Economists Evoke the Spirit of Irving Fisher

Irving Fisher (1867-1947) was a Yale University professor, a wealthy inventor (his “Index Visible” anticipated the Rolodex), a health nut, and probably the country’s best known economist in the early 20th century. So when he said publicly—in mid-October 1929—that stocks had reached “a permanently high plateau,” panicky investors calmed down. Within a week the Dow sank more than 10 percent on its way to an 89 percent meltdown. It took 25 years for stock prices to recover. Fisher’s reputation never did.

Now, as the U.S. struggles to rebound from the housing collapse, Fisher is winning more adherents. Stung by his failure to foresee the Crash and what followed, he spent years figuring out what happened. The prime result of his labors was the 1933 paper “The Debt-Deflation Theory of Great Depressions.”

In it, the economist diagnoses the Great Depression as the consequence of a pre-1929 debt binge. The pressure from excessive debt forced distress selling by investors, which triggered a broad decline in asset values, profit, output, and employment. Debtors’ incomes shrank while their debts remained fixed. “In that case, the liquidation defeats itself,” Fisher wrote.

Sound familiar? Investment banker Dan Alpert of Westwood Capital says Fisher’s name now comes up on Wall Street “all the time.” In London, Adair Turner, chairman of the British Financial Services Authority, warned recently that high levels of mortgage defaults in the U.S. were depressing demand and risked “a deflationary spiral of the sort described by Irving Fisher.”

Fisher’s debt-deflation theory explains why Federal Reserve Chairman Ben Bernanke embarked on such aggressive monetary easing, says Robert W. Dimand, an economics professor at Canada’s Brock University and a Fisher expert. The goal was to keep prices from falling into a self-perpetuating downward spiral. “It is always economically possible to stop or prevent such a depression simply by reflating the price level,” Fisher wrote.

Just as Fisher—whom Milton Friedman once called “the greatest economist the United States has ever produced”—would have predicted, high debt loads remain a problem four years after the recession’s onset in late 2007. That’s because a bubble’s collapse redistributes wealth from borrowers to creditors, says Atif Mian, a finance professor at the University of California at Berkeley’s Haas School of Business. Millions of borrowers have seen the value of their principal asset—their home—fall. Since they still owe whatever they borrowed during the boom, their consumption suffers while they struggle to repay.

Meanwhile, wealthier creditors generally don’t spend as large a percentage of their income as less affluent borrowers do. So as money shifts from the group that spends to the group that saves, economic growth lags. Drawing on Fisher’s research on debt ills, Chris Whalen, managing director of Institutional Risk Analytics, says more than $1 trillion in soured loans must be written off. In early January, William Dudley, head of the New York Federal Reserve Bank, and Sarah Bloom Raskin, a member of the Fed’s Board of Governors, publicly broached the possibility of reducing the value of the principal owed by millions of borrowers.

Not everyone thinks Fisher would approve. Lacy Hunt, chief economist at Hoisington Investment Management in Austin, Tex., and a Fisher fan, says the economist ultimately lost faith in active crisis-fighting. He decided that debt-fueled depressions instead should be allowed to “burn out” to avoid government rescues that encourage future financial catastrophes.

The bottom line: The insights of a long-dead economist explain the deep impact of high levels of debt on the economy.

Lynch is a reporter for Bloomberg News in Washington.

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