Debt-Deflation Theory of Irving Fisher - Essay Example

? Economists-Irving Fisher Affiliation: Outline Introduction 2. Significance of Irving Fisher’s Debt-deflation Theory a. Factors Led to the Great Depression i. Causes of Debt ii. Psychology of Debt b. Stages of Financial Crises and Solutions 3. Fisher’s Plan for the Current U.S Economy a. Fiscal Stimulus b. Reverse Deflation c. Prevention 4. Irving Fisher on Current Economic Policies a. Raising the Debt Ceiling b. Adjust Tax Rates 5. Conclusion Introduction Irving Fisher is among the famous economists in the U.S who experienced the Great Depressed of 1929-33 and proposed relevant solutions using theories and models to solve the prolonged financial crisis (Allen, 1977). Fisher was born in 1876 and received his Business Administration degree and Ph. D in Yale University. As the professor of economics and mathematics at Yale University, Irving Fisher developed extensive concepts concerning money supply and price fluctuations using mathematical evidence (Allen, 1977). Fisher was among the most accurate and leading economists of the 20th century. He used his acquired knowledge and skills from Yale to observe and analyze dramatic and complex macroeconomic events during his era. Fisher also proposed appropriate solutions to the Great Depression that crippled the U.S economy and other aspects of life. The crash of the stock market in the U.S in 1929 and consequential falling of stocks and goods’ prices prompted Fisher to revise his economic theories on price fluctuations, debt and the depression caused by these factors (Mendoza, 2009). Fisher formulated a debt-deflation theory and named the financial crisis, the Great Depression, which is currently used to relate to the economic recession in the U.S.The debt-deflation theory indicates that consumers borrow money for investment on speculation and imagine profits, which leads to losses, debt, deflation and pessimism. Thesis Statement: Irving Fisher has a significance impact on the prevailing U.S economy through his debt-deflation theory, which examines the causes of debt, the deflation and the solutions of the subsequent financial crisis in relation to the current U.S economic instability. Significance of Irving Fisher’s Debt-deflation Theory Irving Fisher’s debt-deflation theory was essential in the Great Depression era and in current U.S economic crisis because it clearly explains the factors that cause the debt and the resultant ripple effect on the economy. The U.S economy is essential in the global market because it is the largest trading partner in the world, which means its financial crisis affects all other foreign economies. The following are causes of debt, stages of the financial crisis and proposed solutions as described and examined by Irving Fisher. a. Factors Led to the Great Depression i. Immediate Causes of Debt During the Great Depression, the two chief causes of debt for U.S citizens were over-investment, over-speculation and over-confidence (Fisher, 1933). Citizens, private sectors and the government borrowed money from banks, the federal government and other private financial lending institutions to conduct investments that they believed would result to higher returns and revenues. Many organizations and citizens wanted to invest borrowed money on new business ideas and receive abundant profits within a short time as compared to the ordinary investments that have moderate profits and interests. New inventions included building industries, railway lines, develop new resources, open real estates and new markets (Fisher, 1933). Financial lenders provided easy money, which led to over-borrowing. Most investors believe through speculation and over-confidence that they can borrow money at 6% and make profits of over 100% (Fisher, 1933). New industrial inventions and technology innovations prompted over-borrowing with the confidence of making a huge profit within a short period. Lucrative investment opportunities allowed people and organizations to have big debts. Major wars that the U.S initiated and partook led to big debts. The U.S also reconstructed loan payment by reducing interest rates policies to domestic, foreign, public and private sectors. Development in real estates in the Southwest and the West led to over-borrowing with the speculation that citizens would invest in the new upscale buildings (Fisher, 1933). He further explained that the other immediate causes of debt in the U.S during the Great Depression period included investing in the cotton industry, building the Erie Canal and manufacturing steam boats among others. When these investments did not produce desired and predicted outcomes, American consumers and other organizations panicked. In the modern economic crisis of the U.S, the same factors that led to the Great Depression in 1929 caused the financial crisis in 2008. This current recession started with the real estate market where consumers over-borrowed from banks to invest in the housing business. It started with a bust but the speculation of high profits quickly dwindled and home owners reduced the values of their houses to sell at a throw-away price. ii. Psychology of Debt In 1929, the American public went into a debt collectively because of poor decisions of over-borrowing and big debts. The cognitive aspect of debt starts with the belief that free money that is borrowed in large sums will achieve the desire of large profits, dividends or gains in the near future (Fisher, 1933).Another psychology of being lured into debt is the hope and speculation of selling goods and services at a high profit of more than 100% of the capital and believing in immediate capital gain.The last aspect of behavioral psychology of getting into debt is the trend of thoughtless promotions, which use consumers’ habits to speculate high profits (Fisher, 1933). However, consumers change their habits with the constant change of environment, technology and social development. b. Stages of Financial Crises and Solutions In all financial crises, there is a chain or sequence of events that finally lead to falling of prices and low quality life. Irving Fisher used his debt-deflation theory to show how these events affected each other in the Great Depression. Over-borrowing and making speculations while investing on other people’s money can lead to undesirable results. Borrowers who have financial loss in their investments cannot pay their loans within the stipulated period with interests thus leading to over-indebtedness (Fisher, 1933). Creditors and debtors panic under these dire conditions and both rush to liquidate their debts.Borrowers who rush to liquidate their debts before interest rates are increased experience loss in their normal lifestyle because they have