the great depression in irving fisher

8/6/2019 The Great Depression in Irving Fisher

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THE GREAT DEPRESSION IN IRVING FISHERS THOUGHT

Giovanni Pavanelli

Dipartimento di Scienze Economiche e Finanziarie G. Prato

Universit di Torino

(e-mail: [email protected])

December 2001

Abstract

This paper offers a critical re-examination of Fishers views on the origin of the Great

Depression, his debt-deflation theory and the policy measures he advocated. On the

eve of the stock

market crash in October 1929 Fisher predicted that the share prices were not

overvalued and that theirincrease was due to new profit opportunities created by technological innovation and

sharp rises in

productivity. As the depression worsened, however, he became convinced that new

theoretical

explanations were needed and presented a new model (debt-deflation theory) based on

the interaction of

real and monetary aspects. In 1932 he also became an active supporter of a stamped

money plan aimed

at counteracting widespread hoarding. During the New Deal he supported expansionarymonetary

measures and promoted a revision of the banking system aimed at abolishing fractional

reserves (100%

money). In the meantime he opposed Roosevelts labour and industrial policies and,

more generally, any

intervention by the government on economic activity with the exception of the control on

money supply.

JEL Classification: B2, B3, E5

Key words: Great depression, debt-deflation, Irving Fisher, stabilization policies

An earlier version of this paper was presented at the Fifth Annual Conference of the

European Society for the History of Economic Thought, Darmstadt, February 2001. I

am


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grateful to the seminar participants and to an anonymous referee for helpful comments.

The

usual disclaimer applies.4

1. IntroductionThe Great Depression was, without doubt, a watershed in contemporary

economic thought: Keynes General Theory can be read in large part as a sophisticated

intellectual effort to explain and counteract this unprecedented downturn in economic

activity. Nevertheless, major debates and controversies notwithstanding, we are still far

from having a complete explanation of this event. The stock market crash of October

1929 and its connection with the subsequent severe contraction of real output have also

been the object of conflicting interpretations.

During the past decade, however, considerable progress has been made.

Research, which was traditionally centred on the events internal to the United States,has now broadened in scope and stresses such factors in the spread and worsening of

the

depression as the gold standard and the related rules of the game on the one hand and

the First World War's legacy of overall indebtedness and reciprocal mistrust and rivalry

on the other (Eichengreen, 1992; Temin, 1993). Some recent studies have focused on

the effects of the fall in prices on the financial stability of households and firms

(debtdeflation effects: cf. Bernanke-Gertler, 1990; King, 1994; Wolfson, 1996).

In this framework, a growing number of studies have taken up the theoretical

contribution and policy proposals of Irving Fisher (cf. Barber, 1996, 1999; Dimand,1994, 1995; Steindl, 1995, 1999). Fisher, who is considered the leading American

economist of the twentieth century, was also one of the most acute observers of the

complex and dramatic macroeconomic events of his day and one of the most active in

seeking a solution to the problems they posed for the scientific community. For Fisher

as for other economic scholars, the Depression was an unexpected event that demanded

new answers. As the crisis was gathering, he had voiced a series of optimistic

assessments of the fundamental soudness of the American economy and had ruled out

any possibility that the stock market would collapse. The crash of 29 and the vicious

circle of falling prices and the aggravation of real private sector debt led him makesubstantial modifications of his theory of economic fluctuations and to elaborate a new

theory of great depressions (debt-deflation theory) which, as noted, has gained

renewed prominence of late. 5

This paper offers a critical re-examination of Fishers view of the origins of the

Great Depression, his debt deflationary theory and the policy measures he advocated.


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2. Interpreting the stock market crash and the Great Depression

On the eve and on the morrow of the stock market crash of 29 Fisher who, by

the way, had put most of his own wealth in shares issued a series of reassuring

statements on the stock market trend and, more generally, on the state of the Americaneconomy. In February 1929, in the face of signs of a reversal of the upward trend in

stock prices, he wrote: The refluent wave of trading has left prices of securities, and

especially of common stocks, on a shelf where they will remain permanently higher

than in past years (Fisher, 1929a). And again, and even more explicitly, in September:

Stock prices are not too high and Wall Street will not experience anything in the

nature

of a crash (Fisher, 1929b). These pronouncements, which were almost immediately

shown to be completely wrong, certainly undermined the Yale economists academic

credibility as well as public trust in his analyses1

.

