Debt Deflation

Irving Fisher was a leading economist in the early 20th century. After being caught out during the Great Depression (he famously quipped, “Stock prices have reached what looks like a permanently high plateau.” right before the bottom fell out), he did a lot of soul-searching and research to understand where he and his profession had gone wrong. By 1933, he had come up with a framework which very well describes what happened during the depression and happens in similar episodes of credit crisis.

From an issue of Econometrica in 1933: “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”. Then we may deduce the following chain of consequences in nine links:

1. Debt liquidation leads to distress selling 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, causes 3. A fall in the level …

Read More