“ it is necessary to have an economic theory which makes great depressions one of the possible states in which our type of capitalist economy can find itself.” ( Can "It” Happen Again? A Reprise )
Theory combined insights from Marx, Schumpeter, Keynes & Irving Fisher
Key foundation Fisher’s “Debt-Deflation Theory of Great Depressions”…
As well as one of world’s most prominent economists, Fisher was also a newspaper columnist (a risky business...)
On Wednesday, October 15, 1929, Fisher comments “Stock prices have reached what looks like a permanently high plateau.
I do not feel that there will soon, if ever, be a fifty or sixty point break below present levels, such as Mr. Babson has predicted.
I expect to see the stock market a good deal higher than it is today within a few months.”
On October 23rd, 1929, Black Wednesday: Dow Jones loses almost 10% in a single day
4 years later, the broad market was 1/6th of its peak, and Irving Fisher had lost over $10 million.
The Wall Street Crash To below 42 at its trough With rallies that implied “the worst is over…” By the final end, market was down 89% from its peak 25 years to recover From 382 at its peak in less than 3 years
When overconfidence leads to overindebtedness, a chain reaction ensues:
“ (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 of prices, in other words, a swelling of the dollar. Assuming, as above stated, that this fall of prices is not interfered with by reflation or otherwise, there must be
(4) A still greater fall in the net worths of business, precipitating bankruptcies and
Fisher’s statement is a powerful argument for disequilibrium analysis in macroeconomics and finance:
“ 9. We may tentatively assume that, ordinarily and within wide limits, all, or almost all, economic variables tend, in a general way, toward a stable equilibrium…
10. Under such assumptions … it follows that, unless some outside force intervenes, any "free" oscillations about equilibrium must tend progressively to grow smaller and smaller, just as a rocking chair set in motion tends to stop…
11. But the exact equilibrium thus sought is seldom reached and never long maintained.
New disturbances are, humanly speaking, sure to occur, so that, in actual fact, any variable is almost always above or below the ideal equilibrium…
Theoretically there may be—in fact, at most times there must be —over-or under-production, over-or under-consumption, over-or under-spending, over-or under-saving, over-or under-investment, and over or under everything else.
It is as absurd to assume that, for any long period of time, the variables in the economic organization, or any part of them, will “stay put,” in perfect equilibrium, as to assume that the Atlantic Ocean can ever be without a wave. ” (Fisher 1933, p. 339; emphases added)
with only overindebtedness or deflation, growth eventually corrects problem; it is …
“ more analogous to stable equilibrium: the more the boat rocks the more it will tend to right itself. In that case, we have a truer example of a cycle” (Fisher 1933: 344-345)
Great Depression: overindebtedness and deflation
with deflation on top of excessive debt, “ the more debtors pay, the more they owe . The more the economic boat tips, the more it tends to tip. It is not tending to right itself, but is capsizing” (Fisher 1933: 344).
Some discussion of debt-deflation when discussing reduction in money wages (neoclassical proposal):
“ Since a special reduction of money-wages is always advantageous to an individual entrepreneur ...
a general reduction … may break through a vicious circle of unduly pessimistic estimates of the marginal efficiency of capital …
On the other hand, the depressing influence on entrepreneurs of their greater burden of debt may partially offset any cheerful reactions from the reductions of wages.
Indeed if the fall of wages and prices goes far, the embarrassment of those entrepreneurs who are heavily indebted may soon reach the point of insolvency—with severe adverse effects on investment.” (Keynes 1936: 264)
“ The method of increasing the quantity of money in terms of wage-units by decreasing the wage-unit increases proportionately the burden of debt; whereas the method of producing the same result by increasing the quantity of money whilst leaving the wage-unit unchanged has the opposite effect.
Having regard to the excessive burden of many types of debt, it can only be an inexperienced person who would prefer the former .” (1936: 268-69)
Keynes’s focus here more physical and macro (impact on investment) than Fisher; Keynes’s main contributions on finance relate to
Dual Price Level hypothesis
Analysis of expectations and behaviour of finance markets
In most of General Theory , Keynes argued that investment motivated by relationship between marginal efficiency of investment schedule (MEI) and the rate of interest
In Chapter 17 of General Theory , “The General Theory of Employment” and “Alternative theories of the rate of interest” (1937), instead spoke in terms of two price levels: commodities (cost price) & assets (speculative)
investment motivated by the desire to produce “those assets of which the normal supply-price is less than the demand price” (Keynes 1936: 228)
Demand price determined by prospective yields, depreciation and liquidity preference.
Two price level analysis becomes more dominant subsequent to General Theory :
The scale of production of capital assets “depends, of course, on the relation between their costs of production and the prices which they are expected to realise in the market.” (Keynes 1937a: 217)
MEI analysis akin to view that uncertainty can be reduced “to the same calculable status as that of certainty itself” via a “Benthamite calculus”
whereas the kind of uncertainty that matters in investment is that about which “there is no scientific basis on which to form any calculable probability whatever. We simply do not know.” (Keynes 1937a: 213, 214)
Given incalculable uncertainty, investors form fragile expectations about the future
These are crystallised in the prices they place upon capital asset
Given fragile basis for expecations, asset prices are subject to sudden and violent change
with equally sudden and violent consequences for the propensity to invest
Seen in this light, the marginal efficiency of capital is simply the ratio of the yield from an asset to its current demand price, and therefore there is a different “marginal efficiency of capital” for every different level of asset prices (Keynes 1937a: 222)
Conventional theory suffers from “barter illusion”
Existing producers using existing production methods exchanging existing products
“ Walras’ Law” applies
Major role of finance is initiating new products / production methods etc.;
For these equilibrium-disturbing events, classic “money a veil over barter” concept cannot apply.
“ From this it follows, therefore, that in real life total credit must be greater than it could be if there were only fully covered credit . The credit structure projects not only beyond the existing gold basis, but also beyond the existing commodity basis.” (101)
Say’s Law & Walras’ Law apply in circular flow, but not entrepreneurial credit-financed activity:
“ In the circular flow, from which we always start, the same products are produced every year in the same way.
For every supply there waits somewhere in the economic system a corresponding demand, for every demand the corresponding supply.
All goods are dealt in at determined prices with only insignificant oscillations, so that every unit of money may be considered as going the same way in every period.
A given quantity of purchasing power is available at any moment to purchase the existing quantity of original productive services, in order then to pass into the hands of their owners and then again to be spent on consumption goods.” (108)
Schumpeter here similar to Marx’s “Circuits of Capital”
Equivalent to Schumpeter’s “circular flow”
Essentially Say’s Law applies
Sellers only sell in order to buy
Equivalent to Schumpeter’s entrepreneurial function
Say’s Law doesn’t apply: “The capitalist throws less value in the form of money into the circulation than he draws out of it...
Since he functions ... as an industrial capitalist, his supply of commodity-value is always greater than his demand for it. If his supply and demand in this respect covered each other it would mean that his capital had not produced any surplus-value...
His aim is not to equalize his supply and demand, but to make the inequality between them ... as great as possible. ” (Marx 1885: 120-121)
Same as Schumpeter’s point:
Capitalist “throws in” borrowed money
Succeeds if can repay debt and pocket some of the gap