Yet Fishers forecasts were neither naive nor totally unfounded. In brief, he held

that share prices incorporated the present value of expected dividends; more generally,

the stock market reflected expectations on companies future performance and that of

the economy as a whole. In Fishers view, immediately after the First World War the

industrialised countries, and the United States in particular, had experienced a great

expansion in scientific and technological research and its systematic application to

manufacturing. American industry had thus greatly increased its productivity and wasable to develop and market new consumer goods (the automobile, the radio, the

telephone). Furthermore, efficiency gains had been obtained thanks to better use of

productive factors and the improved living conditions of the working class. There were,

1

In the thirties, Fisher was relatively isolated in the scientific community, and his

policy

proposals, which, seen with hindsight, went in the right direction, were received poorly

and insome cases with hostility. 6

therefore, expectations of considerable increases in production and profits

2

These .

elements, according to Fisher, explained between two-thirds and three-fourths of the


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rise in the stock market between 1926 and September 1929 (Fisher, 1930)

3

; this

apparently healthy trend, however, had been altered by risky speculative manoeuvres,facilitated by an excessively permissive credit policy. The stock market had therefore

become increasingly precarious and vulnerable to bearish speculation, until the crash of

October-December, which ended up bringing down even first-rate securities.

In 1930 and 1931 Fisher remained basically optimistic about the prospects of the

American economy and continued to predict the imminent recovery of stock prices. In

any case, he affirmed repeatedly, it was not at all inevitable that the crisis in the

financial markets would spread to the real economy. The depression, in other words,

could be avoided as long as businessmen did not let themselves be dominated by

pessimism and did not cut back their production plans.It is also significant, in the light of the recent rediscovery of the international

dimensions of the Depression, that Fisher did not limit his considerations to the

American situation. If a rapid recovery of the economy was desired, he wrote, it was

necessary to get free of the heavy legacy of the World War, such as the inter-allied

debts

4

, and to radically review American customs policy, abolishing the 1930 SmootHawley

tariff, which had reduced international trade and had worsened the current

account deficits of the European countries, preventing them from paying their debts toAmerica in the only way possible, namely by exporting their own products.

As the depression worsened, Fisher became convinced that the crisis could not

be simply interpreted as a downturn in the business cycle, however severe, and that it

was something radically different that demanded a new theoretical explanation.

Starting

2

In Fishers view, another crucial factor was the action of the investment trusts

(mutual funds): Investment trusts have removed much of the risk inherent in commonstocks

by spreading the risks over a large number of stocks [] The elimination of risks has

greatly

stimulated the demand for the formerly despised common stocks and sent their values

up all


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along the line (Fisher, 1929a, p. 64).

3

This stimulating even if controversial thesis has been rediscovered by recent literature

(cf., among others, Sirkin, 1975; De Long-Schleifer, 1991).4

One of the most threatening aspects of the present depression is the staggering

burden

of international debts left by the World War. These debts are a formidable obstacle to

recovery

not only because they operate, as all debts do, to intensify depressions, but also because

they are

so largely political in nature and incite to political unrest (Fisher, 1931). 7

in January 32, therefore, he began to devise a new theory of great depressions, basedon the interaction of two factors: i) an initial situation of over-indebtedness; ii) a

dynamic process of price reduction

5

The over-indebtedness could have had many .

causes and did not necessarily imply the hypothesis of irrationality in the behaviour of

economic agents: on the contrary, it could be explained as a rational response to the

profit opportunities created by technological improvements and inventions. In any

case, according to Fisher, a real shock would usually trigger short-term and not

particularly serious adjustment processes. The explosive dynamic process typical of great depressions had its origins, rather, in the fact that the initial

over-indebtedness

was progressively aggravated by deflation. In brief, the model considered firstly a

system burdened with debt, but otherwise in equilibrium, albeit an unstable one; in this

situation, a minor shock (bad news or a fall in share prices) was enough to undermine

the confidence of either debtors, creditors or both and to lead to a first wave of

liquidation of debts. The rush to liquidate led to distress selling

6

and the consequentsharp fall in share prices and a contraction of bank deposits. This triggered deflation,

which in turn increased the stock of debt in real terms.

7

In essence, the attempt by

individuals and banks to reduce their debt touched off a perverse dynamic process that


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worsened their situation in real terms, dragging them towards financial collapse. The

immediate consequence was a wave of bankruptcies that drove prices still further down.

The generalised reduction in prices also damaged the entrepreneurs who were not in

debt: their sales prices fell faster than costs, squeezing profits. Now, in a capitalisticsystem, Fisher writes, it is the profit taker who usually makes the decision as to the

rate

at which his enterprise is to be run (1932a, p. 30). A fall in profits was thus bound to

bring a general reduction in output and employment. Taken together, these factors

5

The debt-deflation theory was illustrated for the first time by Fisher in a paper

presented at the annual meeting of the American Association for the Advancement of

Science inNew Orleans in January 1932. The theory was expounded most fully in a volume

published that

year (Booms and Depressions). The following year, an abridged but particularly clear

version of

the theory was published in Econometrica (cf. Fisher, 1933a; Dimand, 1994).

