Irving Fisher's classic treatise, The Purchasing Power of Money: Its Determination and Relation to Credit, Interest and Crises (1911), still offers valuable insights regarding monetary reform. This post examines some of Fisher's insights and draws some lessons for Fed policy.
The Importance of Stable Money
Fisher recognized "the evils of monetary instability"—that is, "periodic changes in the level of prices, producing alternate crises and depressions of trade." He argued that "only by knowledge, both of the principles and of the facts involved, can such fluctuations . . . be prevented or mitigated, and only by such knowledge can the losses which they entail be avoided or reduced" (Fisher 1912: ix). 
The main principles that guided Fisher's work were embodied in the quantity theory of money and the theory of monetary disequilibrium. The former held that, ceteris paribus, the purchasing power of money (the reciprocal of the price level) depends on the quantity of money relative to real output (trade). If the economy is at full employment and the velocity of money is stable, then the purchasing power of money will be inversely related to the stock of money. If money moves in line with trade and velocity is stable, then monetary equilibrium will prevail and the value of money will also be stable (see Fisher 1912: 320).
When Fisher wrote The Purchasing Power of Money, the United States was still on the classical gold standard; there was no central bank. In his book, he defined money as "what is generally acceptable in exchange for goods" (p. 8). He recognized that "money never bears interest except in the sense of creating convenience in the process of exchange" and that "this convenience is the special service of money and offsets the apparent loss of interest involved in keeping it in one's pocket instead of investing" (p. 9).
Fisher also importantly recognized that "money itself belongs to a general class of property rights" known as "currency" or "circulating media." More specifically, "currency includes any type of property right which, whether generally acceptable or not, does actually, for its chief purpose and use, serve as a means of exchange" (p. 10). While Fisher classified bank notes as money and circulating media, he viewed checkable bank deposits as currency, not money in the strict sense (p. 11).
"Primary money" referred to commodity money (gold coin at the time), while "fiduciary money" (notably bank notes) referred to money whose value depended "on the confidence that the owner can exchange it for other goods" (ibid.). "The chief quality of fiduciary money," wrote Fisher, "is its redeemability in primary money, or else its imposed character of legal tender" (p. 12).
Fisher refined the quantity theory of money to take account of monetary disequilibrium and used statistical methods to test the theory against historical data. Like his contemporaries, he understood that the fundamental cause of business fluctuations was erratic money.
The Theory of Monetary Disequilibrium
The main tenets of the theory of monetary disequilibrium were well known to Fisher and Harry Gunnison Brown, who assisted in writing The Purchasing Power of Money (see chap. 4). Clark Warburton summarized those tenets in his monumental book, Depression, Inflation, and Monetary Policy (1966). They are listed in Table 1.
Assumptions of the Theory of Monetary Disequilibrium
|1. A change in the level of prices is a process which takes a period of time, and affects prices of various items sequentially rather than simultaneously.|
|2. Some prices are greatly influenced by custom or contract and move less readily than other prices; specifically, wages and contractual elements in business costs tend to be sluggish relative to price of output.|
|3. These differential movements of prices and also prospective further changes in prices have significant effects upon business profits and prospects and hence upon business plans, especially with respect to investment decisions and to holdings of cash relative to receipts and expenditures.|
|4. The economy is not static; more specifically, we live in a world where population is growing, technological developments are increasing production per worker, and other developments tend to increase the volume of transactions (in quantity terms) relative to the output of final products.|
|5. As a result of the foregoing and of the stability of customs (such as the periodicity of income payments) which affect the rate of circulation of money, the economy needs for equilibrium a continuous increase in the quantity of money.|
|6. It is theoretically possible for monetary disequilibrium to persist for months or years, and observations indicate that many such situations have occurred.|
|7. The actual quantity of money reflects primarily the behavior of banks or of a government treasury issuing circulating medium; and the nature of banks is such that they have a tendency to carry forward the expansion of money to the limit permitted by interbank relationships and the laws under which they operate.|
|8. In the United States, subsequent to establishment of the national banking system, the chief restraint on the banks, limiting their expansion and occasionally necessitating contraction, is the amount of legal reserves.|
|9. The impact of monetary disequilibrium is intensified by sequential changes in the rate of circulation of money [i.e., the velocity of money].|
|10. Changes in the quantity of money which are not consonant with the rate of expansion needed for equilibrium also change the amount of funds available in the money loan market; thus they constitute the force which produces a departure of the market rate of interest from the equilibrium rate, and consequently disturbs property values and mutual adjustment of saving and investment decisions.|
|11. If the force impinging on the quantity of money, such as the state of bank reserves, can be observed ahead of change in the quantity of money, or is itself of such character as to have a direct effect on the securities market, the disturbance to property values and to investment decisions may begin ahead of the monetary disequilibrium as observed in statistical data.|
Source: Warburton (1966: 28–29).
