Comparing the financial crisis mechanisms of Fisher, Minsky and Woodford

1. Introduction

 Given the current economic climate of financial instability, it is important to draw inspiration from many texts over the century in order to understand and learn (if not rectify) from the situation. Irving Fisher’s work on the Great Depression in the USA in 1929-1933 will allow us to see a basic overview of the areas in the economy which are most fragile. This work was extended by Hyman Minsky and close parallels can be drawn in their work. However, asking whether money supply even has a role within the economy, let alone the crisis, is a vital one; one which Michael Woodford addresses in a contentious piece of work. Therefore, this essay will look at the similarities between Irving Fisher’s financial crisis mechanism in ‘The Debt-Deflation Theory of Great Depressions’ and Hyman Minsky’s ‘Financial Instability Hypothesis’. It will then discuss the differences of these models to that of Woodford’s (/Wicksell’s) pure-credit economy in ‘Interest and Prices’.


2. Irving Fisher’s Debt Deflation

 Irving Fisher’s work entitled ‘The Debt-Deflation Theory of Great Depressions’ was published in the first edition of Econometrica – four years after he famously stated that “stock prices have reached what looks like a permanently high plateau”[1] on he eve of the 1929 crash. Given that he was famous for being a mathematical economist, this article in Econometrica had no ground-breaking mathematics in it whatsoever (infact it had no evidence at all). Instead, it was a paper constructed purely around a theory. At the start of the article he explains his “cycle theory”[2] whereby an “economic system contains innumerable variables – quantities of “goods”…the prices of these goods, and their values”[3] and that “only in imagination can all of these variables…be kept in equilibrium”[4]. As economic theory highlights both equilibrium and disequilibrium, Fisher tells us that “[t]he former is economic statics; the latter, economic dynamics. So called cycle theory is merely one part of the study of economic disequilibrium”[5].

 Given this framework, and the absurdity of the assumption of perfect equilibrium, Fisher highlights three important variables which are often in disequilibrium: 1. capital items, such as homes, factories etc; 2. income items, such as real income, shares traded and; 3. price items, such as prices of securities, commodities, interest[6] but concedes that disequilibrium in these markets would not bring about large economic change unlike over-indebtedness and deflation. Fisher thought that the over-investment and over-speculation (as specified in the above three points) would always have an effect on the economy but they would have far less of an impact on the economy as a whole if “it was not conducted with borrowed money”[7]. From here he postulates that without debt and deflation, “other disturbances are powerless to bring on crises comparable in severity to those of 1837, 1873 or 1929-33”[8].

 Fisher subsequently produced his economic mechanism whereby over-indebtedness and deflation could result in an economic crisis[9]:

 Start: Assumption of initial over-indebtedness due to speculation of future profits and/or due to low interest rates would increase the incentive to borrow and then speculate 

  1. Debt liquidation
  2. Contraction of deposit currency as bank loans are paid off which will decrease the velocity of money. This will lead to distress selling as over-indebtedness has set in.
  3. Distress selling leads to deflation (the money supply is decreased due to paying off loans). The paradoxical situation arises where the more people try to pay off their debts, the more the debt grows (because the real value of money has increased)
  4. An increase in bankruptcies due to a decrease in the net worth of businesses
  5. Decrease in profits
  6. Decrease in output, trade and employment
  7. Pessimism runs through the economy
  8. So hoarding increases and so the velocity of money decreases further.
  9. Complicated changes in nominal (money) and real (commodity) interest rates

 Given the assumption that it is the expansion and availability of credit fuelled by the temptation of large future profits and low interest rates, Fisher highlights two possible policy implications[10]: 1. the “natural” way out of depression and; 2. reflating the price level. The “natural” way occurs when bankruptcy is fully found throughout the economy thus creating a slower rate of indebtedness. When at this low, a recovery boom period would occur, improving the wellbeing of the economy. However, this “natural” way out of a depression is “via needless and cruel bankruptcy, unemployment and starvation”[11]. The other method of reflating the price level is key to his argument. Controlling the price level, as the Federal Reserve started (but did not continue) under Roosevelt in 1932, via ‘open market purchases’ led to higher prices and businesses making profit[12]. He also mentions that deficit spending could help reflate these prices[13]. The attention to monetary policy is key – an expansion in the money supply will lead to an increase in the velocity of money and so would halt many of the subsequent maladies found in the above model.