6

Distress selling means selling not because the price is high enough to suit you, which

is the normal characteristic of selling, but because the price is so low it frightens you

(Fisher,1932b).

7

The very effort [...] to pay debt [...] resulted in increasing debts; and the more the

American people tried to get out of debt, the more they really got in, when the debts are

measured in real commodities (Fisher, 1934a, p. 128). 8

produced a lack of confidence and pessimism that translated into a general rush

towards

money: phenomena of hoarding thus multiplied, further reducing the velocity of

circulation of money and lowering price levels; consumption contracted even further.8

Again in this case, therefore, the effort by each agent to improve his own position led to

a worsening of the overall situation: Every man who hoards does it for his own

protection; yet by hoarding he aggravates the very condition that started his fear

(1932a, p. 36)


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9

.

In essence, if not adequately countered by the monetary authorities, the

deflationary process will set in motion a perverse, self-fueling spiral bound to cause

almost universal bankruptcy (Fisher, 1932a, 1933a).

The debt-deflation theory, according to Fisher, explained what had happened in

the United States and Europe between 1929 and 1932. Referring to the first factor,

overindebtedness, Fisher had not the slightest doubt that on the eve of the stock market

crash

many firms and households were heavily indebted. One of the factors behind the

enormous pyramid of debt that had been created was certainly the war: To support the

most colossal of wars required prodigies of finance (1932a, p. 71). With reference to

the United States, however, it was also necessary to consider other aspects. As noted, inthe twenties the American economy was characterised by an investment boom, induced

by the spread of technological innovations in manufacturing; this encouraged many

firms to borrow heavily in expectations of higher profits. This process had also involved

8

In Booms and Depression Fisher clarified that in reality the relationships between

these phenomena were more complex.

9

The debt-deflation theory has been repeatedly criticised, in that in an economycharacterised by inside debt (debt and credit are created within an economic system) a

reduction in the price level should simply have redistributional effects between

creditors and

debtors without any consequence at the aggregate level. In an economy characterised by

external debt, the reduction in prices should lead to an increase in demand through

the Pigou

effect. However, these results presume that agents are homogeneous, the exact opposite

of

Fishers assumption. If, instead, we assume perhaps more reasonably that debtorsare

characterised by a higher marginal tendency to consume than creditors, a reduction in

prices

translates into a reduction in demand; in most cases, as Tobin notes, this second effect

tends to


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prevail over that of Pigou (Tobin, 1980). Moreover, in Fishers analysis the supply side

plays an

important role. According to Fisher, the debtors class coincided to a large degree with

that ofentrepreneurs; and, like Schumpeter, he believed that they played a crucial role in the

economic

system, thanks to their willingness to take risks and to seek out new opportunities for

profit.

When, as in the event of a protracted depression, a large number of entrepreneurs

become 9

farming, stimulated by the sharply rising demand for food. Finally, the stock market

boom had been accompanied and fueled by the growing indebtedness of financial

operators. The Wall Street crash was the detonator, triggering the downward spiralpredicted by debt deflation theory.

It is in any case worth noting, in the light of todays debate, that Fisher also

examined the international factors that had acted as accelerators of the deflationary

spiral. Booms and Depression accurately reconstructed the dramatic events of 1931-32

that had thrown the world into depression: in particular, the link between bank failures

in Austria and Germany, the ensuing crisis of sterling, motivated by the huge amount of

short-term credit granted to these countries by the British monetary authorities, and

the

simultaneous speculative attack on American gold reserves. This in particular, wroteFisher, demoralised the US banking community, spread hoarding and prompted bank

runs: The bankers and their depositors began raiding each other in a cut-throat

competition (1932a, p. 104).

3. The stamped money plan

In any case coming to the policy proposal that Fisher drew from his debtdeflation

theory at least in the United States the depression could have been avoided,

or at any rate its consequences mitigated, by expansionary monetary policy. On this

question, Fisher maintained that one of the causes of the collapse of the economy was

the Federal Reserves abandonment of the stabilisation policy that had been pursuedduring the twenties by Benjamin Strong, the powerful governor of the New York

Federal Reserve Bank, who died in 1928 (Fisher, 1934a

10

; see also Steindl, 1995, pp.

103-4 and Cargill, 1992). Once the crisis had started, the right way to get out of it was,


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in his view, reflation, in other words a monetary expansion to bring prices back up to

insolvent, it can be difficult to replace them; and so one has severe reductions in

employmentand output.

10

I thoroughly believe that if [Strong] had lived and his policies had been continued,

we might have had the stock market crash in a milder form, but after the crash there

would not

have been the great industrial depression. I believe some of the crash was inevitable

because of

over-indebtedness, but the depression was not inevitable (Fisher, 1934a, p. 151). 10

their pre-1929 level. Monetary policy, according to Fisher, was extremely effective,while fiscal policy could at best play an ancillary role.

