Irving Fisher and the New Normal

A lot of the debate about how to escape the Great Recession is focused on the question of deleveraging and it is often said that we have entered a period of more or less permanent low growth – a “New Normal”. I fundamentally think the idea of the new normal theoretically and empirically flawed.

Irving Fisher – undoubtedly one of the greatest economists of the 20th century – formulated his debt-deflation theory, which is highly relevant for the debate about the “New Normal” and more importantly about how to escape the “New Normal”.

According to Fisher the economy and market goes through nine phases after the bubble bursts:

  1. Debt liquidation and distress selling.
  2. Contraction of the money supply as bank loans are paid off.
  3. A fall in the level of asset prices.
  4. A still greater fall in the net worth of businesses, precipitating bankruptcies.
  5. A fall in profits.
  6. A reduction in output, in trade and in employment.
  7. Pessimism and loss of confidence.
  8. Hoarding of money.
  9. A fall in nominal interest rates and a rise in deflation adjusted interest rates.

This is how a lot of people today think of the crisis. We had a bubble and it busted and now we have to go through these more or less “natural” phases and therefore we will just have to take the pain.

I would certainly not disagree that there is a serious risk that we indeed will live through a long period of low growth and a quasi-deflationary environment. Here is Fisher:

“Unless some counteracting cause comes along to prevent the fall in the price level, such a depression as that of 1929-33 (namely when the more the debtors pay the more they owe) tends to continue, going deeper, in a vicious spiral, for many years. There is then no tendency of the boat to stop tipping until it has capsized. Ultimately, of course, but only after almost universal bankruptcy, the indebtedness must cease to grow greater and begin to grow less. Then comes recovery and a tendency for a new boom-depression sequence. This is the so-called “natural” way out of a depression, via needless and cruel bankruptcy, unemployment, and starvation.”

This is pretty much Fisher description of the New Normal. However, unlike the New Normal crowd Fisher did not think that we have to live through “a vicious spiral, for many years”:

“On the other hand, if the foregoing analysis is correct, it is always economically possible to stop or prevent such a depression simply by reflating the price level up to the average level at which outstanding debts were contracted by existing debtors and assumed by existing creditors, and then maintaining that level unchanged.”

So what is Fisher saying? Basically advocating a variation of the Market Monetarists solution to bring NGDP back to the pre-crisis trend level.

The skeptics, however, are saying that it is not possible to do that with monetary policy, but Fisher has an answer ready to the liquidity trap crowd:

That the price level is controllable is not only claimed by monetary theorists but has recently been evidenced by two great events: (1) Sweden has now for nearly two years maintained a stable price level, practically always within 2 per cent of the chosen par and usually within 1 per cent. (2) The fact that immediate reversal of deflation is easily achieved by the use, or even the prospect of use, of appropriate instrumentalities has just been demonstrated by President Roosevelt.

Fisher continues – about Roosevelt’s decision to give up the gold standard in 1933:

“Those who imagine that Roosevelt’s avowed reflation is not the cause of our recovery but that we had “reached the bottom anyway” are very much mistaken. At any rate, they have given no evidence, so far as I have seen, that we had reached the bottom. And if they are right, my analysis must be woefully wrong. According to all the evidence, under that analysis, debt and deflation, which had wrought havoc up to March 4, 1933, were then stronger than ever and, if let alone, would have wreaked greater wreckage than ever, after March 4. Had no “artificial respiration” been applied, we would soon have seen general bankruptcies of the mortgage guarantee companies, savings banks, life insurance companies, railways, municipalities, and states. By that time the Federal Government would probably have become unable to pay its bills without resort to the printing press, which would itself have been a very belated and unfortunate case of artificial respiration. If even then our rulers should still have insisted on “leaving recovery to nature” and should still have refused to inflate in any way, should vainly have tried to balance the budget and discharge more government employees, to raise taxes, to float, or try to float, more loans, they would soon have ceased to be our rulers. For we would have insolvency of our national government itself, and probably some form of political revolution without waiting for the next legal election. The mid-west farmers had already begun to defy the law…If all this is true, it would be as silly and immoral to “let nature take her course” as for a physician to neglect a case of pneumonia. It would also be a libel on economic science, which has its therapeutics as truly as medical science.”

So what is Fisher saying? Yes we are going through a debt-deflation cycle started by a monetary shock and it can go on for years, but the downward spiral can be stopped with monetary policy – for example by bringing NGDP back to the pre-crisis trend level – and there is no liquidity trap as long as policy makers use Rooseveltian Resolve or learn a lesson from the Swedish central bank Riksbanken.