Propositions 10 and 11 in Table 1 were of particular importance to Fisher. He argued that, while "it is generally recognized that the collapse of bank credit brought about by loss of confidence is the essential fact of every crisis," it "is not generally recognized . . . that this loss of confidence . . . is a consequence of a belated adjustment in the interest rate" (p. 66). His purpose in writing The Purchasing Power of Money was to emphasize that "the monetary causes [of crises] are the most important when taken in connection with the maladjustments in the rate of interest. The other factors often emphasized are merely effects of this maladjustment" (ibid.).
In seeing monetary instability as the chief factor in business fluctuations, Fisher was following the tradition going back to David Hume whereby classical economic theory consisted of two parts: (1) a theory of equilibrium whereby market forces would restore relative wages and prices to their equilibrium levels, and (2) a theory of disequilibrium in which there is either an excess demand for, or supply of, money. Although the theory of monetary disequilibrium—also known as the "dynamic theory of money"—was widely recognized and developed by the first quarter of the 20th century, the ascent of Keynesian economics diverted attention from that body of knowledge.
Fisher argued that an excess supply of money will not immediately be reflected in a proportionate rise in the price level. The corresponding rise in the supply of bank credit will lower the rate of interest in the short run until inflation is fully anticipated, at which point the nominal interest rate will rise and the expected profitability of investment fall. During the transition to a new equilibrium, bankruptcies will occur and unemployment rise (because of sluggish adjustment of relative wages and prices).
In looking at the case of "overinvestment," Fisher notes:
The stockholder and enterpriser generally are beguiled by a vain reliance on the stability of the rate of interest, and so they overinvest. It is true that for a time they are gaining what the bondholder is losing and are therefore justified in both spending and investing more than if prices were not rising; and at first they prosper. But sooner or later the rate of interest rises above what they had reckoned on, and they awake to the fact that they have embarked on enterprises which cannot pay these high rates [p. 66].
He goes on to explain that "a curious thing happens: borrowers, unable to get easy loans, blame the high rate of interest for conditions which were really due to the fact that the previous rate of interest was not high enough. Had the previous rate been high enough, the borrowers never would have overinvested (p. 67, emphasis added).
In sum, the importance of erratic money in Fisher's theory of business fluctuations and his recognition that transition periods could last a considerable time make his theory part and parcel of the dynamic theory of money (see Warburton 1966: 4–5). Fisher held that, in studying business fluctuations, one cannot ignore variations in the quantity of money relative to output. That is why he chose those variations as the "chief factor" in his study of commercial crises (Fisher 1911: 55). Moreover, he argued that "periods of transition are the rule and those of equilibrium the exception, [so that] the mechanism of exchange is almost always in a dynamic rather than a static condition" (p. 71). One of his major contributions was a rigorous discussion of "maladjustments in the rate of interest" in the process of adjustment to a new equilibrium by distinguishing between nominal and real rates of interest.
Proposed Reforms and Method of Persuasion
Fisher considered a number of reforms designed to stabilize the long-run price level, and thus maintain the purchasing power of money. They included changes in monetary law to:
- "Make inconvertible paper the standard money, and to regulate its quantity."
- "Regulate the supply of metallic money by a varying seigniorage charge."
- "Issue paper money, redeemable on demand, not in fixed amounts of the basic precious metal, but in varying amounts, so calculated as to keep the level of prices unvarying."