On this matter Fishers analysis contains some crucial elements that we must

consider in some detail. A first point is the role that he ascribed to money in the

economy. As is evident from his writings of the thirties, Fishers vision anticipates some

aspects of the monetary circuit schemes recently taken up in the literature (cf.

Graziani, 1988). Money, Fisher wrote, had to be considered as the fundamental

distributive mechanism in the market economy; it was the bridge between the

producer and the consumer (1932a, pp. 6-7). Money, he maintained in a text written

in 1938, has become a prime necessity in our civilization. Without it goods cannot besold, and will not be produced. There may be crying need for the necessities of life;

there may be all the iron, steel, coal, lumber and other raw materials needed for

manufacturing; there may be millions of able-bodied men anxious to work: Yet, if there

is no money, there is no production; there is starvation and unemployment.

11

In advanced economies, of course, what mattered was not pocket-book money,

or cash, but cheque-book money, or the bank deposits that constituted nine tenths of

the total means of payment. The wave of bank failures of 1931-33 had thrown this

mechanism into crisis, depriving the economy of the necessary liquidity. One of thecrucial aspects of the depression, Fisher wrote, was the sudden destruction of more than

a third of the circulating medium (8 billion dollars out of a total of 23), i.e. a notable

part of the money necessary to transact our business

12

.


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A second point is the transmission mechanism, which explains how an

expansionary monetary policy can induce an increase in output and prices. Now,

notwithstanding a few ambiguities, Fisher uses the term money to mean purchasing

power in monetary terms: an increase in the means of payment available to agents, in

11

Irving Fisher Papers, Manuscript and Archives, Yale University Library, III, b. 25, f.

400, Democracy and Monetary Reform. Radio Address, August 1938. Goods, Fisher

wrote in

1933, are not overproduced but deadlocked for want of a circulating transfer-belt called

money (Fisher, 1933d, p. 3).

12

Irving Fisher Papers, Manuscript and Archives, Yale University Library, s. III, b. 25,f. 396, Is a Managed Currency Workable? An Address to the Commerce Club, Chicago,

Ill.,

Feb. 28, 1936, p. 10. 11

other words, induces an increase in aggregate demand, which in turn pushes prices

upwards

13

.

Now, the first causal link in this schema (increase in demand followed by an

increase in purchasing power), could certainly not be taken for granted. During aserious

depression, agents tend to hoard their own liquid assets; a greater supply of liquidity,

therefore, could have no real effect. This crucial point was underscored by Keynes.

Money, he wrote in Chapter 17 of the General Theory, is distinguished from other

forms of wealth by the fact that its elasticity of production and substitution were zero

or at any rate very small, and that its carrying costs were negligible; it therefore

tended to become a bottomless sink for purchasing power (Keynes, 1973, p. 231).

Fisher, in a different theoretical framework, was aware of this point, as is shown by his

handling of hoarding in Booms and Depressions14

In the second half of 1932, the .

bleakest period of the Depression, he became a supporter - as a first concrete measure

aimed at counteracting the tendency to hoarding - of a plan for stamp scrip or

stamped money.


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The proposal of stamped money had first been made at the end of the nineteenth

century by the social reformer Silvio Gesell,

15

but the plan was not applied with

13

It was reported in Chicago that when a big bank there, which had been closed, was

finally opened and the depositors had suddenly more money to spend, the department

stores

were crowded with customers for several days. Such restoration of buying power is

exactly

what has long been needed to restore business, raise the shrunken price level [...] and so

makepossible payment of debts, business at a profit, and re-employment (Fisher, 1934b, p.

5).

14

Hoarding is a slowing of currency turnover of the extremest kind. [...] Housewives

and their breadwinners then become distrustful of everything except money. Bills and

coins are

confided to stockings or mattresses, or are put underground, or (in a larger way) stored

in safety

deposit vaults. Credit deposits may be hoarded too. In such banks as are considered safe,large

credit deposits will be kept, but kept idle (1932a, p. 35). The following passage is also

revealing: To stop hoarding, to take the idle money out from under the mattress, to

quicken the

turnover of bank deposits are essential parts of the recovery program. We want to

re-employ

idle money; it will help toward re-employing idle men and idle machines; it will help

reflate the

price level... (1933b, p. 5).15

Silvio Gesell (1862-1930) was a German-born businessman. From 1886 to 1900 he

lived in Argentina, where he managed a commercial firm. His interest in economic and

social

reform started in the 1880s, after he witnessed a severe deflation which nearly brought


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the

economy of the country to collapse. At the beginning of the century he wrote his main

contribution, The Natural Economic Order, translated into English in 1929 (Gesell,

