Failure to overhaul system may lead to years of slow growth

SERIOUS MONEY:Core of crisis has not been tackled because banks have not taken all advice on board, writes CHARLIE FELL

IRVING FISHER was among the twentieth century’s most celebrated economists though within investment circles he is perhaps best-known for proclaiming on the eve of the 1929 stock market crash that “stock prices have reached what looks like a permanently high plateau”.

Fisher had become a substantial stock investor after he invented and subsequently sold his Rolodex card-index system to the Rand Corporation, but his rosy predictions of a “new era” and continuing prosperity – even long after stock prices had begun their descent – left him penniless and with his reputation in tatters.

Yale University had to purchase his home and rent it back to him to prevent him from being evicted. He had to rely on the kindness of his alma mater and sister-in-law for the remainder of his life.

Fisher’s contribution to economics, in spite of his disastrous stock market prognostications, ranks among the greats. The celebrated Joseph Schumpeter wrote in a memorial article in 1948 that “in his scientific work, he stood alone ... those pillars and arches of Fisher’s theoretical temple will stand by themselves”.

Following the crash and financial ruin, Fisher focused his attention on determining the underlying mechanisms of the economic meltdown and, in 1933, his seminal article, the Debt Deflation Theory of Great Depressions, was published. His theory was largely ignored during his lifetime, but it laid the foundations for the theories of macroeconomic financial instability of both Hyman Minsky and James Tobin.

Furthermore, his work does much to explain the current crisis and offers potential solutions.

Fisher prefaced his theory with a discussion of instability around equilibrium and stated that “exact equilibrium is seldom reached and never long maintained ... 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 anything else”.

His theory then follows and he notes that “in the great booms, each of the above-named factors has played a subordinated role as compared with two dominant factors, namely, over-indebtedness to start with and deflation following soon after”.

This is the critical argument of his article and, viewed in this context, it can be seen that the advanced economies – and the US in particular – have engaged in years of over-consumption, under-saving and under-investment that has contributed to over-indebtedness which has left the economy vulnerable to a deflationary spiral in the event of a negative shock.

Fisher went on to outline how, under conditions of debt and deflation, the interaction of a number of factors can create the mechanics of a move from boom to economic depression. A state of over-indebtedness may arise due to financial or technological innovation, but it will eventually give way to attempts to liquidate.

The debt liquidation may lead to distress selling and to a contraction of deposit currency, as bank loans are repaid, as well as to a slowdown in the velocity of circulation.

The contraction of deposits and of their velocity may result in a fall in the level of prices – eg, an increase in the purchasing power of currency. The fall in prices may proceed faster than the outstanding debt shrinks, leading to further balance sheet deterioration and a dangerous negative feedback loop.

Fisher concluded that “great depressions are curable and preventable through reflation and stabilisation”.

It is clear that the conditions Fisher outlines have been present during the current crisis, but heed has been taken of his advice with official policy rates falling to historic lows everywhere and steps taken to stabilise the financial system.

However, monetary policy has proved ineffective as increased risk aversion alongside a barely solvent banking system has seen real rates on personal loans, credit cards and on corporate debt refuse to come down.

Furthermore, the traditional money multiplier has collapsed as both borrowers and lenders hoard cash. Indeed, the broad money multiplier has dropped from more than nine a year ago to below five recently. Additionally, the velocity of money or the rate at which money circulates through the economy has dropped considerably due to an increase in precautionary money balances.

The traditional monetary policy transmission mechanisms are simply working very slowly and, given the significant output gap, will do little to prevent a drop in the overall price level in 2010.

Central banks have reacted quickly to provide the banking system with sufficient reserves, but little is been done to rehabilitate and restructure the financial architecture à la Sweden in the early 1990s. The US banking stress tests were a sham and take the current position of barely solvent banks as the goal for the future, a dangerous development given that senior management are effectively being encouraged to take outsized risks to return their financial institutions to full health.

The market for bank debt reveals the inadequacy of recent action. Citigroup’s short-term debt, for example, sells close to par as investors are confident that the bank will be kept afloat until further notice. However, longer debt maturities are selling at a significant discount of up to 30 per cent, implying that the probability of default remains high, despite significant injections of taxpayers’ money. The moral hazard introduced to the system almost ensures a repeat crisis in the years ahead.

Irving Fisher’s sound advice on avoiding a deflationary spiral has been taken to some extent, but persistent dithering when it comes to overhauling the financial system is of great concern. The core of the crisis is simply not being addressed. While green shoots may be apparent, years of sluggish growth are the most likely outcome.

charliefell@sequoia.ie