It is extraordinary how the great American Economist, Irving Fisher, has come back into fashion. In the last week I have seen substantial references to him in The Times of London, the Wall Street Journal, and the Sunday Independent, also a London paper. Only one of these articles did I write myself. This follows the flurry of interest in the ideas of Maynard Keynes, who died in 1946.
Irving Fisher, who died in 1947, had the advantage over Keynes of living in the United States during the crucial period of the Great Depression, from 1929 to 1935. He had already established his reputation as an economist in the early years of the twentieth century, primarily by his work on the changing levels of prices. He did not actually invent, but he developed the equation of exchange. As he later became convinced that the business cycle was caused by the movement of prices, one can regard the equation of exchange as essential to his understanding of the causes of the Great Depression.
I find that a surprising number of people can remember the equation of exchange, which they have learned at some stage of their student careers. Fifty years later, they will say “isn’t that the equation which says MV = PT?” Sometimes they can remember what the letters actually stand for. M is the quantity of money, V is the velocity at which it circulates, P is the general price level, and T represents the number of economic transactions in a given period.
In the Great Depression, we know what happened to the four variables. The quantity of money fell, at least in New York between 1929 and 1933; the velocity of circulation declined, prices fell and the number of transactions fell. Irving Fisher advocated the increase in the quantity of money, and persuaded Franklin Roosevelt that reflation should be part of the New Deal. Roosevelt was a tricky President to advise. He agreed with everyone when he was in the room with them. “That’s grand, just grand,” he would say, but he would often fail to adopt the policy. However, he did reflate by raising the dollar price of gold.
The difficulty was that the velocity of circulation could not be controlled in the same way. In New York the velocity of circulation fell by more than 70 per cent between October 1929 and March 1932.
We know that the velocity of circulation has fallen in our own 2008 crisis. Banks have lost trust in each other and have been reluctant to lend, either to their clients or to other banks. As a result money circulates slowly.
Governments can remedy an actual shortage of funds; if the worst comes to the worst they can create fiat money – they can simply print the stuff. Of course, that has an inflationary risk, but the risk of inflation can be offset against the depression itself – which has a powerful deflationary force.
However, Governments cannot print an acceleration of velocity. That is essential to recovery, and indeed it is an essential part of the reflation which almost everyone now recommends. Yet an addition to the money supply in quantitative terms does not automatically result in an acceleration of its velocity.
This was argued about in the 1930s. More conservative economists believed that the conditions of confidence which were required to raise the velocity of circulation could only be obtained by a restoration of the gold standard. I think it possible that banks would have wanted to hoard gold if the gold standard had remained intact. Britain, however, had left the gold standard in 1931.
Yet prudence is still important. A mad rush to print money would not reflect confidence. We need a recovery in the velocity of circulation. We shall only achieve it when bankers trust each other – and indeed when they trust their clients.
Markets and Money