1929).Gesell considered his stamped money plan as a part of a radical reform of the economic

system

aimed at abolishing the privileges of landowners and financial institutions and at

enhancing free

competition. 12

significant results until decades later. The first experiments were conducted in two

small

towns in Germany and Austria in 1931-32 (Blanc, 1998). In brief, stamped money

was a promise of payment issued by a public body or municipality, usually with theguarantee of a bank, which circulated as a banknote but that, within a given period of

time, could be taken out of circulation and converted into legal tender. Its peculiarity

was that it was subject to a periodic tax (for example two cents per dollar per week) in

the form of a stamp that had to be affixed to the back of the note. This made the plan a

self-liquidating operation at no cost to the finances of the authority that issued the

notes.

The city could thus promote public works, remunerating workers who would otherwise

remain idle.

16The notes were obviously characterised by an high velocity of circulation,

as every agent had an evident interest in spending the scrip quickly so as to avoid the

tax (cf. Fisher, 1933d).

During 1932 and 1933 several rural communities in the United States tried to put

limited amounts of stamp scrip into circulation in order to reduce unemployment and

increase consumption. The first experiment took place in Howarden, Iowa, and the

example was soon followed by other municipalities and merchant associations in Iowa,

Illinois and Kansas. When Fisher learned of the plans in the first half of 1932, he

endorsed them enthusiastically. The information was brought to him by Hans Cohrssen,a member of a Free Economy League founded by Gesell (cf. Cohrssen, 1991). In

several syndicated columns written between July 1932 and January 1933, Fisher

presented the stamped money plan as an effective way of stimulating consumption and

putting idle men to work. He included it among other plans for reflation and

stabilization in the British edition of Booms and Depressions. In 1933, with the


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assistance of Cohrssen and of his brother Herbert, he wrote a guidebook on the subject

(cf. Fisher, 1933d) and spent a good deal of energy promoting the plan among private

associations and communities.

17

16

Naturally, this presupposes that stamped money was accepted as money by all

agents as a group.

17

With the help of Mr. H.R.L. Cohrssen I have recently answered four or five hundred

enquiries about it. The letters came from literally every state in the Union and were

written by

persons, largely in official positions, who have a practical interest in introducing stampscrip in

their several towns, cities and states (Fisher, 1933d, p. 1). 13

The Gesell plan also received favourable comment from Keynes: The idea

behind stamped money, he wrote in the General Theory, is sound (Keynes, 1973, p.

357). However, he saw a difficulty that made its large-scale application problematic.

Money, wrote Keynes, was by no means the only form of wealth characterised by a

liquidity premium; it was therefore likely that, once it was subjected to a tax, agents

would try to replace it with other assets, such as gold or silver, bankers cheques or

other means of payment.In March 1933, in any case, all forms of substitute money were declared illegal

by the Rooosevelt Administration, and the experiments came to an abrupt end.

As we have seen, an essential point in Fishers plan was that the increase in

demand, while necessary, was inevitably only a first step. To get out of the depression, a

substantial rise in prices was also necessary. This point was constantly emphasized by

Fisher in his writings from these years:

The government should have borrowed and spent, thus contributing to

reflation and to a higher price level. And every climb in the price level

would have lowered the real debts, public and private [...] This would havestimulated business (1932a, p. 105)

or again:

An increase of prices means, for the producer, an increase of profits or a

wiping out of losses. That in turn means an increase of business activity and

a decrease in unemployment. This rise of prices tends to save us from the


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two great evils of Depression -- bankruptcies and unemployment (1932, p.

10)

4. Fishers proposals during the New Deal

Fisher did not tackle the problem of stabilisation only from a theoreticalstandpoint. Rather, he made great efforts to persuade policymakers and testified at the

main Congressional hearings. In 1932, in particular, he strongly supported the

Goldsborough Bill, which called on the Federal Reserve to take all available steps to

raise the price level to its pre-1929 level and then to stabilise it.

In addition, he corresponded regularly with President Roosevelt and the leading

members of his Administration (cf. Allen, 1977; Barber, 1996). Although it is not easy 14

to determine the exact extent to which Fisher influenced the policies adopted in these

years, it can be hardly denied that at least in the the first phase of the New Deal in

1933-34 the monetary measures of the government went in the direction he suggested.

18

In

this sense, the ideas expressed by Roosevelt in his well-known July 1933 radio address

during the London Conference are revealing: The United States, Roosevelt asserted,

seeks the kind of dollar which a generation hence will have the same purchasing and

debt paying power as the dollar value we hope to attain in the near future

19

For his .part, Fisher commented more and more positively on Roosevelts monetary policy

measures, in the first place on his decision to suspend the gold standard. Fishers

contribution in this area appears even more important if one considers that many of the

most authoritative economists of the day and the most representative bankers

tenaciously opposed these measures as dangerous and subversive, advocating the

retention of the gold standard at all costs.

