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Following the view of Irving Fisher some economists argue that
deflation and the following depression is the result of over indebtedness.
Fisher regarded over-indebtedness as a situation where the debt is out of
line i.e. too big relatively to other economic factors. He held that :
If a debtor has not borrowed enough, he can, under normal conditions,
easily correct the error by borrowing more. But, if he has gone too far into
debt, especially if he has misjudged as to maturity dates-freedom of
adjustment may no longer be possible. He may find himself caught as in a
trap. (Irving Fisher, Booms and Depressions, p. 11)
Fisher maintained that all kinds of shocks can set in motion the
liquidation of debt, which in turn triggers a fall in the money stock and in
prices of goods. These events in turn lead to a depression. According to
Fisher over-indebtedness gives rise to the following nine stages that are
instrumental in causing deflation and depression.
1. Debt liquidation in response to a random shock such as the bursting
of a bubble in stock prices. To liquidate debt people are forced into a
distressed selling of assets.
2. The liquidation of debts leads to the shrinking of money and to a
slow down in the velocity of circulation.
3. This causes declines in the price level
4. The fall in the asset value while the value of liabilities remains
constant leads to a fall in businesses net worth, precipitating bankruptcies.
5. Profits are curtailed and losses emerge.
6. Production, trade and employment are curtailed.
7. These losses, bankruptcies and unemployment lead to pessimism and
loss of confidence.
8. Which in turn leads to hoarding and a further slowing in the money
velocity.
9. A fall in nominal interest rates and a rise in real interest rates.
Fisher’s explanation of what causes depression is based on very
little theory and largely only describes historical events. However, data by
itself doesn’t talk. It cannot be regarded as a fact until it is
identified by means of a theoretical framework. According to the Mises and
Rothbard framework, in order to identify various observed events they must be
reduced to the primary facts of reality. This amounts to the establishment of
a link between the observed data and a non-refutable axiom that human beings
exist and act. Following this procedure, by means of a deductive process,
both Mises and Rothbard have established that boom-bust cycles and hence
inflation and deflation are not an inherent part of a free capitalistic
economy, but rather the result of inflationary policies of the central bank
(Ludwig von Mises, Human Action, p. 422. ).
Since Fisher never bothered to identify the true causes of
over-indebtedness it is not surprising that he advocated loose monetary
policies to arrest depression. Had he investigated further, he would have
discovered, as Mises and Rothbard did, that general over-indebtedness cannot
occur in a free market economy. For general over-indebtedness means that most
borrowers have misjudged the state of economic conditions. This, according to
Mises and Rothbard can only take place as a result of loose monetary policies
of the central bank, which causes businessmen collectively to commit errors
in their business decisions. (Ibid.
p. 422.)
This in turn implies that over-indebtedness is not the primary cause
of instability that leads to an economic slump. According to Fisher the size
of the debt determines the severity of a depression. Thus he observed that
the deflation following the stock market crash of October 1929 had a greater
effect on real spending than the deflation of 1921 had because nominal debt
was much greater in 1929. We however, maintain that it is not the size of the
debt that determines the severity of a recession, but rather the
aggressiveness of the loose monetary policies of the central bank.
It is loose monetary policies of the central bank that cause the
misallocation of resources and the depletion of the pool of funding and in
turn can be manifested in over-indebtedness. So to put the blame on the size
of the debt as the key factor in causing depression is no different to
blaming the thermometer for causing the high temperature
Article originally published on www.brookesnews.com
Brookesnews Editor note : Some people have been given the
idea that according to the Austrians deflation also creates malinvestments.
Not true. Malinvestments are caused by the expansion of bank credit that
lowers the interest rate below its market rate. To put it very simply:
forcing the interest rate below the market rate misdirects investment which
in turn is funded by the newly-created credit. It is impossible for deflation
to create this effect. Anyone who gives an opinion on the Austrian theory of
the business cycle while omitting the crucial role that the interest rate
plays simply does not know what he is talking about.
Frank Shostak
Frank
Shostak is a former professor of economics and M. F. Global's chief economist.
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