 While Fisher is very modest in his style of writing and clearly states that this paper is the first step towards more research in this area, there are, however, still problems with his theory. First of all he starts with the assumption of over-indebtedness and gives us a clue as to how this may begin (low interest rates, speculation of future profits) but he does not go into great detail. There are different types of indebtedness for different demographics and to simply put them altogether and label it ‘over-indebtedness’ is not necessarily pragmatic. Also, underpinning his theory is the idea of decreasing price levels but the link between deflation and depression is much debated. For example, in a study trying to find an empirical link, Atkeson and Kehoe[14] find that there is no (or in some cases extremely weak) correlation between deflation and depression. If we define a ‘depression’ as a negative increase in GDP then looking at the USA and the UK over a 45 year period, we find that it is inflation (due to exogenous shocks e.g. oil shock) which leads to negative GDP growth:

 Figure 1: UK and USA Inflation and GDP Growth Rates[15]

 It is interesting to note that the recent “”deflationary boom” in China”[16] has led economists to reconsider whether deflation is actually bad for the economy:

 Figure 2: China – Inflation and GDP Growth 1961-2007[17]

 3. Hyman Minsky’s Financial Instability Hypothesis

 Minsky drew inspiration from Keynes, Fisher and Kalecki in his analysis of financial instability. There are clear parallels to the work of Fisher – speculation, investment and debt. Minsky’s work is highly influential as it uses Fisher’s unregulated credit expansion which can cause the collapse of the financial system and offers another route out of the ultimatum of “Keynesian fiscal stabilisation or monetarist faith in the natural equilibrium of market economies”[18]. He also revolutionized macroeconomics by taking a “balance sheet approach to the relationship between the financial markets and business”[19]. For Minsky, both fiscal and monetary policy are ineffective, “not only because of the “trade off” between inflation and unemployment…but more significantly because of a strong tendency for an expansion to become an inflationary expansion which, in turn, leads to an incipient financial crisis”[20]. He also feels that the economic theory was not sufficient to predict or explain financial crises and instability as it “offers an explanation of serious business cycles…[and]…stagflation that goes beyond the money supply, the fiscal posture of the government or trade union misbehaviour”[21].

 However, to appreciate this model, we must understand the Kalecki roots which forms its foundation. The essay will then look at the model showing the similarity with Keynes and Fisher.

 Starting with Π = I and assume that workers spend all they earn on consumption and profit receivers do not consume then;

 And that the causation runs from I → Π


 Π* = (1/1-C)(I+DF-BPDF-SW)

 Where Π is profit, I is investment, C is consumption, DF is government deficit, BPDF is the balance of payments deficit and SW is the saving by workers.

 This shows that profits are determined by social, political, psychological and economic variables via their affect on I, C, DF, BPDF and SW as opposed to just technology (which is assumed the case in the neo-classical framework).

 This view of profits as a cash flow “naturally leads to an analysis of the different roles played by profits in a capitalist economy”[22]. For Minsky, profits are the key to a capitalist economy; they determine present and future investment as well as validating past investment decisions. Fluctuating investment could lead to a financial crisis whereby at sufficiently low levels investment, output, employment and thus profits, certain financial commitments cannot be paid through the usual sources. But why would investment fluctuate?

