Plate ix in print

The Spiral

Fisher; debt-deflation, where falling prices raise the real burden of debt and force the selling that drives prices lower still.

The more the debtors pay, the more they owe. Each dollar of debt still unpaid grows heavier as the dollar itself, in a falling market, grows dearer; so that the very act of liquidation, by pressing prices down, defeats itself — the mass effort to lessen the weight of debt increases it, and the boat the debtors bail sinks the faster for their bailing.

— the warning of this plate, after Irving Fisher, 1933

The volume has found where slumps begin and why they last, but not yet why they deepen — why a downturn, once started, can gather speed instead of spending itself, and turn a bad year into a lost decade. Irving Fisher, who watched a fortune of his own vanish in the Crash and spent the wreckage years thinking about what he had failed to see, gave the deepening its mechanism, and the mechanism turns on a thing the cheerful arithmetic of falling prices forgets. To a buyer with money in hand, a fall in prices is a gift: the same dollars now command more goods. But to a debtor it is the reverse, and Fisher saw why. A debt is fixed in money — so many dollars owed, whatever a dollar comes to be worth — and when prices and incomes fall, those dollars do not shrink with them. The sum owed stands still while the means of paying it dwindles; each dollar of the debt, unchanged on the page, grows heavier in the hand, because the goods or labor that must be sold to earn it now fetch less. So the plate's question has a first, blunt answer: the debtor's burden rises when prices fall because his debt is denominated in a money that deflation makes dearer, and he must repay in dollars grown harder to come by than the dollars he borrowed.

From that single fact Fisher built a chain, and it is the chain that does the damage. A boom, he observed, leaves behind it a great overhang of debt — firms and households having borrowed freely against rising values and easy confidence. When the turn comes and values fall, the overburdened begin to sell: assets, inventories, whatever can be turned into cash to pay down what they owe. But mass selling drives prices lower; and as the debtors repay their bank loans, the deposits those loans had created are extinguished, so that the very quantity of money in circulation shrinks, pulling prices lower still. Now the trap closes, for these falling prices raise the real weight of all the debt not yet paid — and the heavier debt drives a fresh round of distress selling, which lowers prices again, which raises the debt again. Net worth collapses as asset values fall against debts that will not; profits vanish; output and employment fall with them; and a pessimism settles over everyone that turns spending into hoarding. Each link tightens the next. The economy is not knocked down once and left to rise; it is pulled downward by a rope that its own struggles draw tighter.1

1. Fisher's chain: a boom leaves a great overhang of debt; the turn comes and the overburdened sell assets to pay it down; mass selling lowers prices, and the repayment of bank loans extinguishes the deposits they created, shrinking the money stock and lowering prices further; the falling prices raise the real weight of the debt still owed; the heavier debt forces fresh selling. Net worth collapses, profits and output fall, hoarding spreads. Each link tightens the next — a downturn pulled lower by a rope its own struggles draw tight.

At the heart of the chain is a paradox, and it is the deepest thing in the plate. Each debtor, alone, does exactly the prudent thing: faced with too much debt, he sells what he can and pays it down, reducing his own burden. The conduct is rational, even admirable, and for any single debtor it works. But let every debtor do it at once, and the collective result undoes the individual intent: the simultaneous selling crashes the prices of the things sold, and the falling prices raise the real value of the debt that remains, so that the more the debtors pay, the more — in real terms — they owe. The act of deleveraging, multiplied across the whole, produces the deflation that makes the whole more indebted than before. This is a fallacy of composition as pure as the paradox of thrift the volume met earlier, and a near cousin of it: there, the prudent saving of all became the ruin of all through falling demand; here, the prudent repayment of all becomes the ruin of all through falling prices. The wisdom of the one is, when it becomes the policy of everyone, a machine for impoverishment.2

2. The paradox at the chain's heart: each debtor, alone, does the prudent thing — sell, pay down debt, reduce the burden — and for him it works. But when all do it at once, the simultaneous selling crashes prices, and falling prices raise the real value of the debt remaining, so the more the debtors pay the more they owe. A fallacy of composition as pure as the paradox of thrift, and its cousin: there prudent saving ruins all through falling demand; here prudent repayment ruins all through falling prices.
⁂