to cut their expenses or borrow more money. In the debtors’ effort to repay all their debts to banks, the deposit currency reduces in value. Debtors quickly pay off their loans, which in turn causes the velocity of circulation to decrease (Fisher, 1933).Since there is limited money in circulation and a slow circulation, prices of assets, stocks and other related goods fall rapidly. The role of government in this stage is to reflate or stabilize the prices of goods and services to prevent further crisis. The U.S state and federal governments must intervene in free markets to protect the interests of consumers who are mostly affected by these financial crises (Mankiw, 2012). In events that the state and federal government does not intervene, most organizations, individuals and companies experience a drastic fall in their net worth. This situation for most companies leads to bankruptcies because their businesses are not achieving their desired objectives. Businesses that continue to be bankrupt experience a decrease in profits, which eventually leads to losses (Fisher, 1933). Private sectors do not operate businesses that incur losses while producing their goods and services and maintaining their employees’ payroll. Production of goods and services in most companies is reduced, trade is minimized and employees are laid-off. The financial crisis is now in a critical stage where great losses, unemployment and bankruptcies lead to loss of overall confidence about investment and improving living standards. Citizens and other business communities start to become pessimistic about their future in relation to overcoming the financial crisis. Consumers and corporations begin hoarding money and further reducing the rate of money circulation. This event finally leads to fluctuation in interest rates where money loses value, while commodities increase in value. Fisher (1933) explained using the above stages how the debt-deflation theory worked during the Great Depression and its evidence in the current economic crisis. Irving proposed two solutions: stabilization and deflation of prices. In the 2008 financial crisis and current recession, consumers over-borrowed and invested real estate during the bust. When the house prices started to fall in contrast to banks and consumers’ expectations, the financial lenders demanded loan repayment from customers who were allowed to over-borrow. These lending institutions repossessed houses and commercial premises that belonged to consumers who were unable to repay their loans and increased interest rates for unpaid loans. The falling prices in real estate markets affected stock markets and the prices of other goods and services, which led to low revenue. Companies that made more losses as compared to profits because of the financial crisis resorted to corporate lay-offs, which in turn lowered the living standards of most Americans. Fisher’s Plan for the Current U.S Economy The plan Fisher would have on the current government to solve the recession that is becoming persistent is by following two chief factors: fiscal stimulus and reverse deflation (Mendoza, 2009). a. Fiscal Stimulus The fiscal stimulus is an immediate remedy for the current financial crisis that is leading to a prolonged recession. Fiscal stimulus is in terms of government support in raising the living standards of people by providing employment opportunities and funding local governments to prevent implosion (Mendoza, 2009).The Congress should raise the debt ceiling or abolish it for the government to receive the fiscal stimulus needed to relieve the effects of the financial crisis for the next two years. The current case where Congress wants the government to repay its debt before requesting for more funding from the Federal Reserve will not only increase U.S debt and cripple the economy of other developing markets but also lead the country into another Great Depression. Irving Fisher would advise the government to enact strict policies that prevent free markets from engaging in malicious economic activities that harm consumers. b. Reverse or Halt Deflation Fisher would advise the government to intervene in the free markets by halting or reversing deflation (Mankiw, 2012). The credit system in the U.S which contributed to the financial crisis should also be restarted and strict policies implemented to protect the consumers. Deflation will be stopped when the credit system is restarted. However, prices of goods and assets must be stabilized for the credit system to be contained. Irving Fisher on Current Economic Policies a. Raising the Debt Ceiling According to Obama’s government, the Congress should raise the debt ceiling to cater for the immediate needs of citizens by creating employment opportunities, providing better healthcare and facilitating knowledge-driven markets. Government’s spending often surpasses its revenues, which creates a budget deficit. This deficit should be financed by borrowing money from the federal government through increasing or completely abolishing the limit of borrowing, which the Congress opposes.Irving Fisher would agree with this policy because it advocates for borrowing money to stabilize the markets and improve living standards. Fisher would disagree with the Congress for forcing the government to pay its debts and prevent it from borrowing money from the Federal Reserve, which will lead to over-indebtedness. b. Adjust Tax Rates President Obama proposed a new economic policy to adjust tax rates for the people earning $250,000 and above annually. Their tax rates will increase while those earning below this value will pay in accordance to the Bush Tax. Fisher would agree with President Obama is adjusting tax rates to prevent crisis from persisting and stabilize the economy. Conclusion Irving Fisher was a famous economist and mathematician of the 20th century. His skills and knowledge are currently used to collect information about deflation and stabilizing the economy. The current economic crisis threatens to introduce an adverse form of the Great Depression if the current government does not take quick and appropriate measures. Irving Fisher would advise the current Congress to raise the debt ceiling and avoid government default in Medicare, social security and military salaries among others. References Allen, W. (1977). Irving Fisher, F.D.R., and the Great Depression. History of Political Economy, 9, 560-587. Fisher, I. (1933). The Debt-Deflation Theory of the Great Depression. Econometrica. 3, 337-357. Retrieved Dec. 4, 2012 from FRASER database. Mankiw, G. (2012). Principles of Economics (6th Edition). Mason, OH: South-Western Cengage Learning. Mendoza, E. (12 Feb. 2009).Hire Irving Fisher! Retrieved Dec. 4, 2012 from VOXEU database. Read More