20

Fisher also openly praised the policy of raising the dollar price of gold,

championed by George Warren and Frank Pearson of Cornell University andimplemented by the Treasury during the course of the two years 1933-34 with massive

purchases of gold (in other words, devaluing the dollar vis--vis the currencies that used

the gold standard) with the aim of raising the prices of goods (cf. Warren-Pearson,

1933).


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18

Interestingly, Roosevelts two most influential monetary experts, the economists

James Harvey Rogers and George Warren, were both linked to some degree to Fisher.

HarveyRogers was Fishers most loyal [] pupil (Dorfman, 1969, p. 302) and became, in 1931,

his

colleague at Yale. It should be added, however, that Rogers analysis of the causes of the

Depression was remarkably original and that he did not openly support Fishers

monetary plans

(cf. Rogers, 1931, 1933, 1937; Steindl, 1995, pp. 105-10). Warren (who had been one of

the few

to predict the deflationary process of the thirties) was a member, together with Fisher,

of theadvisory council of the Committee for the Nation, a pressure group whose institutional

goal

was to promote expansionary monetary policies.

19

The similarity with the concept of commodity dollar put forward by Fisher in the

twenties is indeed striking (cf. Pavanelli, 1997). Your message to the Economic

Conference,

wrote Fisher in a letter to Roosevelt, makes me one of the happiest of men (Fisher,

1997, p.61). As we know, Roosevelts message was also warmly praised by Keynes.

20

The statement by James Warburg, a prominent banker and one of the US

representatives at the London conference, during a meeting of the American Academy of

Political and Social Science is revealing: I do not believe that [...] anything other than a

gold

standard will work satisfactorily [...]; unfortunately inflationist theory was given a

stimulus by

the speculative rise of prices which took place in the first few months of the experiment(Warburg, 1934a, p. 146, 149. Cf. also Warburg, 1934b). 15

In practice, however, the monetary-centred policy of reflation in 1933-34 only

partially achieved its aims.

21

In the second half of the thirties, most economists and the


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Administration, including the Federal Reserve, came to the conclusion that monetary

policy was basically ineffective and that fiscal policy measures were needed to stimulate

economic recovery.

Fisher realised that the open market operations promoted by the Federal Reservehad been only partially successful. His response was to promote a radical revision of the

credit system, based on the abolition of fractional reserves (Allen, 1993). With this

method, wrote Fisher, the circulating medium was in fact simply a by-product of the

private debt, and monetary policy was unpredictable: an increase of the monetary base

could bring about a sustained inflation or be almost ineffective (Fisher, 1936a, p. 105).

This latter was exactly what had happened during the Depression: for fear of

bankruptcy, banks had used most of the liquidity obtained from the Fed to inflate their

own reserves. If the situation improved, these excess reserves could fuel a surge in

inflation.22

These dangers could have been avoided by requiring the banks to hold reserves

equal to their demand liabilities (so-called 100% money)

23

In this way, financial .

institutions lending function would be clearly separated from that of money creation.

The central bank would thus gain full control over the money supply.

Even in this case, however, monetary policy could only be effective if the

velocity of money and of the demand deposits (V and V) were stable. Now, Fisher hadanalysed in detail these fundamental components of the equation of exchange in The

Purchasing Power of Money, published in 1911. The main purpose of this book,

however, was to set rigorously the theoretical conditions under which the quantity

21

The Feds open market operations, adopted on a large scale only in 1932, did not

bring an expansion of production but simply an increase in the reserves of the member

banks.

Cf. Eichengreen, 1992.22

Unless these [huge excess reserves] are absorbed by raising the reserve

requirements, they will continue to threaten us with an inflation ten times their size.

These

reserves were created in a vain attempt by the Fed reserve to increase business loans. A


17/25

chief

reason why the attempt failed was the partial reserve system under which the

commercial banks

feared to lend (Fisher, 1936b, p. 417).23

This reform posed considerable technical problems; for example, to enable the banks

to raise their reserves to the level needed, a large amount of circulating medium had to

be

created and distributed. These aspects will not be dealt with in the present work. 16

theory held. Fisher therefore, was basically satisfied with the assertion that in

equilibrium the causes affecting the velocity of money were exogenous and specifically

that both V and V were independent of the quantity of money or of deposits

(respectively M and M; Fisher, 1911, p. 154). During transitions periods, on thecontrary, V and V could fluctuate considerably as a consequence of changes in M and

M. In 1931-32, as already mentioned, he was ready to admit that, as a consequence of

widespread hoarding, the velocity of money had sharply fallen (cf. Fisher, 1932a, pp.

