Lessons of the Great Depression

Irving Fisher was probably the greatest American economist, both in terms of the development of economic theory and as a teacher. In 1933, having himself misread the early stages of the Great Depression — and virtually bankrupted himself by ill-judged speculation — Fisher published one of his most important works. It is often referred to by its title, “The Debt-Deflation Theory of Great Depressions,” but is, I suspect, less often read by practicing economists. However, one can be sure that it has had considerable influence on what might be called the “economic philosophy” of the members of the Federal Reserve Board.

The peculiarity of the Great Depression of 1929-33 was that the American economy proved not to be self-stabilizing, although some other major economies of the period, including the British, did recover spontaneously in the early 1930s. Indeed, for Britain, the 1930s, with industrial expansion in automobiles and extensive building of houses, was a record decade.

However, recovery in the United States was later and weaker. When one compares Franklin Roosevelt’s first term, from 1933-37, the performance of the U.S. New Deal was not as good as that of Germany, rearming under Hitler, or of the United Kingdom, building cars and houses under Stanley Baldwin and Neville Chamberlain.

This is important, because there appear to be two types of depression, one of which is much stronger and longer lasting than the other. Panics, like those of 1907 or 1987, are steep, but relatively brief; great depressions can last for a decade or more. As Irving Fisher observed — prematurely — “The Depression out of which we are now (I trust) emerging is an example of a debt-deflation depression of the most serious sort.”

He argues, “The debts of 1929 were the greatest known, both nominally and really, up to that time. They were great enough not only to “rock the boat,” but to start it capsizing. By March 1933, liquidation had reduced the debt about 20%, but had increased the dollar about 75%, so that the real debt — that is, the debt as measured in terms of commodities — was increased about 40%.”

Obviously, the combination of the need for debt liquidation with falling prices means that debt has to be redeemed in money that is harder to earn. By contrast, debt can be liquidated by currency inflation, as happened in the 1970s. The relationship between the level of U.S. debt and the level of the U.S. dollar, therefore, becomes critical. Fortunately, the dollar has been very weak, allowing excess debt to be repaid in depreciating dollars. The length of the Japanese depression after 1990 must have been affected by the high relative price of the yen, so that debts in the 1990s were being repaid in terms of a high-value currency.

Irving Fisher argues that the “big bad actors” in the Great Depression were “debt disturbances and price level disturbances.” In 2008, we certainly have debt disturbances, though these are more important in the housing market than in the stock market. However, the global economy is, on balance, in an inflationary stage, with energy prices very high and the dollar weak. China is experiencing significant inflation, and commodity prices are high, if somewhat nervous.

This is a relatively favorable situation, in that the global authorities have to deal with debt and inflation, rather than debt and deflation. As inflation helps to liquidate excess debt, these conditions are more likely to generate panics than great depressions. At any rate, one can hope so.

Lord William Rees-Mogg
March 31, 2008