Debt Deflation Defined

Irving Fisher was a leading economist in the early 20th century. After being caught out during the Great Depression (he famously quipped, "Stock prices have reached what looks like a permanently high plateau." right before the bottom fell out), he did a lot of soul-searching and research to understand where he and his profession had gone wrong. By 1933, he had come up with a framework which very well describes what happened during the depression and happens in similar episodes of credit crisis.

From an issue of Econometrica in 1933:

Assuming, accordingly, that, at some point of time, a state of over-indebtedness exists, this will tend to lead to liquidation, through the alarm either of debtors or creditors or both. Then we may deduce the following chain of consequences in nine links:

  1. Debt liquidation leads to distress selling and to
  2. Contraction of deposit currency, as bank loans are paid off, and to a slowing down of velocity of circulation. This contraction of deposits and of their velocity, precipitated by distress selling, causes
  3. A fall in the level of prices, in other words, a swelling of the dollar. Assuming, as above stated, that this fall of prices is not interfered with by reflation or otherwise, there must be
  4. A still greater fall in the net worths of business, precipitating bankruptcies and
  5. A like fall in profits, which in a "capitalistic," that is, a private-profit society, leads the concerns which are running at a loss to make
  6. A reduction in output, in trade and in employment of labor. These losses, bankruptcies and unemployment, lead to
  7. pessimism and loss of confidence, which in turn lead to
  8. Hoarding and slowing down still more the velocity of circulation.
    The above eight changes cause
  9. Complicated disturbances in the rates of interest, in particular, a fall in the nominal, or money, rates and a rise in the real, or commodity, rates of interest.

Evidently debt and deflation go far toward explaining a great mass of phenomena in a very simple logical way.


  1. Tom Hickey says

    Good to remind of this. What happened this time is the government stepped in promptly to restructure the auto industry and rescue the financial sector in order to prevent systemic collapse and avert another great depression. However, the financial sector was left significantly impaired, and little was done to alleviate other private debt or assist small and regional banks. So while government is to be commended for preventing disaster (so far), there is still a huge debt overhand that either has to be inflated way, liquidated slowly over time, or crammed down to speed up the process. The most probable result is a slow unwinding that will impair economic growth for some time. The other possibility is that there are other big shoes to drop and there is no longer the political will to address them, in which case there will another crisis and possible systemic breakdown. Since this is a global problem, there could be another Credit Anstalt occurrence somewhere that provokes another round, again likely in Eastern Europe. Moreover, there is already political instability developing, with rioting in the street in Europe, for example. Anyone who sees this as a business cycle is whistling in the wind. It is a classic financial cycle that ended in Ponzi finance in Minsky’s sense, and its not over yet by a long shot. A lot of the good corporate earning are the result of retrenchment, and the rising sales the result of inventory replacement. The foundation is not in place for a lasting recovery and won’t be until the credit situation shakes out.

    1. Edward Harrison says

      The Greek crisis could still be the Credit Anstalt event. We have to remember how it started innocuously in May of 1931:

      If we see any of the sovereign issues spiral out of control in the euro zone, then it will look to be an almost identical repeat of the Great Depression.

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