- "Adopt the gold-exchange standard combined with a tabular standard" [p. 348].
In proposing any monetary reform designed to safeguard the long-run value of money, Fisher believed that "the first step" should be "to persuade the public, and especially the business public, to study the problem of monetary stability" (ibid.) When the time is ripe for reform, the intellectual groundwork will be ready for policymakers and the public to take the appropriate action. The fact that certain monetary reforms may not be politically feasible at the moment should not dissuade scholars from contemplating reforms that may improve the monetary arrangement and benefit society. As Fisher wrote,
The necessary education once under way, it will then be time to consider schemes for regulating the purchasing power of money in the light of public and economic conditions of the time. All this, however, is in the future. For the present there seems nothing to do but to state the problem and the principles of its solution in the hope that what is now an academic question may, in due course, become a burning issue [ibid.].
As noted earlier, Fisher saw "the problem of stability and dependability in the purchasing power of money" as "the most serious problem" (p. 321). Variations in the price level can occur due to (1) "transitional periods constituting credit cycles" and (2) "secular variations" due to "incidents of industrial changes." Both those disturbances can be mitigated, according to Fisher, by increasing "knowledge as to prospective price levels." If the public anticipates changes in the price level, then those changes will be reflected in nominal interest rates: "a foreknown change in price levels might be so taken into account in the rate of interest as to neutralize its evils" (ibid.).
Fisher summed up by writing:
While we cannot expect our knowledge of the future ever to become so perfect as to reach this ideal, viz. compensations for every price fluctuation by corresponding adjustments in the rate of interest—nevertheless every increase in our knowledge carries us a little nearer that remote ideal [ibid.].
Giving people better information, however, may not change their behavior if they have a vested interest in maintaining the status quo. Thus, Fisher observes:
The prejudice of business men against the variability of, and especially against a rise of the rate of interest, probably stands in the way of prompt adjustment in that rate and helps to aggravate the far more harmful variability in the level of prices and its reciprocal, the purchasing power of money [p. 322].
Nevertheless, Fisher thought that "while there is much to be hoped for from a greater foreknowledge of price [level] changes, a lessening of the price changes themselves would be still more desirable" (p. 323).
The Search for Stable Money
The quantity theory of money attributes price-level changes mainly to "changes in money and trade." As Fisher remarks,
There has been for centuries, and promises to be for centuries to come, a race between money and trade. On the results of that race depends to some extent the fate of every business man. The commercial world has become more and more committed to the gold standard through a series of historical events having little if any connection with the fitness of that or any other metal to serve as a stable standard. So far as the question of monetary stability is concerned, it is not too much to say that we have hit upon the gold standard by accident [pp. 323–24].
While there is little support for a gold standard at present, that monetary regime was taken as a given in 1911, and there seemed to be little chance of replacing it:
Now that we have adopted a gold standard, it is almost as difficult to substitute another as it would be to establish the Russian railway gauge or the duodecimal system of numeration. And the fact that the question of a monetary standard is today so much an international question makes it all the more difficult" [p. 324].
What is of interest here is that Fisher did "not attempt to offer any immediate solution of this great world problem of finding a substitute for gold." Rather, he reasoned that "before a substitute for gold can be found, there must be much investigation and education of the public" (ibid.). His strategy was
to call attention to the necessity for this investigation and education, to examine such solutions as have been already proposed and, very tentatively, to make a suggestion which may possibly be acted upon at some future time, when, through the diffusion of knowledge, better statistics, and better government, the time shall become ripe [ibid.].
Fisher reviews a number of proposals for fundamental monetary reform in chapter 13, including "honest government regulation of the money supply" aimed at price-level stability. A simple scheme would be for the monetary authority to issue "inconvertible paper money in quantities so proportioned to increase of business that the total amount of currency in circulation, multiplied by its rapidity, would have the same relation to the total business at one time as at any other time." He argued that, "if the confidence of citizens were preserved, and this relation were kept, the problem [of achieving a stable price level] would need no further solution" (p. 329, emphasis added).
