98 THE BiG DROP
economics and is still widely read and cited today. The book
was titled The Debt-Deflation Theory of Great Depressions.
Fisher was the most famous U.S. economist of the first half
of the 20th century and made many intellectual contributions
to economics, including work on monetary policy and equilib-
rium analysis that led to later contributions by contemporary
economists including Milton Friedman and Ben Bernanke. Yet
Fisher’s work on debt and deflation is his best-known and most
important effort.
His thesis was straightforward. Depressions are the inevi-
table aftermath of credit booms and extreme overindebtedness.
During the expansion phase of a cycle, easy credit allows debtors
to bid up asset prices.
The higher asset prices then serve as collateral for further
debt, which is used to invest in other assets, causing those
prices to rise also. At some stage, valuations become stretched.
Creditors refuse to extend more credit and demand repayment
or require more collateral from the debtors.
At this point, the entire process goes rapidly into reverse.
Now debtors have to sell assets to repay creditors. This forced
selling causes asset prices to drop. The lower asset prices re-
duce the collateral values on other loans, which cause those
loans to be called by the creditors also.
Now the forced liquidation of assets becomes widespread,
businesses fail, layoffs increase, unemployed workers cannot
afford to spend, more businesses fail as a result and so on until
the entire economy is thrown into recession or, even worse,
depression.
This process played out in the period 1929–1933, and
again from 2007–2009. The latest episode is usually known
as the Great Recession, but is more accurately called the New
Depression. It is still with us in the form of below-trend growth,
threats of deflation and low labor force participation. This new
episode has led to a revival of interest in Fisher’s theory.