What makes the thing a spiral rather than a stumble is that the loop has no natural floor; each turn supplies the force for the next. A simple shock, however hard, is a blow the economy can absorb and recover from, because the blow does not renew itself. Debt-deflation renews itself: every fall in prices manufactures, in the higher real debt it creates, the motive for the selling that will lower prices again, so the process accelerates downward instead of damping out. This is why Fisher thought it explained the difference between the slumps that stay mild and the ones that become catastrophes. The difference is the debt. A downturn that begins in an economy lightly burdened has little to feed the spiral, and soon ends; a downturn that begins atop a mountain of debt — as the slump of 1929 did, after a decade of borrowing — finds in that debt an engine of self-worsening, and descends into depression. The boom that loaded the debt did not merely precede the bust; it charged the bust with the fuel of its severity, so that the recklessness of the good years is paid for in the depth of the bad.3

3. A spiral, not a stumble, because the loop has no floor: each fall in prices creates, in the higher real debt, the motive for the selling that lowers prices again, so it accelerates instead of damping. This, Fisher held, is why some slumps stay mild and others become catastrophes — the difference is the debt. A downturn in a lightly burdened economy soon ends; one atop a mountain of debt, as in 1929, finds an engine of self-worsening. The boom that loaded the debt charged the bust with the fuel of its depth.

The cure follows from the diagnosis, and it stands the old orthodoxy precisely on its head. The classical prescription for a slump was patience and a falling price: let wages and prices drop until they are low enough to clear the market, and the economy will right itself. For an economy without much debt this counsel is merely useless; for one sunk in debt it is poison, because the falling prices it recommends are the very thing driving the spiral, and to wait for them to do their work is to wait for the noose to finish its. Fisher drew the opposite conclusion. If deflation is the engine of the collapse, then the way to stop the collapse is to stop the deflation — to halt the fall in prices and, if possible, to push them back up, reflating the price level until the real burden of debt is eased and the distress selling ceases. He believed, and the recovery that followed the reflations of 1933 gave him some warrant, that a deliberate raising of the price level could break the spiral where leaving the market alone never would. The lesson outlived the man: the modern central bank's dread of deflation, and its insistence on a small steady inflation as a cushion, is debt-deflation remembered — a buffer kept between the price level and the edge over which Fisher watched the economy fall.4

4. The cure inverts the orthodoxy. The classical prescription — let wages and prices fall until the market clears — is merely useless for an economy without debt, but poison for one sunk in it, since the falling prices are the engine of the spiral. Fisher's opposite: stop the deflation, reflate the price level until the real debt eases and distress selling ceases. The reflations of 1933 gave him some warrant. The modern central bank's dread of deflation, and its small steady inflation as a cushion, is debt-deflation remembered.

Beneath the policy lies a discovery about money that the rest of the cycle had not quite forced. The classical mind treated the price level as a veil — a number that scales all prices together and changes nothing real, so that a halving of every price and every wage and every debt would leave the economy exactly as it was. Fisher's spiral shows the veil to be no veil at all, because debts are not rescaled when prices are. The sum owed is a fixed weight of money, and when the value of money moves, that weight moves with it, transferring wealth from debtors to creditors as prices fall and back again as they rise. The price level, which the dichotomy of classical theory declared neutral, is in an indebted economy the most charged quantity there is — able, when it falls, to ruin the borrower, enrich the lender, and through the spiral drag the whole economy into a depression that no real shock required. So the debtor's burden rises when prices fall because his debt is a fixed weight in a money grown heavy; and the slump deepens because the collective flight from debt, by forcing the sales that lower prices, raises the very debt it flees — a spiral that only a halt to the falling prices can break, and that hands to the family's next motion, the value of money over time, a question the cycle has shown to be no abstraction but a matter, for the indebted, of survival.5

5. Beneath the policy, a discovery about money. The classical mind treated the price level as a veil — scale all prices together and nothing real changes. But debts are not rescaled when prices are: the sum owed is a fixed weight of money, so when money's value moves, wealth passes from debtors to creditors as prices fall and back as they rise. The price level the classical dichotomy called neutral is, in an indebted economy, the most charged quantity there is — handing the value of money over time, the next motion, a question of survival.