of the economy or to the financial system.”
Too bad it was May 2007. Though Bernanke’s follies are not nearly so quotable as Fisher’s, they are no less evident. The sub-prime crisis did indeed spill over to the broader housing market, the financial system, the whole damned economy. Many lenders are now bracing for mounting defaults in auto loans and credit cards. Some fear a sudden collapse of opaque, highly leveraged hedge funds. And amid the feverish chatter about the probability of a recession, an ugly word has surfaced.
“Today we have insolvency problems,” Nouriel Roubini, a bearish economics professor at New York University, declared recently. “It is much worse than the tech bust of 2000 and 2001, when most of the problems were confined to the tech sector and we had a mild recession. You have to go back to the Great Depression for something comparable.”
The D-word should not be invoked lightly. Nevertheless, there are some uncomfortable similarities between 1929 and today. We’ve already witnessed the near-failure of storied Wall Street investment dealer Bear Stearns, which the Fed had to bail out using extraordinary powers it hadn’t exercised since the Depression. And as with the 1929 stock crash, our current situation was built on a foundation of easy money. The ready availability of house-backed credit allowed Americans to embark on a spending orgy. Consumption rose faster than incomes. That’s true in Canada, too: a report released by the Vanier Institute of the Family in February says that debt rose seven times faster than incomes in Canadian households since 1990, moving above $80,000 last year for the first time. “The U.S. and other western economies have shown remarkable ability to leverage themselves up over the past several decades,” BCA Research, a Montreal-based investment advisory firm, observed in a recent note.
Does debt-deflation theory have any relevance in our current situation? “Every so often one hears that such credit crunches can’t happen again, and that financial institutions are very sophisticated in how they value assets,” says Dimand. “It would seem that even very large and sophisticated financial institutions can lose large amounts of money in situations that turn out to be much riskier than they thought. So I think it’s very relevant.”
What we’re seeing in America’s housing market seems a classic microcosm of a debt-deflation. Mortgage debt spiralled out of control, and house prices have now been falling for two years. According to the National Association of Realtors, the average median price of existing U.S. homes fell by 1.4% last year — the first such decline since the Depression. Even that relatively benign decrease has driven the rate of mortgage delinquencies to their highest level in decades. (Other factors, such as the notorious resetting of interest rates characteristic of adjustable-rate mortgages, are also at play.) Many recent homebuyers find themselves “under water” — that is, their outstanding mortgage debt is greater than the value of the property that serves as collateral. We now hear stories of homeowners handing their keys to bankers and walking away. Banks are repossessing homes and dumping them on the market at cut-rate prices. With prices falling, potential homebuyers are delaying purchases. Meanwhile, economists now observe an increase in defaults among homeowners with previously unblemished credit ratings. “This collapse in housing value is sucking in all borrowers,” Mark Zandi, chief economist at Moody’s Economy.com, recently told the New York Times.
Well, that’s housing. But falling home prices do not equal deflation. In fact, we remain in an inflationary economy. At the end of last year, annualized inflation stood at 3.3% in the OECD area. Pundits fret that rising food and energy prices will provoke higher inflation; some even predict stagflation — a stagnant economy and surging prices. In sum, we’ve got mountains of debt but none of the other stuff. So for Fisher’s bastards — those who adhere to modernized versions of his debt-deflation theory — the question is: Could America’s falling house prices trigger a collapse in aggregate demand?
For years, U.S. consumer spending has been the great bulwark of the global economy. According to RBC Capital Markets, consumer spending drives 70% of the American economy. And America remains the world’s dominant economy. Growth in consumer spending has not yet deteriorated markedly.
But it could. Homes have long been esteemed as a sacrosanct ingredient in American middle-class wealth, and more recently have become piggy banks for many consumers. Now that prices are falling (however marginally), many homeowners find themselves in precarious situations. They have steadily reduced their savings rate since the late 1980s — it has withered to almost nothing. Many Americans now must turn their attention to paying down debt and saving for the future.
Imagine what would happen if home prices fell appreciably — as some observers predict. David Rosenberg, Merrill Lynch’s chief economist for North America, says they could slide another 25%–30% over the next two years. Roubini says 20%–30%. Any such decline would crush many homeowners, and cause survivors to dramatically reduce their spending — in other words, a great collapse in aggregate demand.
Some think that it’s all over but the crying. Eric Janszen, founder of the bearish Internet newsletter iTulip.com, recently wrote in Harper’s magazine that the American economy “is in serious trouble.” The finance, insurance and real estate sectors all know “that a debt-deflation Armageddon is nigh,” Janszen wrote, and are “praying for a timely miracle, a new bubble to keep the economy from slipping into a depression.” Jan Kregel, an academic and scholar at the Levy Economics Institute of Bard College in New York state, also recently predicted a debt-deflation disaster. “Lending to households…is likely to decline dramatically,” he warned in a paper released in December. “If the availability of household finance collapses, it is also likely that the long predicted, but never realized, retrenchment of consumer spending may become a reality.” Fisher’s bastards are marching.
They remain in a minority, however. In a recent column in the Financial Times, writer Wolfgang Munchau pooh-poohed the idea that any major economies were at risk of experiencing deflation. BCA Research, meanwhile, sees two possibilities: “Either efforts to stop debt-deflation fail and the U.S. slides into some version of Japan circa 1990–2008 (and counting); or conditions eventually calm and the economy muddles forward.” It predicts the latter. If Wall Street was expecting a debt-deflation, distressed bankers would likely already be exiting skyscraper windows at an alarming rate.
In 2002, Bernanke himself opined that it was extremely unlikely America would experience deflation in the near future. For one thing, he said, the U.S. economy has demonstrated a remarkable ability to absorb shocks. For another, the Federal Reserve would never permit a debt-deflation to take hold. Now top dog at the Fed, Bernanke is doing his best to make good on that promise. The Fed has slashed interest rates aggressively. Most G8 nations have followed suit, albeit less desperately. The Bush administration announced a flurry of tax cuts and more spending.
As for Brock’s Dimand, he acknowledges that the debt-deflation theory suggests today’s debt-laden financial system is precarious. “But there’s this one thing that’s very different from the 1930s,” he says. “Today you have central bankers who are very conscious of the dangers associated with debt-deflation.” Dimand believes central bankers will avoid deflation at all costs.
Plenty else besides has changed since the Depression. Wealthy countries abandoned the gold standard — often cited as a primary culprit for the disaster — long ago. And thanks largely to the Depression, we now have so-called “automatic stabilizers” like unemployment and deposit insurance designed to cushion society from massive economic disruptions. (Critics argue, however, that many of these stabilizers have been watered down or repealed in various deregulations since the 1970s.) These changes make direct comparisons between now and 1929 difficult.
There’s one element, however, that hasn’t changed: We have not yet conquered folly. So watch out for deflation — and try not to say anything quotable.