Irving Fisher: Interest, Money and Debt Deflation

Irving Fisher (1867 to 1947) was one of America’s first great economists. His ideas about interest, money and debt remain central to economics today, even though he is also remembered for a famous forecasting mistake.

Real and nominal interest

Fisher explained the difference between nominal and real interest rates. The Fisher equation says, approximately:

Real interest rate = Nominal interest rate - Expected inflation

If a bank pays 7 percent on deposits and inflation is 5 percent, the real return is about 2 percent. This simple idea is used every day by central banks, investors and savers.

The quantity theory of money

Fisher developed the equation of exchange, linking money, how fast it circulates, prices and transactions. It became the basis for the modern quantity theory of money, later championed by Milton Friedman.

Theory of interest

Fisher explained interest as arising from people’s impatience, or preference for consuming now, and the opportunities to invest and earn returns. His diagrams of choices over time are still taught in economics courses.

Index numbers

Fisher worked on how to build good price indices, and the “Fisher index” is still used in measuring prices and output.

The 1929 mistake

Shortly before the 1929 stock market crash, Fisher publicly declared that stock prices had reached a permanently high level. The crash that followed damaged his reputation and his personal fortune.

Debt deflation

The Great Depression led Fisher to one of his most important ideas. In 1933, he described debt deflation:

1. Over-indebted borrowers sell assets to repay debts.
2. Prices fall.
3. Falling prices increase the real burden of debts.
4. More borrowers default and sell, pushing prices lower still.

This vicious cycle explained why the Depression was so deep. Economists such as Ben Bernanke later built on it, and it influenced responses to the 2008 crisis.