 Minsky offered three different types of financing which would all yield different returns. Toporowski offers a concise description of these financing structures[23]:

 “commitments to make future payments covered by a certain income stream are ‘hedge’ financing; commitments to make future payments which may or may not be covered by future income are ‘speculative’ financing structures; while commitments to make future payments which can only be covered by issuing new liabilities, such as borrowing, are ‘Ponzi’ financing structures.”

 In a period of tranquility where the economy is close to full employment, Minsky suggests that the insurance of holding money would fall. This would increase the price of capital assets and so a shift to higher risk (but potentially higher reward) speculative or even Ponzi financing. This would increase the finance needed “by the increased investment demand that follows a rise in the price of capital assets”[24]. As an economy moves towards the riskier speculative and Ponzi financing structure, the economy becomes more sensitive to interest rate changes. As a result, Minsky’s transmission mechanism is as follows: 

  1. An increase in investment demand will lead to an increase in profits which, in turn, will increase the price of capital assets.
  2. This increase in profits and price of capital assets will lead to an increase overall, of investment → BOOM
  3. The central bank will intervene in order to control inflation
  4. Due to inelastic demand and supply for investment leads to a rapid increase in short-run interest rates.
  5. This increase in interest rate will increase the price of supply of investment.
  6. The increase in short-run interest rate will also lead to an increase in the long-run interest rate which will decrease the present value of profits.
  7. A decrease in investment (from 5) will decrease profits
  8. Decrease in profits leads to a fall in the price of capital assets which leads to a further decrease in investment.
  9. With a fall in profits comes an inability to fulfill financial commitments → INDEBTEDNESS
  10. This indebtedness will lead to portfolios having an increasing speculative and Ponzi financing structure flavour.

 With this view of the transmission mechanism towards a financial crisis, Minsky’s main policy recommendations are to have a large government and a big bank. This large government can offset a decrease in investment with an increase in government deficit and the large swings in profits can be dampened and the big bank can act as a lender of last resort. These policy implications are, what Minsky argues to be, the reason as to why the USA has not fallen into the debt-deflation trap. Therefore, this explains why figure 1 has not strictly followed the Fisher framework. Also a cut in interest rates would improve the firm’s financial position and eases the cash flow problem which could create an increase in investment.

 The similarities with Fisher (and indeed Keynes) can be seen in this model. First of all there is a clear distinction between current trade and future obligations à la Fisher’s dual price system. Another area is that the Financial Instability Hypothesis is an alternative to the neo-classical view that “the technical marginal productivity of capital generates profits”[25] which can draw parallels with Fisher’s work on this topic. On can also see how a decrease in profits will lead to a decrease in output/employment (Fisher) or investment (Minsky) and then how debt can drive risky behaviour and lead to a financial crisis.

 Minsky’s analysis can be used with reference to the East Asian crisis (which many authors have discussed[26]) where “as profits grew, expectations of further profits expanded, which led to further flows of funds, in a speculative, endogenous development of expectations, confirming Minsky’s perspective. As debt was extended and speculative investment expanded, financial fragility in the Asian countries increased”[27].

 However, there are limitations to Minsky’s theory. It does not take into account the self-financing investment – why does investment have to come from credit? Also, the basis of this model comes from Kalecki’s profit model; this is based on national income identities which are not necessarily realistic. Another issue is the principal agent problem which could lead to crises as opposed to this model. As Barnes points out, “while the FIH is underpinned by a microeconomic model of the financial management of a business, it does not recognize the differences between the company’s interests and those of its owners, the conflicts caused, the likelihood of informational asymmetry and its implications for accounting information”[28].

 Woodford-Wicksell Theory of ‘Pure-Credit’

 Woodford takes a very different theory of the economy where he models it without explicitly having the volume of money. It has a distinct Wicksellian flavour in so much as a pure-credit and a cashless economy could be considered the same thing[29]. His theory is “to develop a framework for monetary policy analysis that is firmly based on dynamic, optimising, general equilibrium analysis in a stochastic context while departing from real-business cycle assumptions by replacing the latter’s presumption of full price flexibility with an optimising form of nominal price stickiness”[30]. In Woodford’s analysis, “money does not matter since it is not integrated within the monetary framework that should be used by policymakers”[31]. As his model assumes no transaction frictions, the cashless economy can be considered as people have no demand for money as there is no risk for money to hedge. As will be highlighted when the model is formally shown, Woodford’s theory is based on microeconomic foundations. One advantage of such a model is to try to make it “immune to the Lucas critique”[32].

