Last week, central bankers across the globe reduced interest rates. Combined with government plans to part-nationalise banks and buy up toxic assets, this move may cause prices to rise. We can only hope that it is successful and prices do not fall due to a chronic lack of credit, as Tom Cunningham has argued may occur. For, contrary to what many commentators have argued over the past year, high inflation is exactly what we need right now to avert the second coming of the Great Depression.
Let me explain. The effects of the Wall Street Crash on 1929 were spread from the financial sector to the rest of the economy (from Wall Street to Main Street, if you like) by a phenomenon known as debt-deflation. It works as follows. At the beginning of the year, a farmer, say, borrows $100 from a bank to buy some fertiliser with the expectation of selling her produce, let's say wheat, on the open market at $150. If, come harvest time, the price of wheat has fallen to $50, then the farmer will not be able to pay off her $100 loan.
A bank can cope with isolated defaults of this kind. But if the price of all goods and services is falling, then the bank is likely to be hit by many similar cases. Once deposit holders get wind of the situation, they may want to withdraw their savings and a bank run may ensue. News of one bank run may set off a string of similar bank runs elsewhere, even at banks which have not lent money to borrowers affected by deflation.
The American economist Irving Fisher first put the concept of debt-deflation forward in the journal Econometrica (pdf) in 1933. His idea was largely ignored or forgotten by economists until it was proven in the early 1980s by a little-known Stanford University assistant professor by the name of Ben Bernanke. Today, Fisher's ideas should be on the mind of every self-respecting central banker.
How relevant is Fisher's original debt-deflation article to what we are experiencing now? Fisher warns that of the many different factors that make a depression into a Great one, all play a subordinate role compared with "two dominant factors, namely over-indebtedness to start with and deflation following soon after". He explains that "the two diseases act and react to each other", and "the very effort of individuals to lessen their burden of debts increases it, because of the mass effect of the stampede to liquidate in swelling each dollar owed", or, in other words, "the more the debtors pay, the more they owe". In short, debt combined with falling prices can be a lethal combination.
Fisher presents a chronology of events in 10 stages that together constitute a Great Depression, stage 10 of which includes:
(a) runs on banks;
(b) banks curtailing loans for self protection;
(c) banks selling investments;
(d) bank failures. This stage looks remarkably familiar; we may be already there.
On Sunday, UK treasury minister Yvette Cooper told the BBC's Andrew Marr that consumer prices might finally start to fall as a result of decreasing oil prices. But Yvette, we don't want prices to fall at all! Depressingly, many important prices are already falling. House prices are down, however they are measured.
And stock markets have seen some of the most dramatic falls in value for decades. These assets are not normally included in traditional price indices; perhaps they should be.
Fisher argued that the policy implication of his theory is that "the question of controlling the price level assumes a new importance". Yvette Cooper, please take note of history. Raise the Bank of England's unrealistically low 2% inflation target, for example. We would rather not see a second coming of the Great Depression.