34-7). In the second half of the thirties, however, he gradually modified his position. In

a paper presented in 1940 at the Cowles Commission he come to the conclusion that

velocity of circulation was fairly constant for unspeculative accounts and maintained

that the drop between 1929 and 1933 was probably much more apparent than real

(Fisher, 1940; cf. Dimand, 2000. Presumably his desire to promote a reform that he

considered indispensable to the stability of the economic system had induced Fisher toover-simplify his earlier position

25

.

The 100% money project, which Fisher did his best to push with his usual

energy (he published a monograph and several articles on this subject; see for example

1936a and 1936b), had been borrowed, as he acknowledged, from his colleagues at the

University of Chicago,

26

and it marks an important turning point in his stance onmonetary policy. Starting in the second half of the decade, Fisher strongly supported a

policy of managed money, although limited by rules. It was necessary, he maintained in

1937 before the Committee on Agriculture and Forestry, to get rid of automatic

mechanisms that had once seemed desirable, replacing them with a really managed

currency (Fisher, 1937).


18/25

24

Nevertheless, Fisher did not rule out the possibility of hoarding. Taking up the device

already illustrated in Stamp Scrip, he suggested attributing to the monetary authoritiesthe power

to enforce a tax on liquidity.

25

The question of whether the velocity of circulation of money is a constant or a

variable, wrote Fisher in his 1940 paper, is of great importance both for monetary

theory and

monetary policy []. So far as monetary policy is concerned, if the velocity of circulation

of

money is simply a cushion for changes of quantity, any attempt to control the price levelor

volume of trade by controlling money would be futile (Fisher, 1940, p. 56).

26

It was first illustrated in a document of November 1933 entitled Banking and

Currency Reform drawn up by Simons and signed by various Chicago economists,

including

Aaron Director, Paul Douglas, F.H. Knight, L.W. Mints, Henry Schultz as well as C.O.

Hardy

of the Brooking Institution (cf. Allen, 1993). 17In this context he reiterated his account of the role of the gold standard in

spreading the depression internationally. In the twenties Fisher, together with Keynes,

had been one of the main critics of the gold standard, which he saw as unable to

guarantee domestic price stability. In the thirties, he was commissioned by the

International Statistical Institute to analyse the influences exercised by monetary

standards on the international propagation of economic fluctuations. The results of this

research, published in 1935 (cf. Fisher, 1935b), are striking and anticipate much of the

research conducted in recent years (cf. Choudri-Kochin, 1980; Eichengreen, 1992).

Using data from several nations in different monetary systems, Fisher demonstratedthat

the countries that had abandoned the gold standard earliest or that had never adopted

it

had performed better in output and employment and the level of prices.

27


19/25

On fiscal policy, Fisher had been very critical of the Hoover Administrations

restrictive measures. Balancing the budget, he wrote in 1932, by reducing

expenditures for many useful services and by extracting larger revenues from reduced

income is deflationary (Fisher, 1932c). In general, however, he maintained that anexpansionary monetary policy was sufficient to cure the depression and that there was

no need for deficit spending: Public works, he wrote to Roosevelt in 1934, were the

slowest, dearest and usually least beneficial way of dealing with the problem

28

Fisher .

apparently failed to grasp the multiplier effect and interpreted the expansionary impact

of deficit spending in terms of his monetary model: in order to finance public works,

government had to borrow from the Federal Reserve, thus increasing the monetary base

and stimulating demand.29

27

Fisher had already made this point in 1933 in a letter to Roosevelt: It was the

universal gold standard which made the depression universal, spreading the deflation

infection

from one country to another. Only countries not on the gold standard escaped (Fisher,

1997, p.

57). He repeated this point in 1937 during a parliamentary hearing: During thedepression the

cutting loose from gold by other nations helped them all. I think there is no exception.

Those

that were helped most were those that cut loose first. England, for instance, cut loose in

1931,

France in 1936. England is now out of the depression, practically, and France is just

beginning

to struggle out (Fisher, 1937, p. 278).

28Letter to F.D. Roosevelt, 11 June 1934, in Fisher, 1997, p. 83. It will require

something of a wrench later, added Fisher in the same letter, to get millions of

workers out of

jobs under government into their normal jobs in industry.

29


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Since business wouldnt borrow, the Government is borrowing [...]. Seven or [...]

eight billion dollars have been re-created in this way, and thats the reason we are

getting out of

the depression. It isnt the spending of the Government that is doing it (the Governmentonly 18

On the other hand Fisher vigorously opposed the New Deal measures to restrict

supply and institute economic planning. In particular, he considered the initiatives to

regulate wages and production as totally misguided. He firmly believed that these

policies could jeopardize the results obtained by monetary measures, slowing down the

recovery and prolonging the Depression.