 The agents within his economy are: 1. a representative household (which is a price take and seeks to optimise his intertemporal utility function); 2. firms (price makers in a monopolistic setting, has Calvo pricing (supply and demand are both functions of price which is a general equilibrium feature), assumes to maximise profits and produces a single good with only labour); 3. central bank (fixes the level of the nominal interest rate on its liabilities in response of both the inflation rate and the output gap[33]) and; 4. the government (decides fiscal policy and can issue government bonds). Other assumptions include two frictionless markets and the financial market is perfectly complete.

 There are three sections to his analysis has an IS-AS-MP[34] framework:

 IS: links the expected output gap and the short run nominal interest rate to aggregate demand.

 AS: links the rate of inflation to the gap between aggregate demand and the long run aggregate supply. This uses rational expectations which augments the old Phillips Curve.

 MP: The monetary policy here is based on Taylor’s Rule where nominal interest rate is equal to the sum of the natural rate of interest (time varying real rate which would be obtained if the prices were fully flexible) and the inflation target. As a result, the actual inflation rate depends on the actual output gap and the expected value of the inflation rate in the next period. This would make sense because a positive output gap would lead to higher inflation because production costs would increase e.g. labour costs.

 In this framework, money supply does not affect the economy, but interest rates do. This pure-credit economy arises because there is no money supply and so credit is automatically created to allow payments and transactions. In Fisher and Minsky it was the money supply which links with profit/debt and crises but as there is no money supply in Woodford’s economy, there would be no crisis. As there is no uncertainty in this model, there is no risk and so there is no need to hold money and the economy would reach equilibrium via the only transmission mechanism, interest rates. Both Fisher and Minsky saw the economy being in a permanent state of disequilibrium but it has mechanisms whereby it can stabilise itself. However, under the general equilibrium theory of Woodford, the economy can achieve equilibrium very readily.

 This is by no means a theory which has not been criticised. Eagle tells us of four areas of contention with this model: “(1) Woodford’s assumption that his solution is bounded is inappropriate. (2) Any finite version of Woodford’s model is incomplete. (3) Woodford’s central bank does not control nominal interest rates. (4) Woodford argument that interest rates determine prices and that prices affect the interest rate is circular and hence invalid”[35]. However, it can be argued that this is not a one-size-fits-all theory. It has been stressed that the ““precise content of an optimal policy rule” will depend upon details of the adopted model of the transmission mechanism and thus are likely to be different for different economies”[36].


 In reading Fisher and Minsky, one can draw distinct parallels. There is a clear distinction between current trade and future obligations as seen in Fisher’s dual price system. Both theories are alternatives to the neo-classical view that “the technical marginal productivity of capital generates profits”[37]. Also the expansion of credit availability will lead to over-speculation due to financial commitments needing to be paid and thus highlights the fragility of the system. Both would offer intervention; Fisher would get the central bank to increase money supply while Minsky would prefer to let the large government intervene through fiscal policy spending in productive technologies. The contrast with Woodford, therefore, could not be any greater. For Woodford, the supply of money does not affect the economy and so there would never be a crisis (except from an exogenous stochastic shock). As a result, the mechanism whereby general equilibrium is reached is via the interest rate which the central bank can regulate. For me, Minsky’s analysis seems to have a lot of weight and his recommendation of having a big government and central bank (the latter as a last resort) will always be able to rectify a financial crisis. However, this is not necessarily the best option given the political arena economics operates in – using tax revenue to bail out banks is not popular. However I feel this is the only way to work – how does one tell a money lending institution to not lend to an individual/enterprise etc purely because it feels it is too risky?

[1] Toporowski, J. – ‘Theories of Financial Disturbance’ – Edward Elgar Publishing 2005 p75

[2] Fisher, I. – ‘The Debt-Deflation Theory of Great Depressions’ – Econometrica Vol. 1 No. 4 1933 p337

[3] ibid

[4] ibid

[5] ibid

[6] ibid p340

[7] Ibid p341

[8] ibid

[9] ibid p341-342

[10] ibid p346

[11] ibid p346

[12] ibid p347

[13] Toporowski, J. – ‘Theories of Financial Disturbance’ – Edward Elgar Publishing 2005 p77

[14] Atkeson, A. and Kehoe, P. – ‘Deflation and Depression: Is There an Empirical Link?’ Federal Reserve Bank of Minneapolis Research Department Staff Report 331

[15] Data from the ESDS website – World Bank World Development Index statistics

[16] Salerno, J. – ‘Deflation and Depression: Where’s the Link?’ – Ludwig von Mises Institution website

[17] Data from the ESDS website – World Bank World Development Index statistics

[18] Toporowski, J. – ‘Theories of Financial Disturbance’ – Edward Elgar Publishing 2005 p149

[19] ibid p143

[20] Minsky, H.P. – ‘The Financial Instability Hypothsis: A Restatement’ – Thames Papers in Political Economy p1

[21] ibid p2

[22] ibid p13

[23] Toporowski, J. – ‘Theories of Financial Disturbance’ – Edward Elgar Publishing 2005 p144

[24] Minsky, H.P. – ‘The Financial Instability Hypothsis: A Restatement’ – Thames Papers in Political Economy p16

[25] ibid p12

[26] See Wolfson, M. – ‘Minsky’s Theory of Financial Crises in a Global Context’ – JOURNAL OF ECONOMIC ISSUES Vol. XXXVI No. 2 June 2002 and Kregal, J. A. – ‘Yes, “It” Did Happen Again- A Minsky Crisis Happened in Asia’

[27] Wolfson, M. – ‘Minsky’s Theory of Financial Crises in a Global Context’ – JOURNAL OF ECONOMIC ISSUES Vol. XXXVI No. 2 June 2002  p396

[28] Barnes, P. – ‘Minsky’s financial instability hypothesis, information asymmetry and accounting information: the UK financial crises of 1866 and 1987’ – SAGE Publications Vol 12(1): 29–53 p29

[29] This debate over the differences between Wicksell and Woodford is too long for this essay but is nonetheless very interesting.

[30] McCallum, B. – ‘Michael Woodford’s Interest and Prices: A Review Article’ – Carnegie Mellon University and National Bureau of Economic Analysis 2005 p2

[31] Barbaroux, N. – ‘Wicksell and Woodford: a Cashless Economy or Moneyless Economy?’ 2007 p9

[32] McCallum, B. – ‘Michael Woodford’s Interest and Prices: A Review Article’ – Carnegie Mellon University and National Bureau of Economic Analysis 2005  p2

[33] Barbaroux, N. – ‘Wicksell and Woodford: a Cashless Economy or Moneyless Economy?’ 2007  p11

[34] ibid p13

[35] Eagle, D. – ‘Multiple Critiques of Woodford’s Model of a Cashless Economy’ – Eastern Washington University 2005 abstract

[36] McCallum, B. – ‘Michael Woodford’s Interest and Prices: A Review Article’ – Carnegie Mellon University and National Bureau of Economic Analysis 2005 p25

[37] Minsky, H.P. – ‘The Financial Instability Hypothsis: A Restatement’ – Thames Papers in Political Economy p12


One thought on “Comparing the financial crisis mechanisms of Fisher, Minsky and Woodford

  1. Pingback: Can Japan climb out of this debt-deflation spiral? « Comment Today

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