However, Fisher rejects this proposed monetary rule, because "sad experience teaches that irredeemable paper money, while theoretically capable of steadying prices, is apt in practice to be so manipulated as to produce instability" (ibid.) His preferred reform was to introduce a "gold-exchange standard combined with a tabular standard." He recognized that, a tabular standard alone, which could be introduced by private contractual parties without any government action, would not suffice to bring about monetary and price-level stability (see pp. 334–37). But it should be pointed out that his mixed system also has problems: it is not a real gold standard, it is open to speculative attacks, and it depends on an unsustainable degree of central bank cooperation.
We now turn to lessons for the Fed and monetary reform from the insights of Fisher.
Lessons for the Fed and Monetary Reform
Irving Fisher's examination of monetary theory and history led him to refine the quantity theory of money and to offer various proposals for monetary reform. He took a comparative institutions approach to reforming the monetary regime. He did not expect immediate results, but emphasized the importance of laying the groundwork for future reform so that when the time was ripe he could offer well-developed alternatives to the existing system. He sought to improve the chances for price-level stability and lessen the chances for crises due to erratic money.
Fisher's emphasis on the discoordination generated by monetary disequilibrium is still relevant today, but has been lost sight of in macroeconomic models devoid of money. His emphasis on a stable and predictable value of the dollar is useful as a guide to monetary policy, but ignores problems with a price-level target as opposed to targeting nominal spending. Instead of maintaining a constant inflation rate, a nominal GDP target would allow the rate of inflation to vary with changes in the growth rate of real output, declining in times of relatively rapid output growth, and rising in times of slower growth. As New Zealand economist Allan G. B. Fisher noted, "If prices are not allowed to fall in proportion to improvements in the efficiency of production, misleading indications will be given to producers as to the directions in which it is desirable to retard or accelerate the flow of capital; and the errors thus encouraged are likely to cause dislocation throughout the whole economic structure."
Fisher's attention to transition periods and especially to the "maladjustments in the rate of interest," caused by an excess supply of money, is relevant for helping understand financial crises. His analysis of financial booms and busts led to the idea that interest rates can be kept too low for too long and that "had the previous rate [of interest] been high enough, the borrowers never would have overinvested" (p. 67). This idea is evident in John Taylor's and Anna Schwartz's critique of Fed policy prior to the 2008 financial crisis and the Great Recession.
The 2008 financial crisis revealed the flaws in the current discretionary government fiat money system with a central bank that kept its policy rate too low for too long. Although there were nonmonetary factors contributing to the 2008 crisis, especially misguided housing policy, the monetary policy mistakes were of critical importance.
John Taylor, in his reassessment of the 2008 financial crisis after 10 years, concluded:
There was a significant deviation in 2003–2005 from the more rules-based monetary policy strategy [the Taylor rule] that had worked well in the two prior decades. The resulting extra low policy interest rates were a factor leading to a search for yield, excessive risk taking, a boom and bust in the housing market, and eventually the financial crisis and recession. . . . These actions spread internationally as central banks tended to follow each other in setting their policy interest rate" [Taylor 2018: 2].
To support his monetary theory of the 2008 crisis, Taylor used an econometric model to simulate what the housing market would have looked like if the Fed had followed the Taylor rule in setting its policy rate. He found that "the [housing] boom and the bust disappeared"; and that, "if the Fed had not held rates too low, there would have been less search for yield, less risk-taking and fewer problems on the banks' balance sheets" (pp. 3–4).
Taylor's "real concern" is with "preventing central banks from causing asset bubbles" by keeping rates too low for too long (p. 4). A rules-based monetary policy would help in that regard. Moreover, "a rules-based monetary policy is an essential part of a well-functioning market economy" (p. 24).
Anna J. Schwartz also argued that "if monetary policy had been more restrictive, the asset price boom in housing could have been avoided." She criticized Alan Greenspan for not seeing this fact (Schwartz 2009: 22–23). In Fisherian fashion, Schwartz (p. 19) stated:
The basic groundwork to the disruption of credit flows can be traced to the asset price bubble of the housing price boom. It has become a cliché to refer to an asset boom as a mania. The cliché, however, obscures why ordinary folk become avid buyers of whatever object has become the target of desire. An asset boom is propagated by an expansive monetary policy that lowers interest rates and induces borrowing beyond prudent bounds to acquire the asset.