Roth’s Monetary and Fiscal Framework for Economic Stability

Steve Roth over at has a comment on my previous post ”Be right for the right reasons”, which in itself was a comment on Richard Williamson who had commented on one of my previous comments (“NGDP targeting is not a Keynesian business cycle policy”) so you might consider this as ponzi-commenting…Anyway, Steve’s comment deserves an answer. He has some intriguing ideas.

What Steve suggests is what he calls “the MMTer’s guaranteed employment scheme”. For those who are not following the monetary debate in blogosphere it might be helpful to tell that MMT means Modern Monetary Theory – or what in the old days was known as Chartalism. I don’t want to use too much time explaining Chartalism (I am not really that strong on what they think), but lets just say that MMTer’s fundamentally think that monetary policy and fiscal policy is the same thing and that money enters circulation through government spending.

Steve’s idea is the following:

“My personal preferred stabilizer is to up the EITC bigtime, expand it up the income spectrum, pay it on weekly paychecks, and index its benefit levels to some measure of unemployment.”

EITC for those who don’t know it means “Earned Income Tax Credit” and is a Federal tax credit given to low income families in the US.

Steve does not say it directly, but I guess that his idea is that the Federal Reserve should fund this scheme. Or at least for a monetarist or a Market Monetarist this is crucial if the programme is going to “work”.

Some would consider Steve Roth’s idea to be completely insane. I do not. However, I have a number of reservations, but most important I have serious trouble with Steve’s premise.

I fundamentally think that recessions are always and everywhere a monetary phenomenon and hence monetary and fiscal policy should not be designed to be “countercyclical”. Monetary policy should be designed not mess with Say’s Law or said in another way monetary policy should not create recessions in the first place. If central banks where to engage in countercyclical policies then it basically end up fighting against it’s own past mistakes. This is also why I so strongly oppose when some Market Monetarists call for “monetary stimulus” as it exactly sounds as if we would like central banks to follow some kind of “countercyclical” policy.

Therefore there is no need for an “employment scheme” if central banks stop messing with Say’s Law by introducing credible NGDP level targeting.

That said, Roth’s scheme might not be in conflict with the idea of NGDP target. In fact if the Federal Reserve said that it in the future would say it would send each a American a cheque of the same size as the average EITC (hence doubling the EITC cheque) and that it would do so until NGDP had returned to the pre-crisis level then that in my view most likely would be a successful mechanism for returning NGDP to the pre-crisis trend. That does not mean that I endorse Steve’s scheme and and the fact that I think it would “work” does not mean that I in anyway agree with MMT theories – I don’t. The only thing it really means is that I think monetary policy is very powerful and that NGDP always can be increased by the use of monetary policy – then it is less important how you inject the money into the economy.

Fundamentally I think it is a pretty bad idea to have the central bank funding government expenditure and given central banks exist I believe they would be made independent of political pressures.

Finally, a comment on my headline. When I read Steve’s comment I came to think of a paper Milton Friedman wrote back in 1948 “A Monetary and Fiscal Framework for Economic Stability”. In the paper Friedman suggests something similar to Steve. Friedman’s suggestion is basically that the government should balance its budgets over the “business cycle”, but in downturns the central bank should print money to finance the public deficits. That in Friedman’s view creates a monetary-fiscal stabiliser of the economy. Friedman luckily became wiser as he aged. Here is a he said about in 1960 in “A Program for Monetary Stability” about his 1948 proposal:

“I have become increasingly persuaded that the proposal is more sophisticated and complex than is necessary, that a much simpler rule would also produce highly satisfactory results and would have two great advantages: first, its simplicity would facilitate the public understanding and backing that is necessary if the rule is to provide an effective barrier to opportunistic “tinkering”; second, it would largely separate the monetary problem from the fiscal and hence would require less far-reaching reform over a narrower area.”

So Steve, I don’t think we need to get the central bank involved in getting NGDP back on track and monetary policy should not be funding government programmes – especially not programmes that are not to great to begin with.

PS Steve, you have one advantage in the debate with me. Friedman suggested in 1948 to use a monetary-fiscal stabiliser and the EITC is of course a (bad) variation of Friedman’s suggestion for a Negative Income Tax and I hate arguing against any of Friedman’s ideas.

PPS Steve got my surname slightly wrong – it is Christensen and not Christiansen.

%d bloggers like this: