Britannia Radio

From The Times

November 24, 2008

You can print money, but not confidence

A £100 billion deficit that damages 

the Government's credit will 

leave it unable 

to offer more support to the banks

William Rees-Mogg

Irving Fisher (1867-1947) was probably the greatest economist the United States has produced. He developed, though he did not invent, the equation of exchange; he was, so far as I can trace, the first economist to describe the “tipping point”, when natural equilibrium turns to inevitable disequilibrium; he formulated in the early 1930s a policy for reflation that would now be called “Keynesian”; he developed the “debt-deflation” theory of the Great Depression, in which the repayment of outstanding debt causes further falls in asset values; he advised President Roosevelt that deflation could not cure the slump.

He has been much mocked for his forecast, on October 23, 1929, that “we shall not see very much further, if any, recession in the stock market”. He published his book on Booms and Depressions, Some First Principles in 1932. I find his writings essential reading in trying to understand the crisis of 2008. He still has insights that spring to life as each new stage of the crisis is reached.

Today's debate in the House of Commons can be best understood in terms of Fisher's work; indeed, a sentence of Fisher's describes what Alistair Darling is trying to achieve. “The chief purpose of the correction must be to secure the future, so that things can go on.”

He argued that the economy should be “first corrected by reflation and thenceforward safeguarded”.

“Reflate and then stabilise” is an attractive policy. Yet there was considerable resistance to Fisher's ideas as there was to the similar policies advocated by Keynes. Some of the most interesting criticisms come from quantity theory monetarists of the 1930s, who might have been expected to support Fisher.

Professor E.W. Kemmerer was an economist who also based his analysis on the quantity theory of money. In 1932 Kemmerer and Fisher gave evidence to the House committee on banking and currency. Fisher argued for reflation; according to William Barber, who edited the relevant volume of his works, “as Kemmerer read the situation, little could be accomplished by increasing the money supply or by pressing the central bank to expand the lending capacity of banks still further. Attention should instead be directed towards creating conditions conducive to stimulating the velocity of monetary circulation. The basic requirement, in Kemmerer's view was the restoration of confidence.”

Fisher listed the underlying causes of depression in his own order of significance. Overindebtedness comes first, the volume of currency second, the price level third, net worth fourth, profits fifth, employment sixth, optimism and pessimism seventh and the velocity of circulation eighth. The difference between Fisher and Kemmerer seems to come down to different ratings of two of the eight causes of depression.

Kemmerer would have put expectation - that is optimism and pessimism - very high. Managing the psychology of the marketplace is of crucial importance for him. He would also put the velocity of circulation very high, probably above the volume of currency.

Today the Government will argue for monetary reflation more or less in Fisher's terms; the Conservatives will be arguing for stabilisation with the emphasis, as with Kemmerer, on confidence. Fisher's own figures do lend support to Kemmerer's view of the importance of the velocity with which money circulates. Reductions in the velocity of circulation had a more damaging effect in the crucial period of the early years of the Great Depression. Fisher gives the figures from October 1929 to March 1932 for the New York member banks of the Federal Reserve system.

In that period the volume of money in circulation in New York fell by 13 per cent, from $5.8 billion to $5 billion. The velocity fell by 72 per cent. The monetary crisis that was the primary cause of the Great Depression was one of falling velocity rather than of falling volume.

Fisher understood this: “Suppose, for instance, that the currency, beside being contracted 50 per cent is slowed another 50. This means that there is only half the currency moving half as fast. Therefore the currency as a whole will do only a quarter of its former work.”

In 1929-32 the currency in the New York banking system lost 76 per cent of its efficiency in these terms. The trouble is that governments, which can increase the quantity of money - if necessary by printing - have only psychological means to encourage the increase in the velocity of circulation.

Fisher saw the need to restore the morale of the banking system; the Great Depression, like the 2008 crisis, began as a crisis of the banks. “In a depression the banks themselves are as badly scared as the public, and only the government is strong enough to handle such a scare.”

This brings the argument to its crucial point. The creditworthiness that must be protected at all costs is the creditworthiness of the government. Any government's credit is bound to depend on its own financial strength. The credit of the British Government will now be prejudiced by the prospect of a deficit expected to run at £100 billion a year. Such a deficit would undermine confidence in its ability to give further support to its banks. If confidence in the Government's credit is damaged that will also reduce confidence in British banks.

A government trying to prevent a recession turning into a depression must support its banking system to help to reflate the economy. That will require cash. But these reflationary policies must be balanced against the overriding need to protect the national credit, on which banking credit ultimately depends. Anything that weakens national credit should, therefore, be avoided. We have seen the pound lose a quarter of its value in terms of the dollar as a response to a large cut in interest rates. To restart the engine of credit, confidence will matter most. Governments can print money, but they cannot print the increased velocity of circulation that only confidence will produce.

• HAVE YOUR SAY

Can we please just have a simple statement of total debt, annual deficit, source of funds and cost of servicing debt? 

When we know how bad it really is, we can talk about the film, rather than just a freeze frame.

David Williams, Eastnor, England

Open Fisher theory is as much a reflection of confidence between currencies as purchase or interest rate parity. I think its more about which currency is less weak that more strong.

Rex Lester, Surbiton, Uk

Much has been said about the pound losing 25% of it value vs the dollar but it was excessively overvalued. $1.50 is roughly where it has fallen back to in the past, when it has reached the $2 level. Where the $2 level was a sign of pain to come, the $1.5 level gives hope.

Paul, London, UK