Schwartz then laid out the sequence of monetary policy steps that helped fuel the housing boom:
The Fed was accommodative too long from 2001 on and was slow to tighten monetary policy, delaying tightening until June 2004 and then ending the monthly 25 basis point increase in August 2006. The rate cuts that began on August 10, 2007, and escalated in an unprecedented 75 basis point reduction on January 22, 2008, was announced at an unscheduled video conference meeting a week before a scheduled FOMC meeting. The rate increases in 2004 were too little and ended too soon [pp. 19–20].
The Fed's unconventional monetary policies, characterized by near zero interest rates, large-scale asset purchases (i.e., "quantitative easing"), and forward guidance (keeping rates "lower for longer") were designed to revive the economy after the panic of 2008. There is no doubt that those policies boosted asset prices and had a wealth effect, but they increased risk taking, incentivized leverage, and misallocated capital. Raising rates is more difficult than lowering them—as Fed Chairman Powell is experiencing from President Trump's harsh criticism and the market's reaction. When rates do normalize the wealth created by unconventional policies may well turn out to be a pseudo wealth effect rather than a real one; after all, "easy money" can't permanently increase real economic growth.
Nevertheless, the Fed seems determined to keep unconventional monetary policy tools available in case of another recession, reverting once again to quantitative easing if the effective fed funds rate reaches the zero lower bound (i.e., a zero nominal rate). In the meantime, there is the danger of drifting toward a higher inflation target to push nominal interest rates up and thus have more room to decrease the policy rate in case of a recession. Such interest-rate manipulation is part and parcel of our government fiat money regime.
The main lesson from Fisher's work is that there needs to be a thorough study of the current discretionary regime and an examination of alternatives that would reduce regime uncertainty and mitigate monetary-induced business fluctuations. Possible alternatives include a price level rule, nominal GDP targeting, Fisher's compensated dollar plan, and Hayek's free-market money proposal. The return to a commodity-based regime, in which there is no central bank and the supply of money is market determined, should also be part of the debate over the future of money, as should the use of cryptocurrencies.
The Fed plans to host a conference later this year at the Chicago Fed to discuss its dual mandate and strategies to achieve full employment and price stability. Hopefully, that discussion will include a close examination of the current operating procedure by which the Fed uses interest on excess reserves (IOER) and the overnight reverse repo rate (ONRRP) to set the range for its policy rate. Paying IOER to banks above the opportunity cost of holding those reserves at the Fed plugs up the monetary transmission mechanism, increases the demand for reserves, and reduces the impact of changes in the monetary base on broader monetary aggregates—and thus on nominal GDP. Moving away from the "floor system" to a "corridor system" and reducing the size of the Fed's balance sheet are necessary steps for normalizing policy.
The Fed conference is a step in the right direction for increasing public debate over the role of the central bank, but it is insufficient. Congress, in its constitutional duty of safeguarding the value of money, needs to take that responsibility seriously and establish the Centennial Monetary Commission that was proposed under the Financial CHOICE Act of 2017 (Title X, Sec. 1011) to examine the Fed's performance since its creation in 1913, and to consider various reforms. In doing so, it should not neglect the importance of restoring constitutional money and understanding how alternative monetary regimes affect uncertainty.
In thinking about monetary alternatives, there is no better place to start then a review of Irving Fisher's work, especially The Purchasing Power of Money. His insights can guide all those interested in improving the current government fiat money regime and in avoiding the mistakes of the past. The Fed, in particular, ought to listen to what Fisher had to say about sound money—that is, money of stable purchasing power. There is no perfect monetary system, but one needs to understand what a "good system" would look like in order to move in the right direction. A deep knowledge of monetary theory, monetary alternatives, and monetary history are essential in order to improve the present monetary regime.