The policy of high wages, wrote Fisher, was based on the hypothesis that in this

way it would be possible to create new purchasing power. The demand for labour,

however, was not invariable: Wages, he wrote in 1936, are affected by supply anddemand like any other price []. If you raise the price of labor arbitrarily, less labor

will be bought [...]. Arbitrary mark-ups never succeed.

30

In Fishers opinion, this was

why, in a context where the Depression appeared to be fading, the unemployment rate

remained high. He concluded that in order to reduce unemployment, it would have been

better to grant subsidized loans directly to employers, according to the number of

additional workers they hired (cf. Fisher, 1997, pp. 63-4).

No less severe were his objections to the policies aimed at restricting production,for the purpose of raising prices:

The philosophy of limiting production is particularly out of place at present

for we are suffering from too little wealth, not too much - notwithstanding

popular illusions as to overproduction. We can scarcely feed the hungry

more bread by destroying material of which the bread is to be made nor

clothe the naked by destroying the material of which the clothes are to be

made (1933c, p. 6)

31

More generally, Fisher strongly criticized the idea that the slump of the 1930swas due to structural flaws of the market economy and that it demonstrated the need

of

spends it once); but it is spent normally 25 times a year after it is once created. The

Government


21/25

spends it, giving it to the contractor or to the people on relief, and they spend it at the

store, the

store gives it to the wholesaler, the wholesaler to the jobber, the jobber to the

manufacturer, andthe manufacturer to the laborer [...] When the Government manufacturers the money,

that helps,

and it is the manufacturing of this money, a by-product of debt and spending, that has

gotten us

out of the depression (Irving Fisher Papers, Manuscript and Archives, Yale University

Library,

212, s. III, box 25, f. 396, Is a Managed Currency Workable?, cit., p. 10).

30

Irving Fisher Papers, Manuscript and Archives, Yale University Library, s. III, b. 25, f.397, How to Secure Re-employment, New York, May 21, 1936.

31

It is interesting to observe that a similar criticism of policy measures aimed at

achieving a rise in prices by reducing production was expressed by Keynes in an open

letter to

Roosevelt in December 1933. 19

more government in business. If my analysis [] in Booms and Depressions is

correct, he wrote in 1935, the depression does not indicate a general breakdown of

capitalism []. It indicates almost solely a breakdown of our monetary system (Fisher,1935c).

5. Conclusion

The events of the 1930s, writes William Barber in a recent article, presented

formidable challenges for Fisher as an economic theorist [and] as an economic policy

advocate (Barber, 1999, p. 25). On the eve of the stock market crash in October 1929,

as mentioned, Fisher was still convinced that share prices were not overvalued and that

their unprecedented increase was due to new profit opportunities created by

technological innovation and sharp rises in productivity. As the depression worsened,

however, he became convinced that new theoretical explanations were needed. In 1932and 1933 he presented a new model (debt-deflation theory) based on the interaction of

real and monetary aspects: starting from an initial situation of over-indebtedness,

Fisher

demonstrated that a minor shock could induce an explosive process characterised by

reductions in the price levels and by an increase in real terms of the stock of debts. The


22/25

likely consequences were widespread failures and continuous reductions in output and

employment. In Fishers opinion, this process could be stopped and reverted thanks to

expansionary monetary measures: these would have increased aggregate demand and

prices provided that the economic agents would have left unchanged their spendinghabits. During the Depression, however, there was a widespread tendency for economic

agents to hoard their liquid assets; in 1932 the Yale economist became therefore an

active supporter of a stamped money plan aimed at counteracting this process. During

the New Deal he lobbied actively the Roosevelt Administration to support expansionary

monetary measures and promoted a radical revision of the credit system aimed at

abolishing fractional reserves (100% money). In the meantime he strongly opposed any

governmental control on economic activity or arbitrary reductions in economic supply.

20

As a matter of fact, the dramatic events of the Depression had not shaken Fishers faithin the fundamental capacity of market economies for re-equilibrium. There was,

however, one crucial exception: the money and credit system. In this case the

spontaneous interaction of individual actions did not appear to be able to guarantee a

stable equilibrium. Furthermore, the institutions adopted up to then, such as the gold

standard and fractional banking reserves, had turned out to be sources of further

disequilibrium. The consequences, given the centrality of money in the production

system, had been nothing short of disastrous. The entire sector therefore had to be

radically reformed and co-ordinated by government. This reform, and this alone, could

provide a dependable guarantee against the recurrence of large-scale depression. 21References

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Political Economy, Vol. 9, Winter, pp. 560-587.

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of Law and Economics, pp. 703-17.

Barber, W.J. (1996), Irving Fisher as a Policy Advocate, in M. Rutherford (ed.), The

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