Irving Fisher, the premier American economist of the early twentieth century, earned the first Ph.D. in Economics ever awarded by Yale, where he taught “political economy” for his entire career (1898 to1935). An accomplished mathematician and an engaging and talented writer on even the most technical of subjects, Fisher’s investigations ranged beyond economics to encompass astronomy, health and hygiene, mechanics, philosophy, poetry, science, and myriad public policy issues. Fisher was also the inventor of scores of useful (and profitable) devices, patenting, among other things, a folding chair and the Rolodex – the small wheel for mounting business cards which even today remains a fixture on desks in offices not yet fully computerized. A three year bout with tuberculosis (1898-1901) sparked Fisher’s interest in public health. A health faddist, he wrote How to Live: Rules for Healthful Living Based on Modern Science, which advocated regimens of vigorous exercise and vegetarianism. Fisher proved to be a living advertisement for his book [he lived to be 80], and it quickly became a best-seller. Fisher also devoted time and money to campaigns for temperance (the prohibition of alcohol), eugenics (policies to limit reproduction by less-than-perfect humans), and world peace. He amassed a fortune from his inventions and writings but Fisher, an avid investor in health food companies, lacked the gift of timing and lost most of his wealth in the stock market crash in 1929. As a theoretician, Fisher’s goal extended beyond merely developing theory with robust explanatory power. In his view, economic theory must be expressed in operational terms. A pioneer in testing theory with statistical tools, he crunched numbers, and he did this extremely well, cofounding the Econometric Society. Fisher’s two major works, The Purchasing Power of Money [1911] and The Theory of Interest [1907] address money, capital, and interest, and stress the desirability of stable monetary policies. His meticulous methods are evident in the equation of exchange which, even today, remains central in resolving disputes about macroeconomic theory and policy. Fisher formalized arguments from John Locke, David Hume and John Stuart Mill in his equation1, which can be summarized as: MVt= PT, where M= stock of money, Vt = the transaction velocity of money (i.e., how quickly it circulates), P = price level, and T = total monetary value of all transactions. Here M, P, and T, are directly observable and measurable, so Vt can be solved as V = PT/M, and Fisher's hypothesis that V is stable can be tested. Books by the Austrian economist Eugen von Bohm-Bawerk were starting points for Fisher’s inquiry into capital and interest. Inspired by Bohm-Bawerk, Fisher saw interest rates as determined by the interactions of two forces: (a) the time preference people have for consuming today versus consumption at a later time, and (b) the expectation that income saved and invested today will yield greater income tomorrow – capital produced today will generate greater future production than was required to construct the capital. Fisher labeled these forces impatience and opportunity. To simplify investment decisions from the perspectives of investors, Fisher blurred distinctions between investment in physical capital and investment in financial capital (stocks and bonds), instead treating as “capital” any asset that produces a flow of income over time. Because a dollar today is better than a dollar tomorrow, calculating the present value of capital entails using the interest rate to discount the flow of (net) income an asset generates. Fisher also distinguished between real (r) and nominal (i) interest rates. The nominal rate is the monetary rate of interest stated in contracts for loans or purchases, and consists of the real rate (based on time preference and the real productivity of new capital investments), plus a premium for the inflation anticipated by lenders. The desired real interest rate (r*, as measured by purchasing power) is, according to Fisher, determined by time preference and capital productivity. But inflation may cause the realized real interest rate (r) to differ from its desired value. According to “the Fisher equation”: (a) subtract actual inflation from the nominal interest rate to compute the “real” interest rate (in purchasing power terms) realized, ex post, on a loan, and (b) add the expected rate of inflation to the desired real interest rate (r*) to yield the nominal interest rate (i) that will be charged, ex ante, on a security. Thus, the purchasing power of the interest rate (r) realized from a loan is:
and the nominal (monetary) interest rate (i) that will be charged for a loan is:
where p = the annual rate of inflation and E(p) = the expected rate of inflation. Modern economists describe the changes in nominal interest rates that occur as expected inflation changes the Fisher effect. Irving Fisher also opposed the taxation of income tax enacted with the Sixteenth Amendment to the US Constitution [1913], favoring consumption taxes instead. Fisher reasoned that an income tax is effectively double taxation. People are first taxed on their incomes, but then they are taxed again on income generated by invested income. Consequently, income taxation promotes consumption rather that the saving that facilitates investment and economic growth. Few of the reform movements Fisher supported ultimately achieved any of their goals. For example, the Sixteenth Amendment to the U.S. Constitution [1913] ushered in income taxes, and the Eighteenth Amendment [1918] was repealed [Amendment XX1, 1933] after it ushered in an era of lawlessness. Eugenics came into disrepute because of Nazi atrocities during World War II, and some health food firms he invested in—Kellogg's and Post – now produce such sugary cereals as Coco-Puffs and Sugar Pops, which says something about where the profit motive can lead even the most well-intentioned of reforms. Nevertheless, Fisher was an active participant in the social and economic debates of his time. His life was one of accomplished scholarship and useful invention. Fisher's ideas live on. The financial literature bristles with discussions of the Fisher effect, and growing numbers of modern economists echo his call for monetary stability. Footnote: 1 Fisher actually decomposed the transaction velocity of money (currency in the hands of the nonbanking public plus checkable deposits in banks) into the transaction velocity of currency (Vc) and the velocity of transactions based on deposits in banks (Vd), so that his more formal equation (using this notation) was McVc + MdVd = PT. Modern quantity theorists usually simplify Fisher's equation to MV = PT by summing the two forms of money, cash (c) and deposits (d). Even more commonly used are the MVI = PQ (or MVI = Py) formulas, in which VI = the income velocity of money, and Q (or y) measure real output and income. |
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Author:
Ralph Byrns |
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Economics
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