Fisher (1911: 329) sought to avoid those reforms that "would be subject to the danger of unwise or dishonest political manipulation." That is wise advice. We cannot assume that public officials have perfect information or will act in "the public interest." That is why James Madison, the chief architect of the Constitution, wrote:
The only adequate guarantee for the uniform and stable value of a paper currency is its convertibility into specie—the least fluctuating and the only universal currency. I am sensible that a value equal to that of specie may be given to paper or any other medium, by making a limited amount necessary for necessary purposes; but what is to ensure the inflexible adherence of the Legislative Ensurers to their own principles and purposes? [Madison 1831, "Letter to Mr. Teachle," Montpelier, March 15, emphasis added].
Fisher recognized that, even under the gold standard, the price level would vary in the short run; indeed, it had to in order to maintain stability over the long run. By anchoring the price level under the price-specie-flow mechanism, interest rates stayed low for long periods and governments could issue long-dated bonds (consols). Fiscal rectitude accompanied monetary stability.
In the search for stable money, reform proposals that may seem farfetched today may become feasible in the future. Those who lived under the classical gold standard would be shocked to learn of its demise and replacement with a central bank having a balance sheet of more than $4 trillion and the power to engage in large-scale asset purchases, including mortgage-backed securities. It's time for an audit of the Fed: not just its books, but its structure, conduct, and performance. Revisiting the works of great monetary thinkers like Fisher is not a bad place to start.
 All quotes are from the 1912 reprint of The Purchasing Power of Money (Macmillan). The 1922 edition can be found at https://www.econlib.org/library/YPDBooks/Fisher/fshPPM.html.
 See Warburton (1966: chaps. 1 and 4). Also see Leland B. Yeager, The Fluttering Veil: Essays on Monetary Disequilibrium, Part 3 (Liberty Fund, 1997).
 See Fisher (2012: chap. 4).
 Under this so-called compensated dollar plan, "the amount of gold obtainable for a paper dollar would vary inversely with its purchasing power per ounce as compared with commodities, the total purchasing power of the dollar being always the same." In such a system, "the supply of money in circulation would regulate itself automatically" (Fisher 1911: 331). For a more thorough discussion of Fisher's compensated dollar plan, see Don Patinkin, "Irving Fisher and His Compensated Dollar Plan," Federal Reserve Bank of Richmond Economic Quarterly (79/3, Summer 1993):1–33. Also see Chapter 6, "The Quantity Theory Alternative," in Thomas M. Humphrey and Richard H. Timberlake's forthcoming book, Gold, The Real Bills Doctrine, and the Fed: Sources of Monetary Disorder, 1922–1938 (Cato Institute, 2019).
 A gold-exchange system would provide for a country not on the gold standard to exchange its currency at par with a country whose currency is linked to gold. A tabular standard uses a price index to ensure that creditors are paid back in dollars of constant purchasing power.
 For a discussion of the operation of this standard, see Fisher (1911: 337–47).
 Allan G. B. Fisher, "Does an Increase in Volume of Production Call for a Corresponding Increase in Volume of Money?" American Economic Review 25/2 (June 1935): 197. Also see George Selgin's Less than Zero: The Case for a Falling Price Level in a Growing Economy (Cato Institute, 2017).
 It is important to note, however, that the Taylor Rule is not the same as Fisher's compensated dollar rule. Unlike Taylor's rule, Fisher's allows for no feedback from the state of output or employment. It is a price level or inflation rule pure and simple. It is also a general inflation rather core inflation rule. As such, it would have called for more tightening than Taylor's rule, and even more than the Fed engaged in, during 2008. I am indebted to George Selgin for this point.
 In a study of 18 OECD countries from 1920 to 2011, Bordo and Landon-Lane (2013) found that "'loose' monetary policy—that is, having an interest rate below the target rate or having a growth rate of money above the target growth rate—does positively impact asset prices and this correspondence is heightened during periods when asset prices grew quickly and then subsequently suffered a significant correction."
 For a detailed analysis of the pre- and post-crisis operating system, see Selgin (2018): Floored! How a Misguided Fed Experiment Deepened and Prolonged the Great Recession.